20 July 2011

Definition of a bubble (part 2)

In Definition of a bubble (part 1), I aimed to prove that high house prices during a bubble are not caused (or justified) by any of the ‘fundamental’ reasons claimed by spruikers. 

The question then arose: if it wasn’t fundamentals, what did cause the over-valuation in Aussie house prices?

Going back to economics 101, you learn that when the price of something goes up, all other things being equal, the demand for it comes down. For example, when the price of petrol rises, public transport becomes a more attractive option. This reduces the demand for petrol, which puts downward pressure on price. 

However, in a property bubble (or any bubble), something extraordinary happens.  When the price goes up, demand also goes up, further increasing prices, and demand, and so on.  It works in a seemingly never-ending feedback loop.

To put it another way, during a bubble, prices rise simply because … prices are rising! 

But if demand falls when the price of petrol goes up, why does demand increase when the price of houses goes up? 

These are the some of the factors that create the positive feedback loop, and therefore create the bubble:

As property prices rise, investors speculate on further rises.  For speculators, it doesn’t matter if the rental return on their investment is less than they can get if their money was in a bank earning interest.  It doesn’t even matter that, after expenses, there is a monthly loss. 

It’s the Greater Fool theory: it doesn’t matter how much you pay for something, because you know a greater fool will pay an even higher amount when you are ready to sell.  So rising prices encourage speculators into the market who bid up the price on properties, encouraging even more speculation.

While speculators are driven by greed during a bubble, first-home buyers are driven by the fear of being priced out of the market and missing out on home ownership forever.

During a bubble, first-home buyers notice that they are unable to save money as fast as house prices are rising, so they bring forward their decision to buy. 

The fear of missing out also means many first-home buyers extend themselves and pay more than they would normally be willing to pay, further bidding up the price at auctions. 

Incorrect forecasts
The emotions of fear and greed are compounded by people’s tendency to incorrectly forecast the future.  Markets move in cycles; however, people have a tendency to forecast in straight lines. So while prices are going up, it’s very hard to imagine them ever falling.

This leads to irrational thinking like “property always goes up” and “house prices double every 7-10 years” which results in people feeling more comfortable about paying ever-increasing amounts for the same thing.

Rising equity
As the value of property goes up, investors and home owners can borrow against their rising equity to help buy a second property, then a third, and so on.  This perpetuates the increased demand / rising prices cycle. 

Strong economy
During a property bubble, the broader economy gets a huge boost as demand increases for construction, furniture and other property-related products and services.  

Indirectly, the economy benefits because of the wealth effect.  People feel richer (as the value of their houses goes up) and they then spend more on other things.  This extra demand results in more employment, which enables more people to borrow to get into the property market.

Because wages cannot keep up with house prices, a property bubble must be fuelled by debt. Banks have played a major part in supporting and encouraging the bubble by constantly reducing deposit requirements. 

Economist Steve Keen recently used this example:  Say you walked into the bank thirty years ago with $30,000 saved. They required a 30% deposit, so they would lend you $70,000 and you would have a total of $100,000 to bid on a house.

These days, the deposit that banks demand can be as low as 3%. So, if you walk into the bank with the same $30,000 today, the bank will loan you $970,000 – and you’d have $1,000,000 to bid on a house!

During a bubble, people who have already entered the property market will be buying and selling their homes in the same market, so sky-rocketing house prices don’t affect them too badly. But housing affordability becomes a major issue for potential first home owners, who haven’t as yet participated in the boom. 

The government’s solution to this was to increase the first home owner’s grant.  First home-owners took their $15,000 grant to the bank and, thanks to the power of leverage, used it to borrow an extra say $75,000, which went straight onto the sale price.  The seller then took the extra $75,000 to the bank and was able to borrow an additional $300,000 for their next home, and so on. 

The first home owner’s grant, therefore, dramatically pushed up prices throughout the housing-market ladder and ultimately harmed the very people it was supposed to help (as government tends to do so well).

Other vested interests
Of course, there are other entities with a vested interest in propping up property prices, not the least of which is the media, who are in a powerful position to do so. Newspapers make more money from advertising when the property market is booming, so it is in their interests to report a positive spin on the situation. 

Also, headlines such as “White hot property market” and “See how much your suburb has risen” go a long way to selling more newspapers and further stoke the emotions of fear and greed for anyone sitting on the property sidelines.

So if higher prices leads to more demand, which feeds into higher prices, what’s to say this cycle can’t continue indefinitely?

I’ll attempt to answer that next time.  In the meantime, do you agree with the above points? Can think of any other factors that have contributed to the bubble? Please comment below.



  1. I'll add another factor, which I think is important: inter-generational brain-washing. This is where mum and dad "encourage" their little dears to buy a house, as renting is "dead money" and "look what this house is worth now, and to think that it cost us only $20,000 to buy it!".

  2. foreign investors are a major part of this bubble that is often overlooked...

  3. I agree with your points. Other factors? Aus property is also being pushed up by high immigration rates, a taxation bias towards home ownership and banking deregulation from the 1980s. And don't underestimate peer pressure. I get lectured all the time by friends and family about the gazillions of dollars everyone is making on their properties.

  4. Its interesting reading a site like this as someone from the US: AU is going through the exact same thing we in the US went through a few years ago. I expect it will end the same way as well.

  5. Hi Simon - I tend to think that your first 3 points are ‘fundamental’ reasons that may actually justify some of the increase in house prices that we’ve seen. But I don’t think they create a feedback loop that has led to bubble prices.

    For example, high immigration does increase demand and push up house prices. But I don’t think that higher prices then feeds back into higher immigration (probably the opposite).

    I do, however, agree with your last point – that peer pressure contributes to the increased demand / increased price cycle.

  6. Hi Andy,

    From the ""Lucky to the "Schmuky" country....the banker induced speculative money pyramid casino has infected Australia.

    Great post....I don't think you left anything out. The underwriters and the banks are most to blame. The point you made about using newfound "equity" to purchase ever more property is right on the mark...dominoes on the way up...and dominoes on the way down. Banks use this same methodology to report their health or reserves. This is going to end badly....take it from a Californian now living in Melbourne...I laugh at the real estate advertising signs:

    "Don't Gamble" billboard near the casino

    "Money Machine" near the racecourse

    "The future looks bright!" sign on a plain Jane home in my neighbourhood for sale

    The radio advertisement where women in conversation discuss how their husbands are safe and boring so they only invest in real estate.

    The list goes on and on....

    These ads are a form of agnotology denying the inevitible here in Australia.

    Sell your holdings before it is too late....and then just wait...because prices WILL collapse....then Australia will again be the "Lucky" country:)



  7. dredmorbius22/7/11 3:03 PM

    Econ 101 primer.

    In non-bubble conditions, when prices rise, ceterus paribus, demand doesn't decrease, but rather, quantity demanded is reduced as it moves down along the demand curve.

    "Supply" and "demand" are treated as functions (usually not specified with a specific mathematical equation though you could attempt to fit a function with a regression analysis), and generally price changes are seen as resulting in a change to one or the other -- supply increasing through increased resources or decreased production costs, leading to a reduced price, and increased quantity demanded (though demand hasn't changed), or a decrease in demand as a result of changing preferences, resulting in reduced prices and (since producers won't produce as much given a lower price) a reduction in quantity demanded.

    A bubble implies a feedback loop in demand, supply, or both.

    The rise in prices is due, in at least part, to an increase in demand, for whatever reason: greater fool theory, liberalized credit terms, promotion, changing tastes, perceptions of further future increases in demand, belief in a new economic peradigm, fraud, collusion, whatever.

    In most cases, it's likely that the initial price increase is largely due to changes in demand, which then feed on themselves.

    Signs of bubbles vary, and there's a pretty extensive literature, specific examples of which generally illustrate one or more of the above causes (the East India Company, the Tulip bubble, the 1920s Florida land boom, the 1929 stock market, the Hunt brothers attempts to corner the silver market, the first dot-com bubble, the housing bubble, ... But if you see a self-reinforcing change in demenad particularly in the presence of one or more of these factors, you're well and good to suspect a bubble.

  8. Along the same thread as the media hype under "other vested interests", the property renovation and auction programs being the current favorite of television networks has encoraged many into this property renovation and speculation mentality.

    I imagine most "dud" auction results end up on the cutting room floor whilst the positive results make the program.

    Good TV is only "colour and movement" and the truth should never get in the way of a good story.

  9. Andy,

    You left out rent. Under your assumptions, I assume that rent will fall as more empty homes come onto the market.

    If people start to share accomodation as prices rise, that seems a logical conclusion - yes?

    What is your rent forecast then? Because if you expect rents to rise it puts a hole into your thesis.

  10. Hi PF,

    I’m not sure I follow your question. Are you asking what I think happens to rents while the bubble is inflating or bursting?

    And if I think rents would rise, why would that put a hole in my thesis?

  11. Andy is right with the rents... I had been increasing the rents on my IPs by 5%-6% pa, but over the last year or so I have been increasing rents at the steeper pace of 6%-8% pa with always plenty of applicants.

    With the current housing shortage I see that rate of increase being maintained over the next few years as at least!!

  12. Peter Fraser26/7/11 9:22 AM

    Because Andy, if rent returns fall that pushes down the value of a property, and vice versa.

    When most people buy they compare the home loan repayments to their rental cost, so it becomes a consideration.

    That doesn't negate your points, but it is a point that you don't seem to have given due consideration to.

    For what it is worth, I expect prices in Victoria to fall a bit more, much the same for NSW, but Qld and WA should stabilise soon. We'll have to wait and see though.

  13. PF – it’s true I haven’t given much consideration to rents. But that’s because I think rental returns play an insignificant role in a bubble. In fact, it’s almost a pre-requisite of a bubble that investment income is ignored and the focus is on the asset’s price movement.

    As the bubble bursts, I think two things will happen that will put downward pressure on rents. One – the housing shortage will become a massive housing surplus. Two - the economy will be dragged down with house prices.

    I’m not sure if rents will actually fall by much, but I doubt they will rise by more than inflation, as Anonymous suggests.

  14. Peter Fraser2/8/11 11:08 AM

    Andy - it's complex. It's a mix of prices, interest rates, rental returns, wage levels, consumer confidence, employment levels, demand vs stock available, and much more.

    I don't think that just looking at a couple of features really gives you the overall picture, and no equation will do it either.

    We will never see a prolonged housing run up again in our life times, but you will see booms again.

  15. Hi Andy,
    Well thought out articles.
    I really agree with the point of the first home buyers grant and stamp duty exemptions giving buyers more in their pocket and pushing up prices. The first home buyers grant was affective in july 2000 for about 4 weeks, since then its made it harder for first home buyers (or missed timed mugs like me who sold my home in 2005 and have been renting since. In cronulla where i live homes need to reduce by about 30% to go back to 2005 levels-I'm hoping they do)

    It is such a waste of money that this nearly bankrupt government is helping people buy personal property. This encouragement to buy could really persuade people to overstretch and if they default , the fed. govt. bears some of the responsibility. It happend in the early 80s-Can't remember the scheme, but people got burnt....

  16. Another issue that wasn't mentioned that is a factor in the demand side of the equation. In 1970 the majority of households were 1 income, whereas now the majority are 2 incomes. Prices are compared to incomes, eg. prices are 8 times average wages compared to long term average of 4 times. The difference is there are 2 average wages in some households.

    Limited commodities like land are valued by home much people are prepared to pay. So if a household has 2 incomes they can afford to spend more.

    On the supply side of the equation, developers build less if there is less prospects for return. I saw yesterday that building approvals were down by 8% last month to a 5 year low. You would think this would result in less supply. I know its not good for the building industry but its funny how financial commentaters treat this aspect as being bad for the property industry.

    Am I missing something?

  17. Hi Andy, which state are you in?

  18. Hi justin, I'm in Victoria.

  19. Hi Andy, i am from vic also (Essendon). I have noticed local sales are struggling a bit and reckon you are right about a few things. What suburb are you from?

  20. justin, I'm in the south-east suburbs of Melbourne. What do you think I'm right (and wrong) about?


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