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sumner's in a post bubble

When you first made this point, my reaction was the same as Rogue's: this insight deserves a post of its own.

I'm now ashamed that this idea hadn't occurred to me before. Well done!

While interest rates do affect the fundamental value of the asset, is it not possible that they affect the value (& perhaps more importantly affordability) of the asset by less than people believe they do? This is how I would describe house prices right now, based on the reactions of the people I see around me: (a) as non-economists, we have very little sense of how "valuable" the asset is; (b) we just know that rates are low now, and will not be low in future; so (c), we want to buy now, and because others do as well, excess demand leads to an unrealistically large increase in prices, to the benefit of the seller. I don't know if that qualifies as a bubble - I'm utterly unqualified in this area - but it seems to me, here in Toronto, that people are buying houses who shouldn't be, and paying more than I think they'd be willing to pay if they didn't feel that current interest rates are a use-it-or-lose-it once-in-a-lifetime deal.

nice post. It is better to be conservative in pricking bubbles. I think it is worse to selectively prick bubbles. Then do all bubbles have same outcome? So there has to be a bubble policy.

I think there needs to be more analysis on this. At least a ideation or debate.

"all we are really saying is that we can't think of any plausible fundamental explanation of the time-path of prices"

This seems unnecessarily vague. I see a bubble as occurring when the negative feedback of higher prices = lower demand is replaced by the positive feedback of higher prices = higher demand. With a bit more clarity on the definition, we can see that an asset bubble is a psychological phenomenon.

The belief in rising prices is self-reinforcing until either the psychology changes or, more likely, the bubble simply runs out of fuel (new money) to sustain itself. A bubble which is deflating because it ran out of fuel can be reignited by the provision of more fuel, provided that the additional fuel arrives in time to prevent the psychology from changing.* It's not that lower interest rates make housing more valuable, it's that they allow people to borrow (banks to print) more money to buy houses.

The NASDAQ took a sharp drop in 1998, and it took almost a year before it regained it's early 1998 peak, but to argue that this means there was no tech bubble because we use the word 'bubble' to describe this economic phenomenon and, in the real world, physical bubbles can only pop, not shrink and then re-grow even bigger doesn't seem like a particularly convincing argument to me. Unless the point is simply that the word bubble isn't a perfect analogy in which case, point taken, I guess.

* If you want to be convinced that the psychology hasn't changed, just visit Vancouver and ask people on the street about real estate, I suspect it will go something like the following:

NR: What's the best asset to invest in?

Man on the street (MotT): Real Estate

NR: Why?

MotT: Because real estate always goes up.

NR: What makes you say that?

MotT: My friend bought a place a few years ago and now it's worth triple what he paid. He makes more money from owning his house then he does from his job.

NR: You're not worried that there is a housing bubble?

MotT: You can have a bubble in stocks, because stock prices go up and down, but you can't have a bubble in housing because housing always goes up.

NR: But what about last year when prices were falling?

MotT: That was a great buying opportunity!

NR: Well, good luck

MOTT: You know, if you don't own a house and can afford to buy a house you should really buy one as soon as possible before you are priced out forever...

Would you care to take on (in a later post) the importance of the ballooning balance sheet at the CMHC and the role this is having on prices?

The effect of interest rates on the fundamental value is important, but so is the amount of credit extended at these rates, the downpayment, the fact that banks no longer hold the loans they originate.

Furthermore the psychological, or 'mania' like elements of a bubble should probably be more important than whether or not it reinflates once pricked or not. Unfortunately, economics has little to say about this. Since the Canadian way of thinking is that things are fundamentally different vis a vis the US, I see no reason to interpret the dip and subsequent in prices last year as signs that housing in Canada is more-or-less frothy. Especially so long as consumer credit (mostly mortgages) grew by 14% from April 08 to Oct 09.

"How do you know if something was a bubble? If you prick it and it bursts, it probably was a bubble. If you prick it and it goes back to the original size, it probably wasn't."

Wisdom! :) So much for the idea that regulators need to be supersentient to detect bubbles.

"We can (at least in principle) decompose the price of any asset into a fundamental component and a bubble component. The fundamental component evolves over time according to the expected present value of the dividends, rents, or whatever other benefit holding the asset indefinitely would yield the owner. And the bubble component must be expected to grow (or decline, if a negative bubble) exponentially at the rate of interest."

Does that last statement hold true for the bubbles that appear in experiments?

"In the US, with non-recourse mortgages, there is no problem in explaining why buyers would pay very high prices for houses. Get a 100% mortgage: if prices go up you win; if prices go down the bet's off, because you walk away from the house and mortgage. Panglossian expectations are rational with that payoff function. The puzzle there is why anyone would lend them the money, not why they borrowed it to pay very high prices. If there was a bubble, it was a lenders' bubble, not a house buyers' bubble."

How about a brokers' bubble? As long as the risk could be passed on, why not generate as many mortgages as possible?

This is not scientific, but I suspect that con men can smell a bubble. Easy money. ;)

I agree. A bubble strongly resembles a ponzi scheme and though it need not have a con man behind it, it certainly does attract them. Often what bursts it is not a loss of belief but a lack of new entrants. One of the difficulties for US housing is that much lending was at short rates, so while long rates are lower, they are still much higher than they were now that short lending no longer exists, and jumbos are next to nonexistent. I wouldn't blame non-recourse much as that should have made lenders more diligent; no doc, stated income, qualification on below market rates, securitization, ratings agencies, and insurers like AIG were much more serious.

"In the US, with non-recourse mortgages, there is no problem in explaining why buyers would pay very high prices for houses. Get a 100% mortgage: if prices go up you win; if prices go down the bet's off, because you walk away from the house and mortgage."

I would guess that most buyers of a home with a mortgage had no idea whether the mortgage was recourse or not.

Looking around the world, I see some asset prices in some countries have gone down and stayed down. But other asset prices in other countries have gone down, then bounced back up again. US vs Canadian houses are just one example. They can't all have been bubbles.

lol, you have a lot to learn about markets. Among other things: inventory, demand scheduling, and supply's susceptibility to control. Perhaps you are better off as an english major pondering metaphorical explanations for what is a bubble.

Sorry to be dry, but on recourse vs non-recourse and Canada vs US.

Non-recourse lending is not prevalent across the entire US. It is a state-by-state thing. A large chunk of the US is characterized by recourse lending or something close to it, including the states of NY, TX, Massachussets, and Florida, whereas Arizona and California are considered non-recourse states. See this paper for classifications: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1432437

There were price bubbles in recourse states like FL, although the above paper notes that "empirically, we …find that, at the mean value of the default option at the time of default, the probability of default is 20% higher in non-recourse states than in recourse states." So the distinction between recourse/non-recourse is important, people don't walk away in recourse states.

The paper also finds, significantly, that the lower default rate in recourse states is cancelled out when the lender was Ginnie Mae, Fannie Mae, or Freddie Mac. In other words, the intrusion of government into mortgage lending entirely cancelled out the perceived or actual disciplinary effect of recourse.

Which brings us to what Nick has missed out in his discussion of bubbles - the influence of large government lending/buying agencies such as the US GSEs, and in Canada the CHT and IMPP, in short circuiting adopted market discipline and influencing bubbles. Who cares if Canadian loans are recourse if, as in the US, the ever growing component of loans held by the government are not credibly enforced as recouse and/or believed by the borrowing public to be recourse?

JP, I think you give too much weight to the value of government programs supporting a bubble post-pop.

By 2007, at the very least mid-2008, many had reached the conclusion that the Canadian housing market was a bubble and due for a popping. Subsequently we suffered a severe recession, a huge shock to confidence and ngdp, and the housing market saw a sharp dip.

The recovery, as you note, aided by low interest rates and government support, saw the housing market recover and then roar back in Canada. More drastic support measures were taken in the U.S., no recovery.

If housing was truly a bubble, I would argue that no government support short of the most incredible, Herculean program would prop up the market back to the pre-pop peak. Whether government policies are supporting the housing market during what would otherwise be a cyclical downturn is a completely different question than whether a bubble is inflating.

I suspect when activity moderates next year and prices come down a couple of ppts, a lot of bubbleheads will be saying "I told you so" while most people were expecting a market moderation due to many explicable factors such as rising interest rates, removal of the Reno Tax Credit and the HST in some provinces. Contrary to my experience with most bubbles, I think few people think Canadian prices will keep rising next year.

Nick said: "Now some might argue that the Bank of Canada's low interest rates have re-inflated the bubble. But if the metaphor "bubble" means anything, it means you can't just re-inflate it after it's burst. It's supposed to be unstable."

This statement seems to absolve the Bank of Canada, Fed, in causing bubbles. Implication here is that their policy actions cannot create a ‘bubble’ because it is primarily caused by people who believe in an asset’s continued price appreciation. Is this correct?

Nick said: “Maybe you could argue that there was a bubble in Canadian house prices; that bubble has now popped; but the fall in long term interest rates has raised the fundamental value by enough to compensate for the popped bubble; so the net effect on prices is about zero. But higher unemployment, and lower expected growth in real incomes, should have reduced the fundamental value of houses, and may well have offset any effect from lower interest rates”

Implication here is that lowered rates are a central bank’s policy to offset lower incomes, and an offset to owners for the lowered nominal prices. So you’re saying there is an inevitability to the lowered rates? No central bank blowing bubbles?

Nick, Great post, and thanks for the plug. Question: Is it true that Canadians without mortgage insurance must put at least 20% down? That would surely reduce some of the problems we saw in America.

I was going to make the same comment as Declan. In the stock market prices follow a zigzag pattern on the both upswings and the crashes, so a temporary downturn would not necessary indicate that a bubble wasn't building. And sudden drops almost never seem explicable on the basis of fundamentals, hence they are called "corrections" even if they are in fact due to fundamentals.

My view is that bubble theories will never be accepted, and will never be defeated. This is because believing in bubbles is essentially that same as believing "I am smarter than the market consensus." There will always be people who think they are smarter than the market consensus, and there will always be people skeptical of the ability of others to be smarter than the market consensus. I also like your unidentified flying prices metaphor. When faced with a ufo some people say "I saw a flying saucer from alpha centauri," while others say "I saw something I can't identify." When faced with an ufp, Shiller says "I see an overvalued market" and I say "I see a market price that I cannot explain."

I wonder what someone like Krugman or Shiller would say about the Canadian price graph. They claimed they knew America had a bubble when our prices rose much faster than incomes/rents, etc. Would he have said the same thing about the Canadian market? If not, why not? And if Canada is not a bubble (and I suspect you are right that it is not) then, ex ante, how could Americans be expected to know that our market would behave differently from the Canadian market? I also read that Australia was thought to have a bubble (by The Economist) but did not.

Using http://blogs.reuters.com/felix-salmon/2010/01/12/house-price-chart-of-the-day/
and selecting prices against average income, Canada is still 10% below where it was in 1990. The US increased 20% in value, Britain 40%, and New Zealand 100%, while Japan lost 60% of its value. It doesn't appear there was much if any bubble in Canada but what was going on in New Zealand? Australia's higher inflation may explain why it hasn't declined. Identifying a bubble where there are fundamentals to compare it to is may be possible, but what of many markets that have no fundamental value? Gold isn't really anything other than a speculation.

I hope there's no housing bubble because I just borrowed over $100,000 to double the size of my house.

Scott, Shiller has made occasional comments on the Canadian market, see here for example, generally he views(viewed) western Canada as being in bubbly territory (he once called Vancouver the 'bubbliest city in the world') but is more equivocal on central Canada. Of course, I agree with Shiller, so I don't see that as a counter-argument against identifying bubbles.

Also, I know you asked Nick, but since I'm already commenting, yes, you need to put 20% down to avoid needing to acquire mortgage insurance - it used to be 25% up until 2007. This rule hasn't prevented some extreme price swings in the past, a bubble in the late 80's in Central Canada, and in the early 80's in Western Canada, although it certainly limits the financial fallout from the price swings.

Finally, since JP has already started the dryness on recourse vs. non-recourse, I'll point out that although Canada is generally a 'recourse' market, it's worth noting that mortgages in Alberta and most mortgages in Saskatchewan are non-recourse (except the CMHC ones, which are the risky ones anyway)

Let's talk about the biggest bubble of them all, the currency denominated debt one since about 1980.

How should a currency denominated debt bubble that has been manifesting itself as asset bubbles because of an imbalanced economy be burst?

I probably can't find the link, but I believe geekspeak (greenspan) has said asset bubbles tend not to form with interest rates above 5%. That is actually one of the FEW things we might agree on.

So, if an economy is getting asset bubbles with interest rates below 5%, are interest rates too low?

Let's assume some entity (or group) is smart enough to believe that low interest rates feed asset bubbles thru financial speculation with cheap debt and moral enough to NOT want to enrich themselves and to empower themselves and their rich banking friends/economic friends (wealth/income inequality). That means NOT the fed, NOT other central bankers, and NOT most economists.

So if price deflation or near price deflation occurs and this entity does NOT want to lower interest rates to prevent price deflation, what should be done?

In other words, how should an economy be price inflated without lowering interest rates and better yet be price inflated while causing interest rates to go up?

given that we can't predict bubbles

This whole post hinges round that statement. But what about those who did call it a bubble before it popped? What about those that also predicted the dot com bubble? Did they just get lucky?

Too Much Fed:

I believe geekspeak (greenspan) has said asset bubbles tend not to form with interest rates above 5%. That is actually one of the FEW things we might agree on

Why not? Borrowing and lending are just too sides of the same coin. High borrowing costs mean attractive lending conditions.

Finally catching up on comments:

Thanks Stephen! And thanks too Rogue, for the encouragement.

Nick R: (And your name sure confused me!) One of the things that has always puzzled me is the idea (to which you refer) that 'we had better buy a house now, while interest rates are low, because they won't stay this low for long'. If you borrow (say) on a 1 year term, then you are going to have to renew your mortgage next year at higher rates. Don't they think about this? And if you borrow (say) on a 30 year term, so you don't need to renew, then 30-year rates should already reflect the market's expectation of future interest rates. So, I don't get it.

I remember someone saying to me: "so, if it's generally expected that interest rates will start rising 6 months from now, I should stick to a variable rate for the next 6 months, then lock in to a fixed rate just before interest rates start to rise?" It's just so damned hard to explain that if interest rates do what everybody expects them to do, and if the pure expectations hypothesis of the term structure of interest rates is correct, there's no gain either way. Long rates will start rising before the date at which everyone expects short rates to rise.

Rahul: Thanks! One thing that worried me, after I had written this post, is "what does it take to prick a bubble?" I don't know the answer to that question. All I can say is that if what happened over Winter and Spring 2009 wasn't enough to prick a bubble, then what the hell would be enough? I remember being downright scared, since Fall 2008, and I think anyone else would be too, unless they were living in some sort of....er....bubble.

Declan: yes, underlying a bubble must be some sort of positive feedback mechanism where rising prices create expectations of further rising prices, and this positive feedback mechanism must be strong enough to be self-sustaining. But unless we have a theory that tells us more than this about the psychology of those expectations, we cannot distinguish a bubble from people having optimistic expectations about the fundamentals themselves. For example, if people believe Vancouver house prices will rise because there will be massive future migration into Vancouver, that is not a bubble. Even if we think their beliefs about immigration will turn out to be wrong, it is nevertheless a belief about fundamentals, not a bubble.

I loved your imaginary conversation. I have a similar conversation with my Mother every week or so, except it's about the price of English farmland, not Vancouver houses. And Mother quite correctly adds :"they're not making it any more". But the very fact that we cannot give an accurate and convincing argument about what the fundamental value of those assets should be (to counter a bubble-blower) is precisely what also makes it so hard to identify a bubble. We just do not really know what Van houses should be worth, because we just don't know how many people will want to live in Van in 10 years time, for example.

Carlos: "Would you care to take on (in a later post) the importance of the ballooning balance sheet at the CMHC and the role this is having on prices?" I would love to, but I have already done a couple of posts on the CMHC in the past, and I reallt just don't know enough about the subject. The best part of my posts was the comments from people who did know more about it than me, but still couldn't really figure it out, though they had a very good constructive argument among themselves.

Min: "Does that last statement hold true for the bubbles that appear in experiments?" good question. I don't know the answer.

"This is not scientific, but I suspect that con men can smell a bubble. Easy money. ;)" I suspect you are right. In general, if I were trying to identify a bubble, I would maybe look at all sorts of other symptoms of mass hysteria, rather than just prices. Look at who the players are. Shoeshine boys giving stock tips, etc. Back in the early 1970's, when a friend's grandmother appeared in a miniskirt, I knew that bubble/fashion was about to burst!

Lord: "A bubble strongly resembles a ponzi scheme and though it need not have a con man behind it, it certainly does attract them. Often what bursts it is not a loss of belief but a lack of new entrants."

That's a very interesting point. I'm going to let that idea brew in my head, and maybe see what I can come up with.

Too much Fed: "I would guess that most buyers of a home with a mortgage had no idea whether the mortgage was recourse or not." I wonder. If true, it would suggest that the non-recourse feature is less important than I thought.

JP and Mark: two very good comments there. I have nothing useful to add.

Rogue: Since we don't really have much in the way of a theory about when bubble start and stop, it is hard to say whether monetary policy (or, more strictly, the need for interest rates to be low) was or was not responsible. There is some possibility that low interest rates make bubbles more likely to form, because very small changes in fundamentals (like expected growth rates) will then have bigger effects on fundamental values, so it becomes harder to tell what the fundamental value of an asset is. And *falling* (as opposed to low) interest rates, by causing rising fundamental values and prices, may sow the seeds of a bubble. But this is so speculative. And (see Stephen's post), the early 1980's, when there did seem to be a house price bubble in Canada, were not a time of especially low interest rates. "Dunno" is the only sensible answer I can give.

Scott: Thanks! Declan has answered your question about 20% downpayments better than I could have done (thanks Declan).

Over and above the drop in Canadian house prices a year ago, the sheer fear that was gripping people *ought* to have burst any bubble, if there was one. Let's put it another way: some people (not you of course) say that central banks should identify and prick bubbles. OK, even assuming they can identify them, what does it take to prick a bubble? If the last 12 months weren't enough to prick a bubble, then god only knows what it would take. And if it takes something bigger than that financial crisis and recession to prick a bubble, so it stays pricked, do we really want to go there?

I strongly disagree with Nick that we need to understand why bubbles happens to be able to define them.

In medicine, most diseases are defined by their symptoms long before we understand their causes.
A four year old kid knows what "rain" is, even if he doesn't have a clue about the water cycle.

There's a bubble when the price of an asset is significantly higher than it's fundamental value for an extended period.
We can disagree about the definition of the fundamental value of a particular asset. Even if we agree on a formula, we can disagree about it's usefulness. But the definition of Bubble still hold.

By the way, "rain" is real and easy to define even for someone who can't predict it or can't take advantage of it.

And naming them "Bubbles" is just a convention. Everybody know that an asset bubble is not the same thing than a soap bubble, including the fact that they doesn't pop the same way. You could name them "Rockets", some of them having parachutes allowing them to fall gently. Then some smarty pants will observe that asset rockets aren't like real rockets because blah blah ...

Setting aside semantics, I agree with everything Nick said about the housing market.

Alex's post said:

"Too Much Fed:

I believe geekspeak (greenspan) has said asset bubbles tend not to form with interest rates above 5%. That is actually one of the FEW things we might agree on
Why not? Borrowing and lending are just too sides of the same coin. High borrowing costs mean attractive lending conditions."

One reason would be because to earn good returns with currency denominated debt from speculating in financial assets, the nominal return would have to be at least positive 8% (probably higher and not lose "money") and not be very volatile. It seems to me that is pretty hard to do over a long enough period of time (say 1 to 3 years).

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