Housing bubble trouble: separating facts from fiction

Reprinted from academic e-zine The Conversation

In a previous article, I analysed four of the common arguments used by those who deny there is a bubble in Australia’s residential property market. The bubble deniers have employed other explanations for the largest run-up in prices in Australia’s 131 years of land sales records.

Restrictive government regulations

One argument is that restrictive government regulations (RGR) limit the supply of land and timely dwelling construction through zoning controls, development, planning and building laws, driving up housing prices. This idea gained popularity in the US during the property boom, with some economists asserting that it is a substantial factor in creating a bubble.

The major difficulty is that RGR can only affect rent prices and thus the market-efficient price for land. The logic is straightforward: if RGR limits supply with demand holding constant or rising, and property prices increase, then it follows that rents too must rise proportionally as well. If rent and land prices diverge, however, this argument falls flat – as is the present case. Housing prices have experienced a far greater run-up than rents since 1996. Further, markets would have already priced the supply-side distortions into the cost of housing long before the bubble began. There is no change in RGR that could explain the increase in housing prices from 1996, skyrocketing in 2001.

The other case against this argument is that the boom-bust housing cycle has existed for centuries in many countries, far before bureaucrats perfected the art of red tape during the 20th century.

The theoretical and empirical literature provides little help with this topic. Some studies show RGR comprises a large factor, some claim a smaller impact, and others argue it results in no tangible effect, and that correlation is often confused with causation. Even the idea’s leading proponents acknowledge the benefits of RGR could well outweigh the costs.

Arguing that a greater supply of housing could limit skyrocketing prices is similar to saying that the 17th century Dutch bubble driven by tulip mania could have been mitigated if farmers had grew more tulip bulbs. The problem is not on the supply side; rather, debt is used to fuel a pyramid scheme, resulting in a tremendous demand surge that significantly raises prices.

This is not to say that RGR shouldn’t be changed; many aspects need improvement. The case for RGR causing bubble-level pricing, however, is slim to non-existent.

Low inflation and interest rates

Another explanation cited is the structural downturn in inflation and interest rates that began in the late 1990s and continues today. Interest rates peaked in 1990 when the RBA radically increased interest rates to combat inflation, culminating in the recession “we had to have”.

That year, the standard mortgage rate stood at approximately 17% and real interest rates at 11% (nominal rates were higher). Eventually, the rate of inflation fell, and interest rates followed. With cheaper borrowing costs, households could take on greater levels of mortgage and personal debt.

But the decrease in inflation and interest rates can only explain part of the increase in household debt. In 1990, the household debt to disposable income ratio was 46 per cent, rising to almost 160 per cent today. The household debt to GDP ratio jumped from 19 per cent to 86 per cent.

Even as far back as 2004, the RBA noted that the decrease in inflation and interest rates could only explain a doubling of household debt relative to incomes, and probably less. Household debt has more than quadrupled over this period.

If this argument were credible, the 1960s should have prompted an even greater household debt ratio as rates were the lowest on record throughout this decade. This did not occur.

Returns to property

That residential property provides substantial and ongoing returns to investors and owner-occupiers, based on fundamentals, is another argument.

Two types of return tempt house buyers: owning a property valued by the market at a higher price than it was purchased for (capital gain), and increases in the rental income (yield). Property owners hope that they will make a substantial capital gain when they sell, and that rental income can overtake costs over the long run.

Data from the ATO tells an interesting story. On aggregate, net real rental income has resulted in continuing losses starting at $966 million in 2000, and peaking at $8.8 billion in 2008. Rental income has not exceeded interest costs since 2000, let alone met the costs of maintenance, rates, agent fees, and property tax.

No rational investor knowingly purchases an asset that yields a negative return. Investors are sacrificing cash flow to build assets and realise eventual capital gains.

The problem with this state of affairs was explained long ago by the late economist Hyman Minsky, who showed state capitalist economies cyclically generated crises due to the interaction of financial markets with the productive economy. Minsky’s analysis revolved around describing three stages of financing.

Hedge finance: income flows from an asset is sufficient to pay down both principal and interest on the debt financing asset purchases. Prices are based upon fundamentals.

Speculative finance: income flows cover only interest, not principal, requiring debt to be continually rolled over. Asset owners may experience financial stress, but it is not widespread, and fundamentals are in kept largely in check.

The final stage is Ponzi finance: income flows cover neither principal nor interest charges. Owners are completely reliant on escalating sale prices (capital gains) to make a profit and meet the cost of the debt. Prices are completely delinked from fundamentals at this stage, resulting in the dreaded bubble.

The tipping point comes when the household sector is so overloaded with debt there exist no more ‘greater fools’ willing to commit to a lifetime of debt serfdom to purchase property. With few buyers and many sellers, prices stagnate then rapidly fall as assets are unloaded en masse onto the market. With demand falling in the housing sector, coupled to an inevitable increase in unemployment, a vicious deflationary spiral occurs. Economy activity grinds to a halt.

That Australia’s residential property market has resembled the Ponzi stage of financing for the last 11 years is nothing short of astonishing. The market would have collapsed during the GFC in 2008 were it not for another First Home Owner’s boost re-inflating asset prices to a new, higher peak.

Trusting the “experts”

Rational discussion about the state of the property market is fraught. Many outspoken bubble deniers are conflicted by their interests in industry and government. Many – not all – are employed by, consult for, manage, and/or own organisations with a direct interest in maintaining the status quo of an overvalued property (land) market. These institutions are primarily commercial lenders, investment banks, real estate intelligence firms, insurance, real estate agents, Treasury, the RBA, vote-seeking politicians, and the mass media.

Skilled and intelligent specialists, trained in neoclassical economics in leading US institutions, did not see their enormous housing bubble until it burst in front of them with horrendous consequences. What makes Australia’s “experts” any more competent?

As investor Jeremy Grantham has noted: “Bubbles have quite a few things in common but housing bubbles have a spectacular thing in common, and that is every one of them is considered unique and different.”


  1. Yendis27-01-2012

    A very good article. Would it be that all financial interest was examined in such a manner.

  2. aushousingcrash27-01-2012

    As predicted by Michael Hudson, Oz FIRE sector in trouble as housing crash underway. http://www.smartcompany.com.au/cashflow/2012-01-25-finance-insurance-real-estate-lead-increase-in-delinquent-payments-db.html

  3. Adrian B30-01-2012

    A very interesting and informative article thanks Philip. It is staggering that losses to the Treasury have increased 8-fold between 2000 and 2008. Why is this sort of statistic not mentioned in the mainstream press and why don’t journalists give polititians a hard time over this kind of taxpayer subsidy? I think most of us who read this site and Money Morning Australia know the answer – powerful vested interests. Among some people I know you are nothing unless you own an investment property. I’ve been renting for many years and have thought even since 2003 that residential property was overpriced and did not buy because I was afraid of a severe correction. But since then prices have easily doubled and I now simply can’t afford to get in to anything reasonable. I’d rather rent and live in something decent. But I’ve stopped worrying – when I do buy in 10 years time I’m almost certain that prices won’t have risen much from today’s levels even in nominal terms as people’s capacity to pay has reached it’s absolute limits. I don’t think there will be a sudden and disruptive correction – instead I suspect that as long as demand for, and prices of our commodity exports remain stable, prices will remain steady until average wages are more in line with capacity to pay. I this will be a long-term, ongoing, and painful correction for many. As for myself I will keep buying shares while they’re cheap. Thanks again for a great article.

  4. John Salamon06-02-2012

    No-one in government or real estate/finance want’s property to fall. Land Tax, Council Rates, Real Estate Commissions, Mortgage Insurers, even the Federal Government are in the business of spruiking house prices via the Housing Affordability Scheme which does nothing to make homes more affordable rather than attract more speculation. It should be called the Real Estate Shyster Scheme as its not designed to help blue collar workers into a home but investors into property as land tax does not apply to a property that IS YOUR HOME!

    Don’t trust the government nor real estate agents, both will screw you!

  5. David Collyer07-02-2012
  6. Kallie Meiring19-02-2012

    Thanks for the informative article Philip. It is like a breath of fresh air to read well a balanced opinion regarding property. It appears that government does not care about the wellbeing of their citizens, otherwise they would put policy in place to prevent bubbles of all kinds. I have listed a number of items that I would like to see implemented.
    1. Phase negative gearing out. It is an unfair systems that transfer tax payments from one group of people to another. Without it, taxes can be lowered to give government the same net receipts.
    2. Limit lending from banks to a multiple of rent. The best one I have come across is Steve Keen’s proposition of 20 years of rent.
    3. Government must be responsible for providing accurate and timely information about all aspects on property. Do not leave this function to vested interests. This asumes that government is honest and that is a big assumption of course, but it is hard to see a successful country without a government that has the best interests of all its citizens at heart.
    4. Give children a good financal education at school. It should not be hard to show that interest on a mortgage exceeds the rent that you will earn from a property by anything from 20 to 50%. Therefore it does not make a lot of cinancial sense to buy a property to rent it out.

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