Written by Douglas Ross in Buying on January 2, 2018
A housing bubble is just one example of the various kinds of economic bubbles that can occur in the market. The basic definition of a bubble is when an asset increases dramatically in price so that the price seems unrealistic. ‘Dramatically’ means both in the extent to which the price increases as well as the speed in which it increases. This idea of ‘unrealistic’ is where disagreements begin to occur in discussions over bubbles.
Is there such a thing as a housing bubble?
The idea of a housing bubble or any other kind of economic bubble has always been debated by economists. Some believe that a bubble cannot be separated from the market when trying to think about it as a phenomenon. They believe that the market determines the price, based on supply and demand, and if there is a lot of demand then the price will go up. If not, it goes down. To some economists, there is no reason to think that the price is divorced/separate from the asset.
However, there is a larger consensus on the idea of an economic bubble (whether it be a housing bubble, tech bubble, stock market bubble etc.) being a valid phenomenon.
When flowers were more precious than gold
In 17th century Holland, advancements in the breeding of new varieties of tulips created a number of beautiful variants of the flower. What resulted was one of the most famous economic bubbles of modern times. The price of tulip bulbs accelerated incredibly quickly, to be worth 10-15 times the average salary of a craftsman. What caused this? It wasn’t just that people thought that these new tulip varieties were beautiful. There were a number of particular factors that influenced this bubble.
The bubonic plague had recently hit the Netherlands so there was a heightened emotional factor that impacted the bubble, a human-based factor that is common to a housing bubble or any other kind of economic bubble. Bidding for tulip bulbs also took place predominantly late at night in pubs/taverns where people were influenced by the effects of alcohol, where bidding on tulips became a drinking game, while much of it relied on credit/debt, another fundamental aspect of an economic bubble. The crash of the tulip price was just as quick and dramatic.
What are the signs of a housing bubble?
Since the Global Financial Crisis, a number of countries, including Australia, have seen dramatic rises in property prices. There is no greater example of this than in Melbourne and Sydney.
Housing affordability is often paired with the idea of a housing bubble, but there are a number of factors that influence housing affordability, such as general economic growth in a country, wage growth, energy prices, job growth or decline etc.
However, in 2017 average Sydney house prices averaged 13 times that of average yearly incomes. Anything above 5 is considered to be severely unaffordable.
What fuelled this housing bubble? A construction boom of high density living (apartments) is generally seen as a strong cause of a rise in property prices. In the 2015-16 financial year, 24% of Australia’s GDP growth occurred from just three inner-Sydney districts. This predominantly came down to the construction of new apartment buildings.
There are other reasons for dramatic rises in house prices: strong population growth, offshore demand increase for properties in Sydney and Melbourne, risky lending practices and easy access to credit (such as a large number of interest-only loans), and a lack of financial literacy in new homeowners to name some of the larger influences.
What tells us that Sydney and Melbourne were the epicentre of this housing bubble was the lack of similar performance outside of this inner city areas, especially in cities such as Perth and Darwin.
Some are hesitant to identify housing bubbles as ‘bubbles’ because this implies that there will inevitably be a housing bubble burst, just as there was a sharp fall in tulip prices in the 17th century or a sharp fall in the Japanese stock market in the 1990s after its own growth bubble. Economists are less convinced that property prices in Melbourne and Sydney are as susceptible to a crash in value, but more to a gradual and manageable downturn.
When looking at the housing market in Australia and trying to figure out whether there is a housing bubble or not consider the following:
1. Is there an element of emotional drive behind the rise in house prices? Is there/has there been a rush to enter the property market for fear of missing out, while entering into financial arrangements that do not reflect an individual’s ability to pay off a mortgage (such as a home being worth 13 times more than an average salary)?
2. Has there been easy access to credit? What have the attitudes of lenders been towards offering what you might call risky lending opportunities to investors and new home owners?
3. Has there been a sharp rise in the gradient of house prices?
Has the ratio of investor lending for speculators been commensurate with the rise in prices?
4. Is the rise in house prices specific to particular areas or is it wide-ranging?
5. Are those that drive the economy (teachers, nurses, police officers, admin workers etc.) being priced out of living close to their work?
6. Has there been an extended period of growth that far exceeds historical trends?
The Harvard Economic Complexity Index rates countries according to the complexity of their economy or in other words, how many eggs they have in the one basket. In 2017 Australia was ranked 77th. So it is highly susceptible to changes in the economy, whether they be in the stock market or the housing market.
However, there are arguments for letting the air out of a bubble without it crashing. In 2017, macro prudential regulation techniques by the Australian Prudential Regulation Authority (APRA) were announced in March, aimed at reducing the influence of speculation/investor lending on the housing market. This proved to be successful in reducing the ratio of investor lending within the market and in essence, slowly letting the air out of the tyres.