They Huffed and They Puffed: By Guest Blogger Paul Anglin
Three Stories of House Price Bubbles
Many authorities are raising red flags over house prices in Canada and waving them very energetically: The Economist shows that, compared to history, prices are very high relative to income (implying affordability issues) and very high relative to rents (implying that people are choosing to buy over the alternative). So, are people stupid to buy now?
We should start with some facts: when looking at individual cities, most people are concerned about “excessive prices” only in the Toronto and Vancouver markets and, even then, mostly in the condominium segment. Second, the standard comparisons noted above use history as a benchmark but that history involves a very different level of real and nominal interest rates.
Although some people try to draw attention to the most recent history, I would like to note some distinctions between price paths in three countries which are in the news frequently and often described as having unsustainable bubbles: Canada, United States (before 2007), and China.
First, China: most of the news in English-language media focuses on Beijing and Shanghai. But people from “second tier” cities in China are moving to these “first tier” cities, and people are moving from “third tier” cities and farms to second tier cities. It would be surprising if market prices were not affected by excess demand: if prices did not rise then the media would report on the economic costs using ideas which would be familiar in any introductory textbook. At this point, students in introductory economics classes are reminded that there is an important difference between a change in an aggregate price index and a change in relative price of one good (e.g. housing) relative to another good or service.
In the past year or so, various Chinese governments are imposing policies designed to reduce prices and they are beginning to have an effect, as shown by the evidence at The National Bureau of Statistics of China . As bad as high prices can be, I imagine that these governments are quickly learning the markets have two sides: most of the policies which improve housing “affordability” for a buyer would also reduce the wealth of the current owners. Few of the familiar policies designed to resolve economic issues make everybody happy.
Second, the US: as most people now agree, the demand which raised the prices of houses in the early 2000s was driven by expectations of future prices and by mortgage financing which could not be sustained. We see the evidence of such silliness in the US now but media reports on the Canadian experience are not investigating such issues: most writers are content to point to the easy-to-obtain data on prices alone (in spite of the issues raised above).
Lastly, Canada. In my opinion, the high prices of houses are justified by a bet against the policy of Bank of Canada. And, given that the Bank has said that interest rates will not rise for the near future and are not likely to rise quickly after, it would be “irrational” for a person who has enough wealth and a taste for ownership to not be willing to pay a higher price than in the past.
I leave it to you to use the back of an envelope and a simple mortgage calculator on a big bank’s website to show how a change in interest rates affects the maximum mortgage that can be “afforded”: consider a household with a combined income of $75,000 at a nominal interest rate of 6 percent (2006) or 20 percent (1981) versus the current interest rate of 4 percent (or less). FYI: Many people argue that your monthly payments should not exceed 32 percent of your monthly income.
http://www.tdcanadatrust.com/docs/mortCalc/MortgageCalculator.jsp?locale=en_CA, https://www.rbcroyalbank.com/cgi-bin/mortgage/mpc/start.cgi) http://www.cmhc.ca/en/co/buho/hostst/hostst_002.cfm
So, is the Canadian price bubble going to “pop” soon? If I knew the answer then I would not need to work as a university professor. The three cases noted above imply that you should pay close attention to the comments from the Bank of Canada. If you believe that prices will fall then I suggest that you look for a house so nice that you would like to live in it even if you knew that you would experience a 10 or 25 percent capital loss on its value. Or rent.
Paul Anglin Associate Professor and teaches students in the Real Estate and Housing Major
Tags: Canada, China, Guest blogger, housing bubbles, Paul Anglin, Toronto, United States, Vancouver