In my post “Asset Bubble Microeconomics: a Peculiar Demand and Supply Diagram” I’ve argued that in a housing bubble the demand curve is upward sloping, positioning itself below the supply curve at the boom phase and shifting to the position above the supply curve at the bust phase.
Yet there is always a pre-bubble history of the market functioning “normally”, in a regular mode, with customers buying homes to live in. Investors and speculators exist even in a regular market, of course, but they do not change the nature of the market at this phase. Consumer choice shapes the market, and the demand curve is downward sloping.
The question arises: how does the transformation from a regular market into a housing bubble actually happen?
Do steadily rising home prices necessarily mean a new bubble is already at work?
“Through the roof again?“ asks “The Economist” in June 29th referring to the rising S&P/Case-Shiller index of house prices in the US in 2013. It underscores the specific combination of rising prices and rising sales of new homes (which means that the demand for homes is growing too). The combination, which may look like the beginning of a new boom because at a boom phase quantity demanded and price rise in tandem too. Based on opinions of some business leaders, though, the unknown author of the article comes to the conclusion that so far so good – there is no newborn housing bubble in the US economy as of the middle of 2013 (The Economist, June 29th 2013, page 59).
Let us interpret the issue of possible market transition to a bubble in terms of abstract demand-supply model. In a regular, non-bubble market, as I have mentioned earlier, its demand curve must be downward sloping. In a bubble, it is upward sloping. That means at some point a cardinal shift of the demand curve occurs. There is no hope that the transition could be smooth. It is like an explosion (see my posts “Modeling the US Housing Bubble of the 2000s” and “Asset Bubble Patterns: Japan’s Case”).
It would be interesting to detect this tipping point using some economic indicator. Later in this piece, I will hypothesize on the matter.
I think the demand-supply diagram of the mentioned transition to a bubble may look like this:
The diagram shows how the transformation process unfolds in time. S denotes supply. Suppose the supply curve does not shift in the process. Demand curves D1, D2, D3, D4, and DB belong to 5 consecutive moments of the transformation.
At the beginning, there is no bubble (diagram D1-S).
From this point forward, there are changes in demand. The number of potential buyers of homes increases, perhaps due to improved economic situation in the labor market, cheap credit, lower mortgage rates, and the like.
These changes shift the demand curve to the right, to position D2.
As a result, some shortage of homes emerges (red section at the initial level of the price).
The market is still regular: buyers have no intention to make money out of their purchases. They have a number of choices; therefore, the demand curve is downward sloping.
Being regular, the market gradually eliminates the shortage, going in the direction of the equilibrium point (follow the arrow), and the shortage diminishes. Note that the price and the quantity demanded grow as well.
There is an important qualification, though.
The concept of the market moving towards equilibrium (self-regulating market) is not an absolute. According to an American economist Hyman Minsky (who used the term “coherence” as a proxy for the term “equilibrium”), it is true only if and when market agents believe that the existing prices will hold in the future (Minsky, 2008, pages 116-121).
I think it is possible to somewhat loosen this constraint. In my post “Market Expectations Paradox” I tried to illustrate the possibility of reaching equilibrium point under the condition that the expectations of the future price are “cautious” or moderate.
I am deeply convinced that the issue of expectations of the future price is critical for our understanding of all modes of market dynamics – be it a regular, self-regulating, coordinating the distribution of the resources market, or a wild, inflating the price bubble.
Let us continue to follow the transformations in our market. So far, we are in the self-regulating mode.
The demand curve continues to shift to the right, to position D3. This time around it is the result of emerging speculation (like flipping homes practice) and other forms of activities, aiming to extract additional money out of purchases (like using home as collateral to borrow money). This causes demand to grow. Yet the demand curve gets flatter. The reason is that for the same price the quantity of homes demanded grows due to the moneymaking component of the market. The seeds of a bubble are planted.
Still, the market is not a bubble. It moves gradually to the equilibrium point (follow black arrow), not necessarily reaching it. Meanwhile, the demand curve shifts to position D4, due to increasing activities I mentioned earlier. It becomes even flatter than before, but the trend to the equilibrium holds. The price continues to grow.
At some point, the situation changes dramatically. Perhaps, the volume of speculative and other moneymaking activities reaches a critical point. From this point on there is a bubble, and the demand curve jumps to become the upward sloping line (position DB).
The transformation of the market into a bubble is complete.
To my mind, the volume of moneymaking operations in the market in relation to the volume of other purchases of homes may be the indicator we need to monitor with the goal of detecting its critical value.
As Andrew Haughwout and his coauthors mention (“Flip This House”: Investor Speculation and the Housing Bubble, FRBNY), at the peak of US housing boom the investor share of all purchases reached 30%, it roughly doubled from 2000 to 2006. The authors prove statistically that investor share of the housing market is a substantial factor in the development of 2000-2006 US housing bubble.
As to other traditional indicators, like home price to income ratio, or home price to rent ratio, they may be useful, of course, yet they do not go too far, meaning they do not touch the nerve of the transformation process.
Returning to the title of the article in “The Economist”, its question mark is quite appropriate because growing home prices accompanied by rising home sales as such say nothing about the emergence of a housing bubble. As far as the current US situation (year 2013) is concerned, we would rather start looking at moneymaking deals and their relation to the volume of other operations. As analysts have noticed, the recent growth of home prices is due to massive purchases of foreclosed homes by big investors aiming to resell them with a big profit (flipping homes). Is it the beginning of a new housing bubble? It is possible, but to make an accurate statement we need to know the critical value of the ratio between speculative operations in the market and the regular transactions, which will trigger a housing bubble and radically shift the demand curve from downward sloping to upward sloping kind.
Hyman P. Minsky. Stabilizing an Unstable Economy. McGrawHill, 2008.
“The Economist”. “Through the roof again?”, Print edition, June 29th, 2013.
Mike Whitney. US housing market shifts into reverse: A whirlpool of speculation. http://www.soft.net