Warning about an impending housing bubble or denying that any signs of a bubble can be detected are popular media pastimes in the UK. Bubbles are bad. Bubbles shut people out of the housing market because property is unaffordable. Bubbles store up trouble for those who buy at the height of the market. Bubbles are a sign of a market out of control. Bubbles lead to the demand for government action to avert disaster.
The alternative not-a-bubble view is that increases in house prices – and no one can sensibly deny increases are happening in parts of the country at the moment – are justified on the basis of underlying economic conditions and therefore not necessarily a cause for concern or a trigger for action. Not only that, rising house prices have positive consequences in terms of consumers’ confidence and wealth effects.
Today the Ernst & Young ITEM club produced a special report warning that while there are no signs of a housing bubble in most of the UK there were clear signs that the London housing market is displaying “bubble-like” conditions. E&Y argue that demand for property is:
very high due to a combination of heightened risk elsewhere in the world, low returns on other assets such as bonds, equities and cash, and a weak pound, which has made London properties cheaper for foreigner buyers.
Bubble discussions are a recurrent feature of the media landscape when it comes to commentary on the housing market. Commentators almost invariably frame the discussion in terms of the risk of an imminent bubble. Few, it seems to me, are willing to state emphatically that a bubble is in progress.
The unwary might suppose that for such talk to be meaningful we should have a pretty clear idea what a market bubble is and how to spot one. Then, if there is dispute about whether a bubble is emerging or in progress, it must be something to do with the empirical difficulties – have we got all the right data and the right analytical techniques to identify the characteristics of a bubble?
It might come as a bit of a surprise to find that this isn’t the case.
There is surely a range of alternative empirical methods used to try to identify bubbles, and this in itself opens up room for debate. For example, you could look at the issue from the point of view of price-income ratios and deviation of the ratios from long term trends or you could look at the ratio of the costs of owner-occupation (suitably adjusted) to the costs of renting. These don’t necessarily give you the same answer.
But more fundamentally there is limited agreement over what constitutes a bubble in the first place. Is it simply a ‘rapid’ run up in prices? In which case, how rapid? Is it not just about speed but also about level? A quick rise to a modest level isn’t a bubble. Or is it the other way round? The level is the key – high prices are a bubble – but it doesn’t matter how long it takes to get there. Or is it both? And what about price decreases? Should a bubble only be declared when we have witnessed a rapid rise in prices followed relatively quickly by a rapid fall, as some have suggested? If so then it may be that bubble-spotting can only happen in retrospect.
Underlying all of this is the question of when “high” prices are too high, in a way that is problematic. The standard answer is that high prices may not be problematic when they are justified in terms of economic “fundamentals” – population growth, rates of household formation, increasing household real incomes and declining interest rates. They can also be driven by institutional innovation – deepening mortgage markets allowing households to sustain higher levels of debt off the back of the same income. If fundamentals move in these directions then high prices may be ‘rational’. This makes intuitive sense, but it doesn’t necessarily offer a clear calibration – how far above the levels justified by fundamentals do prices have to get before we start entertaining other explanations?
And, even if they can be justified in terms of economic fundamentals, high house prices in some localities may still be problematic when looked at in broader context – for example, for their negative impact on macroeconomic volatility, investment in productive assets, or inter-regional labour mobility.
The term “irrational exuberance” has come to be associated with the alternative position: that prices have risen above levels justified by fundamentals and are being driven by other factors. Then the bubble-talk starts. The key alternative drivers here are speculative investment, momentum trading or other actions driven by expectations of future price increases. If I think prices are going to continue to rise then I may buy simply in order to take advantage of the expected capital gain or I may change my plans to buy sooner rather than later in order to avoid being shut out of the market. Either way, by acting on those plans I am contributing to making my expectations self-fulfilling.
But invoking these sorts of psychological factors as part of bubble identification increases the complexity of the analytical task. We cannot only look at prices – up/down, fast/slow. We also need to know why this is happening. And to analyse this comprehensively we need to know something about the motivations of those participating in the market. Few economic researchers are happy with this sort of primary research. Case and Shiller produced some path-breaking studies using survey data for the US in the 1980s and 1990s. While they are widely cited, they have been more rarely followed. Much more effort has been directed at demonstrating that what appears at first sight to be a “bubble” can in fact be accounted for by “fundamentals” – suitably specified.
How does this relate to today’s Ernst & Young report? If we define a bubble as associated with an irrational run up in house prices, which takes prices a long way above fundamentals, then we might argue that the factors identified are not necessarily irrational. Therefore it might be wrong to talk in terms of a bubble. We could frame the issue of international buyers, referred to in the quote above, as about portfolio investment, constant risk appetite, interest rate changes, and changing relative prices of substitute investment goods. These factors have shifted the demand curve for housing in London to the right. That is, we could develop an explanation that is largely in terms of the market fundamentals found in the textbooks.
Some researchers have argued for the possibility of “rational bubbles” in asset markets – individual economic agents make decisions that are perfectly sensible and justified in the light of the options and constraints they face, but the aggregate result is excess volatility and a bubble in prices. We might suggest that this is more like the situation we are witnessing in London. Yet, the idea of a rational bubble introduces a further permutation in the definition of a bubble. In so doing the analytical task we face is even further complicated.
Of course, what we would be doing in rationalising London house price increases in this way is subtly, or perhaps not so subtly, redefining the scope and nature of the market we are discussing. It is no longer just about somewhere to live in the London area, it is about a global market for safe assets.
That is an indirect illustration of the point that some of the ways in which we seek to divide up the world for the purposes of analysis – ‘the London housing market’, ‘the global market for financial assets’ – can be somewhat arbitrary. In reality, the demand and supply of particular goods can be characterised by overlapping and contradictory logics.
Even if one were inclined to argue that what is going on is “rational” from a certain perspective and that calling current developments “a bubble” isn’t helpful, that doesn’t mean these developments are unproblematic. The rational actions of the international elite have negative consequences for the accessibility and affordability of housing for everyone else.
E&Y suggest that the Government might want to act more firmly to curb demand for London housing originating from international property investors. That is not an unreasonable suggestion. Greater decoupling of the housing market from the global investment market would inevitably attenuate housing demand and insulate it from the vagaries of the changing map of geopolitical risks. Plenty of countries have policies in place that try to do this. Indeed the UK Government has already taken steps in this direction, although clearly not decisively enough to act as a major disincentive.
The typical response to bubble-talk is to label it scaremongering or to claim that there is nothing to worry about. Often such responses are accompanied by some plausible sounding, but often highly contestable, statistics. We’ve seen that today. Some commentators have pointed out that prices are not currently at or much about their 2007 levels. So that’s ok. But that begs all sorts of questions. Were prices in 2007 – which was the last time they peaked – firmly grounded in fundamentals? If not, and they represented a previous “bubble”, then to say prices today are at or above those levels is hardly a comfort. Indeed it should be a source of grave concern.
But that brings us back to where we started. There isn’t exactly unanimity about how best to interpret what happened to house prices in the run up to the 2007-8 Global Financial Crisis. The fact that, unlike the US, house prices in the UK didn’t decline sharply after 2008 muddies the water even further in terms of diagnosing the episode as a bubble.
So we are left with considerable room for debate. And it is a debate that shows no sign of coming to a conclusion.