Wed, Oct 01, 2003 - Page 9 News List

Is there a bubble in home prices?

Evidence about a housing bubble in the 1980s was compelling, but a recent survey indicates that US homebuyers are not as confident of real-estate prices now as they were before the bubble burst

By Robert Shiller


Around the world, newspapers trumpet a "housing bubble" about to burst. The Economist has run numerous cautionary articles with titles like "Castles in Hot Air." "Housing Prices Soar, Fueling Bubble Fears," chirped The Wall Street Journal. "The Property Bubble Menaces Growth," warned Le Monde. "Homes Bubble May go Toxic," The Sydney Morning Herald admonished.

Are such fears justified? How do we know if the housing market is in a bubble?

The term "bubble" is widely used but rarely defined. A bubble occurs when public expectations for future price increases become exaggerated, pushing prices up to unsustainable levels. When this happens, many people buy homes to rent out as investment properties, and many more who are buying homes to live in also behave like investors, fearing that if they wait, they will be priced out of the market.

During a bubble, buyers are relatively undeterred by high prices because they think that even bigger price increases will compensate them for spending too much. If expectations of rapid and steady future price increases are important motivating factors, then the price level is inherently unstable, because prices cannot rise forever. The bubble will eventually burst and prices will fall.

At least one aspect of a housing bubble is visible: rapid price increases. A surge in home prices has infected almost all advanced countries since 2000, with the exception of Germany and Japan.

But the key question is whether expectations of large future price increases are sustaining the market. If the relationship between average incomes and house prices is stable, then economic fundamentals clearly have the potential to explain prices.

The increase in housing prices during the 1980s is now viewed as the veritable model of a boom cycle turned bust. A pattern of sharp price increases, which peaked around 1990, was followed by declines in cities from Boston and Los Angeles to London, Sydney and Tokyo, contributing to severe regional recessions. Will the current run up in prices be followed by similar, or worse, collapses?

Evidence about a housing bubble in the 1980s was compelling. Buyers were influenced by strong expectations about future price increases, and they perceived little risk.

Responses to a survey that my colleague Karl Case and I conducted in 1988 during the US boom revealed that casual word-of-mouth transmission of emotional excitement played a big role in purchasing decisions. Moreover, there was no agreement among buyers about the causes of recent price movements and no cogent analysis of fundamentals.

Earlier this year, we conducted another survey of US homebuyers who bought between March and August of last year. For the vast majority, investment was either "a major consideration" or at least "in part" a motive for buying. But far fewer homebuyers this year said that they were buying "strictly for investment purposes" than in 1988. Thus, conditions would appear to be consistent with a bubble, though less so than in the 1980s.

The US is hardly alone. In Europe, the average ratio of home prices to incomes is slightly below its long-term average, mainly because housing prices in Germany are at historically low levels by this measure. In France, Italy, and Belgium, the ratio is close to its long-term average, and in Spain, the Netherlands, and Ireland, it is 40 percent to 50 percent above it. Australia, too, is close to the level that preceded previous crashes.

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