Wednesday, April 8, 2015

"Over-valued" is the wrong metric about "bubbles"--housing or otherwise.

Thinking about asset price stability is pervaded by incorrect framings. Particularly if folk start throwing around the term "bubble".

Not the fault of the central banks
One incorrect framing is "the central banks did it"; with the finger usually pointed at low interest rates and clams of "easy money" fuelling "bubbles".  Low interest rates are not a sign of "loose money". Judging the stance of monetary policy from interest rates is deeply problematic. In Milton Friedman's words:
Initially, higher monetary growth would reduce short-term interest rates even further. As the economy revives, however, interest rates would start to rise. That is the standard pattern and explains why it is so misleading to judge monetary policy by interest rates. Low interest rates are generally a sign that money has been tight, as in Japan; high interest rates, that money has been easy.
This is hardly surprising, as nominal interest rates include inflationary expectations, so will be higher if inflationary expectations are higher. During the Great Moderation, inflation and interest rates were low: in what world is low inflation a sign of "loose monetary conditions"? To quote Milton Friedman again:
After the U.S. experience during the Great Depression, and after inflation and rising interest rates in the 1970s and disinflation and falling interest rates in the 1980s, I thought the fallacy of identifying tight money with high interest rates and easy money with low interest rates was dead. Apparently, old fallacies never die.
Apparently, they don't. Yes, low real interest rates  combined with strong income expectations will lead to more use of credit, particularly to purchase assets. But central banks have no influence over real interest rates and maintaining strong (or at least stable) income expectations is what they are supposed to do. Failure to do the latter is what led to the Great Depression and the Great Recession.

So, low real interest rates (not the fault of central banks) + strong income expectation (what we want them to do) => more use of credit to purchase assets.

Does that mean we get surges in asset prices?  No, because there is the little thing called the supply side. Prices are a matter of supply AND demand.  If the supply of assets responds to the surges in demand, there are no price effects.

If the assets are slow to construct, you might get some price surges, but they are unlikely to persist once supply catches up with demand. If, however, supply permanently lags demand, then the price surges can persist (as demand is continually outpacing supply). Such as, for example, from land rationing in housing markets blocking supply from catching up to demand. (Remembering that houses are large decaying structures, the enduring asset is the land the house is on.)

About housing and "bubbles"
We live in an age of low real interest rates. The Reserve Bank of Australia (RBA) has been doing an excellent job in maintaining income expectations. (No recession since the early 1990s). All our State and Territory Governments, aided and abetted by many of our local governments, land-ration. We are relatively high immigration country (and we are good at cherry-picking our migrants). Of course our housing prices have surged, and surged, and surged.

So, is it a "housing bubble", allegedly one of the worst seen? The problem is the word "bubble".  By "bubble" people typically mean that (asset) prices surge upwards, then collapse pretty quickly. The problem is that the term bubble has no useful predictive value. If we could reliably predict turning points (of prices) there would be no such "bubbles", because people would generally not purchase at a price that were reliably expected to collapse. So, the entire notion depends on unknown turning points.

The same goes with notions of "overvalued" assets. If that means anything, it means that future prices are expected to be lower. But, if that is a general expectation, they will not reach that price in the first place.

Expectations matter a lot to asset prices, because assets are things which are expected to provide enduring benefits--either as a store of value, or a producer of income, or both--over more than one time period. And we have no information from future time periods, only expectations about them based on already existing information.

Asking the right question
The question which people are fumbling towards asking is the one they should focus on directly: how stable are these prices? How vulnerable are they to new information? That is an excellent question.

In the case of new technology, very vulnerable: because, well, it is new, and thus has large amount of uncertainty (in the Knightian sense of unable to be reliably calculated). Hence new technology is a great generator of asset price instability (pdf), of asset boom and busts. One of the features of the Global Financial Crisis (GFC) was new technology in the finance industry.

If the asset prices are built on strong income expectations, they will be very vulnerable to any sudden fall in income expectations. That is, the central bank screwing up. They will be particularly vulnerable to that if the asset purchasing is highly leveraged.

If the asset prices are built on supply constraints, they will be vulnerable to any sudden removal of said supply constraints.

They will also be vulnerable to any sudden shift in specific demand for that asset not covered above.  For example, in the case of housing, a drop in immigration.

So, does Australia have various housing bubbles? That is the wrong question, focusing on unknowable turning points based on not yet existing information. The correct question is: are Australian house prices vulnerable to sudden downward shifts?

Absolutely: if the RBA screws up income expectations, if there is a major drop in immigration, if State and Territory governments suddenly abolish land rationing--from which they garner a lot of tax revenue plus grateful home-owning and -buying voters while political parties get a lot of funding from developers who (in a land rationing policy regime) simply have to have access to officials to operate their businesses and are willing to pay for it. (Ironically, that it is such a universal practice among our State and Territory governments actually makes its price effects more resilient, as there is unlikely to be negative signalling across markets.)

So, how likely do you think any of them are? Not very I would have thought. Ironically, the most likely is the RBA screwing up; and the most likely scenario for that is that it makes the mistake of paying attention to (via) the "it's your fault!" bubble-manics and does what no central bank should ever do--get into the "bubble-popping" game. Especially as the most likely effect thereof is to make the leveraging problem worse (pdf); potentially much, much worse.

So, do Australian housing prices make much more sense now? Isn't to useful to frame the questions in the right way? Bubble-mania, it will rot your analysis.

[Cross-posted at Skepticlawyer.]


  1. Lorenzo, excellent. Since no one knows what a bubble is, everyone feels "comfortable talking about it. It´s a fad that Greenspan helped establish in 1996 with his "irrational exuberance". As regards the RBA, I recently detected worrisome signs...

    1. Ta :) Like your post, and have added a link from it to my post.

  2. Lorenzo, I think this post well describes the dangers of central banks thinking "bubbles":

    1. Yes :) "They know not what they do".

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