By Philip Soos
As Australian housing prices have boomed over the last decade and a half, there has been much discussion over whether a bubble exists in the residential property market. More recently, the concern is the record-low interest rate of 2.5% may cause a housing bubble.
Conspicuously absent in the debate over the housing bubble within the mass media is a clear definition of what constitutes a bubble. This is not only the fault of the media, as a bubble is often vaguely defined within the academic literature, usually on the basis of “irrational exuberance” or “animal spirits” or chasing capital gains, rather than in terms of specific and measurable metrics.
An outside observer may find this difficult to believe, particularly given the history of regular booms and busts in the land and share markets, as recent events in the US, Ireland and Spain have shown. Mainstream economists typically claim bubbles can only be recognised in hindsight, but not identified beforehand.
Without a concrete definition, it is impossible to find something because one does not know what to look for. It is similar to telling a blind person to choose the blue pill instead of the red. Accordingly, how can a reasonable definition of a bubble be determined?
In search of a definition
One economist did provide a straightforward definition of an asset bubble: Hyman Minsky. He belonged to the post-Keynesian school of economic thought, a heterodox school with an alternative theory of how financial markets and the banking system interacts with assets, typically shares and real estate.
One of the centrepieces of Minsky’s work is the “Financial Instability Hypothesis” (FIH) which argues financial markets are intrinsically chaotic and inefficient, eventually sowing the seeds of their own destruction. According to the FIH, a bubble is defined on the basis of how an asset class is financed.
This is important, as it allows us to assess whether overvaluation exists within any particular asset class, or in this case, real estate. According to Minsky, the state of financing can be described as either hedge, speculative, or Ponzi.
With hedge financing, asset income flows are sufficient to pay down both principal and interest on the debt used to finance the asset purchase, and prices are based upon fundamental or intrinsic value. The second state is speculative finance, where income flows cover only interest repayments but not principal, requiring debt to be continually rolled over from the current time period to the next.
The terminal phase is that of Ponzi finance, as income flows cover neither principal nor interest repayments. This leaves owners completely reliant upon escalating asset values to realise substantial capital gains upon sale to meet the cost of debt and expenses. In the case of real estate, if property investors can’t profit from rental income, then realising capital gains becomes the only avenue.
As investors speculate, the debt used for asset purchases inevitably rises as both the cause and response to price increases, creating a positive feedback loop between prices and debt. Put simply, for the residential property market to meet Minsky’s definition of a bubble, three conditions must be met: increases in real (inflation-adjusted) housing prices and mortgage debt, along with persistent rental income losses.
Three conditions of a bubble
There is evidence to show all three conditions exist. From the trough in 1996 to the apparent peak in 2010, real housing prices increased nationwide by 123%, the mortgage debt to GDP ratio rose from 35% to 87% over the same period, and from 2001 onwards, aggregate rental income could not cover running expenses and interest repayments on aggregate, let alone principal.
(It’s worth pointing out that Australia’s negative gearing policy amplifies aggregate rental income losses by providing an incentive for investors to run their properties at a loss while expecting capital gains. Investors should not be profiting from capital gains but long-term rental income. While it can be argued negative gearing is an unjustified subsidy (tax expenditure), it should be banned on the basis that it amplifies financial instability through helping to create asset bubbles.)
Minsky’s FIH has some predictive power as the data shows all three conditions were met during the late 1980s, as a small residential bubble arose on the back of a colossal commercial real estate bubble. Real housing prices increased by 39% between 1987 and the peak in 1989, before falling 8% by 1991. The mortgage debt to GDP ratio also increased during this period, and aggregate rental income was negative from 1989 to 1992.
There are eight measures of property valuation that show a substantial increase since 1996, collectively peaking in 2010. They are: nominal prices to inflation, mortgage debt to GDP ratio, rental income flows, gross yields (or P/E ratio), price to income ratio, Kavanagh-Putland Index (aggregate property sales to GDP ratio), aggregate land values to GDP ratio, and housing stock value to GDP ratio.
Bubbles don’t exist
There are two primary reasons why definitions of bubbles aren’t used in the mass media and academia. Self-interest is the obvious motivation; Australia’s residential property market has a bubble in prices, creating around $2 trillion in paper (phantom) wealth. This has made the finance, insurance and real estate (FIRE) sector fabulously wealthy, and government at all levels have benefited from rising property taxes.
Mainstream economists don’t like the idea of bubbles because the highly unrealistic theory they teach to promote policies of privatisation, deregulation and liberalisation have resulted in the largest asset bubbles in history, in direct conflict of the allegedly efficient outcomes markets supposedly create. When theory and the real world conflict in economics departments, data are dismissed because it doesn’t fit the models.
The doctrines of conventional economic theory – such as equilibrium, rational expectations and optimising behaviour – are empirically false. Economists’ models of markets are like that of an astronomer who creates an incorrect model of the solar system by excluding the sun and moons. Given the deleterious state of economy theory, it should come as little surprise the economics profession cannot identify colossal asset bubbles right in front of them.
Elite Harvard-MIT-Princeton economists in the US not only missed the obvious dot-com and housing bubbles, but put a significant amount of effort into denying these bubbles existed. On this basis, there is little hope for Australian economists, especially for those who work for government and the FIRE sector.
In the debate over the housing market, it is important for those who have vested and conflicts of interest to avoid using definitions of an asset bubble so as to create confusion regarding this matter. Further, it is difficult to claim the presently low interest rates could risk causing a housing bubble when it is readily apparent one has existed since 2001.