2.3 Housing Bubble Indicator

Even though all bubble episodes have elements in common, each bubble is different in its own way. In this book, we focus on one particular type of asset price bubble: housing bubbles. There are two main reasons for this choice. First, bubbles in house prices are recurrent in different countries and over different periods of time. Second, housing bubbles tend to exacerbate the effects of asset price bubbles on the economic activity, as the bust of the recent housing bubbles illustrates.

We start the book with a formal defnition of asset price bubble. Everyone recognizes a bubble after it has crashed. However, it is not easy to spot a bubble in real time. Chapter 2 defnes the bubble component of an asset as the difference between the price and the fundamental value of the asset. Unfortunately, given the uncertainty around the fundamental value of an asset, there is not a scientifc procedure to be sure that there is a bubble in real time. Nonetheless, we construct a housing bubble indicator to keep track of past episodes and analyze its evolution over time and across countries. We also review in Chapter 2 three of the most famous asset price bubble episodes in history: (i) the Dutch Tulipmania, (ii) the South Sea Bubble and (iii) the Dot-Com Bubble. By reviewing these episodes, we explain that these famous bubble episodes have some elements in common, which can be extrapolated to most asset price bubble episodes. In particular, their boom-bust behavior can be summarized by the title of the seminal work of Kindleberger and Aliber (2005): “Manias, Panics and Crashes”. Bubble episodes begin with a mania. For some reason, investors get excited about the prospects of purchasing an asset. This mania phase is followed by a panic in which a pessimistic sentiment is spread throughout investors. This pessimistic sentiment is transformed into a massive amount of sales orders, which derives into the ensuing crash of the price of the asset.

Once we are familiar with the notion of asset price bubble, Chapter 3 offers two theories on the origin of bubbles. The frst theory is based on behavioral economics. The idea is that some investors start to believe, for some unexplained reason, that the return on the asset will be very high. Actually, higher than what well-informed (rational) investors think. These (too) optimistic investors purchase the asset and push the price above its fundamental value. The second theory offers a “rational” view on the origin of bubbles. According to this view, asset price bubbles are the optimal market response to a shortage of assets. This theory implies that bubbles emerge when the demand

of assets is very high, so that, the return on savings is very low. The bubble increases the supply of assets, thereby solving the shortage of assets problem. Finally, we apply this notion of rational bubble to the particular case of a housing bubble.

One of the most remarkable facts of the world economy in the last two decades is the spread of fnancial globalization. Chapter 4 explains how this globalization process may affect the emergence of asset price bubbles. First, we show how, from a purely accounting identity, the current account of a country is related to the emergence of asset price bubbles. When the bubble emerges in a country, it raises the supply of assets, which reduces the current account of the country. Suggestive empirical evidence is provided on this negative correlation between house prices and the current account for a large sample of countries. Then, we extend the model of rational housing bubbles explained in Chapter 3 to understand the effect of fnancial globalization on the rise of asset price bubbles. In this model, a fnancially developed country would not have rational bubbles in autarky. However, bubbles can arise in this country if it opens up to trade with fnancially underdeveloped economies. Finally, we apply this model to explain the behavior of house prices at the municipality level and the current account defcit in the United States in the mid-2000s.

After providing different theories of the origin of bubbles, Chapter 5 describes its economic consequences. House prices affect the economy both when they are rising and when they are falling. There are two main economic agents affected by changes in house prices: (i) households and (ii) frms. Housing wealth is an important determinant of household consumption. Moreover, households can use the increase in house prices to borrow more against their house. We explain how both effects were present in the United States during the recent housing bubble. This implies that households overborrowed and overconsumed during the housing boom. Similarly, an important component of the collateral of frms is their real estate assets. In theory, fnancially constrained frms can borrow and invest more when the value of their collateral increases. This theory is also confrmed by the data. Thus, the distortion in house prices also resulted in a distortion in investment. Finally, we consider the case of Spain. We discuss how the housing bubble distorted the allocation of capital and credit and reduced the aggregate productivity of the country.

We conclude the book with a discussion on how enhanced regulation could mitigate the emergence of housing bubbles. First, we explain that the supply of credit played a determinant role in the buildup of the recent mortgage debt bubble. Then, we analyze the Spanish bubble to illustrate that a limit on loan-to-value ratios, heralded as a leading macroprudential tool, is not a universal solution. Finally, we describe how the consensus among policymakers on the relevant indicators to assess the vulnerabilities of countries radically changed after the recent fnancial crisis. Indeed, managing the fnancial globalization, which is at the heart of this book, has been given a prominent role.

reference

Kindleberger, C. P., & Aliber, R. (2005). Manias, Panics, and Crashes: A History of Financial Crises (5th ed.). Hoboken: Wiley. ISBN 0-471-46714-6.