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Who’s afraid of the big bad bubble?

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Written by Stefan Kostarelis

With housing prices surging in Sydney and Melbourne and a budget just around the corner, the dreaded “b-word” has been popping in the news a lot recently.

So what is a housing bubble, and are we (well really just Sydney and Melbourne) in one?

The RBA and the Four Big Banks say “No” but if history tells us anything, the bad news is we won’t know until after the thing pops.

Put simply, an economic bubble occurs when the price of something strongly deviates from its value. In other words, a bubble occurs when there is an overinflation of price.

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There have been several great bubbles throughout history.

Perhaps the first happened in the Netherlands when a speculative bubble in tulip bulbs took place from 1634 – 1637. Dubbed “Tulip Mania”, it all began in 1593, when tulips brought from Turkey were introduced to the Dutch.

People were already fond of tulips but when a virus created interesting patterns on the petals, prices went wild.

Everyone began to deal in bulbs, and at the peak in 1637 it was estimated that bulbs were selling for more than 10 times the annual income of a skilled crafts worker.

When some folks decided to sell their tulips and lock in those profits, it began a domino effect and the prices began to dive. Soon everyone was selling and after the dust had settled, people suddenly realised they had traded their homes for flowers. Whoops.

Although hard evidence about Tulip Mania is scant and some economists believe the buyers were acting rationally, it’s a great example of how prices simply can’t go up forever.

Another classic is the South Sea Bubble of the 18th century.

The South Sea Company was a British trading company that was granted special trading rights in the South Seas. Company executives spread rumours about the commercial value of those rights, and in no time the stock was through the roof.

After three years riding high, it crashed in 1721, leaving many broke.

The South Sea Bubble is also notable for duping one of the smartest men in history.

After losing the equivalent of more than $3 million in today’s money, Isaac Newton famously declared: “I can calculate the motions of heavenly bodies, but not the madness of men”.

Then, of course, there is the United States housing bubble of last decade. When it burst, the ripple effects were felt everywhere and the world suffered a global financial crisis.

Despite being huge, the U.S. bubble was again only really identified in hindsight. Yes, there were some who caught what was happening early on, but for the most part, the bubble grew, unnoticed.

The big banks and lenders may have been incompetent, they may have been in denial and they may not have cared. However, when the inevitable correction did happen 2007, we all took notice.

Indeed, economists disagree on how to define a bubble or if they even exist.

Writing for Domain, economics professor Timo Henckel notes that bubbles exist when the price of an asset is over-inflated relative to a benchmark. The problem is, no one can agree on what the benchmark should be.

So how about causes

Like anything, the price of housing is primarily driven by demand. According to Investopedia, there are ten factors that may lead to the creation of a housing bubble. And plenty – if not all – of these sound applicable to the current situation in Australia:

  1. A general upturn in a nation’s prosperity
  2. A new demographic segment entering the market
  3. Low interest rates
  4. Innovative mortgage products
  5. Easy access to cheap money
  6. High-yielding structured mortgage bonds
  7. Potential mispricing by lenders and investors
  8. Mortgage brokers encouraging borrowers to take excessive risks
  9. Borrowers’ generally lacking financial literacy
  10. Speculative behaviour by investors and buyers fueled by unrealistic and unsustainable property appreciation estimates

There’s another less flattering name for the last one on that list: greater fool theory.

This theory states that the price of an object is not determined by its intrinsic value but rather the irrational beliefs and expectations of market participants. In others words, the price of something can be justified provided that can be resold to a “greater fool” later.

And it certainly comes to mind when dilapidated cottages such as this are going for a couple of million in Sydney.

Professor Henckel believes that double-digit increases in house prices combined with unprecedentedly high household debt and household debt servicing ratios make for a precarious situation in the housing market.

Although the pain of the pop varies (for example, the dotcom bubble wasn’t such a big deal), Henckel notes that historically, housing collapses have always led to severe recessions. And to think this time will be any different is pure hubris.

Indeed, we may need to stop and smell the tulips before its too late.