Guest Blogger Blows Bubbles
Why do they use the word “boom” to describe what happens before a price bubble ends?
“Boom” normally refers to a growth period of an economy but it also refers to the kinds of explosions used to destroy buildings. Lots of commentators are concerned that house prices in Canada are too high and cannot do anything but fall (with the subsequence destruction of national income, wealth and of Western Civilization). If true then two questions should be answered but the possible answers illustrate the weaknesses of the comments. The answers indicate ideas which students should think about more carefully.
First question: what can the average homeowner do to profit from a price bubble before it ends? The challenge, as when investing in any other price bubble, is to know when to sell. Being too greedy, and waiting too long, implies that you lose money. A person must have the knowledge to make informed decisions and the ability to act. Textbooks mention a practical issue with this advice but rarely emphasize it: it is not possible for all sellers to sell at the same time if there are no buyers at that time. If something makes a group of investors more likely to sell then they are also less likely to buy. Therefore, if you expect that you will not be able to sell first then that fact increases the cost of the risk associated with the investment, at the time of the initial investment.
An even trickier aspect of a price bubble is that the high price is unstable by definition. Economic analysis normally looks for specific events which cause a price change. In dynamic problems, that trigger can be hard to identify ahead of time. When the situation is also unstable, a change in the animal spirits (to use Keynes’ phrase) is not necessarily connected to any real or specific event.
Another way to profit from a crash is to learn a lesson from the US experience: “short” property stocks in order to profit from the predicted price decline. Globe Investor allows anyone to filter the list of all stocks offers on the Toronto Stock Exchange to choose likely victims by industry (and other criteria). Are the commentators putting their money where their mouths are by advocating such strategies on what, they say, should be a sure thing? Not according to the comments which I have seen in the popular media.
If you want to continue to study Finance, and are interested in the US market, an interesting alternative is represented by the derivative contracts related to the price of housing in various US cities: based on the “Case-Shiller Price Index” Similar contracts do not exist in Canada. (For students new to Economics, the discussion of how to construct a measure of price trends which is independent of changes in “quality” or quantity is an interesting and important puzzle with deep applications from economic theory and data analysis click on “Methodology”.)
Even without applying the full logic of a market equilibrium, every sale must represent the decision of a buyer who is willing (if not happy) to pay the seller’s price. In part, that balance explains why the Greater Fool Theory is so important to explaining the US experience. So, if you believe that prices might pop then I suggest that you look for a house which you would like to live in even if it experienced a 10 or 25 percent capital loss on its value. Or rent now and buy it after the price drops and after the seller who bought a too-big mortgage is forced to sell.
Which leads to the second question: what to do about differences of opinion? If all of these smart people debate whether a price bubble exists, who should you believe? “Reasonable People did Disagree: Optimism and Pessimism about the U.S. Housing Market before the Crash” is the title of an interesting working paper by Kristopher Gerardi, Christopher L. Foote, Paul Willen . They note why it is so hard to find a consensus ahead of time
Perhaps more important for current students scared by your current student debt and the appearance of a future with impossibly high house prices, there is good news in a bubble: all bubbles must end (eventually) because the price is above the long run equilibrium level. So, by the time you have paid off the student loan (at the relatively low interest rates) and built a downpayment, then prices will have crashed below the long run equilibrium level. If it is a true bubble.