The Economist has an excellent survey on the housing bubbles that seem to be appearing in the major industrial economies. Point by point, they take on the conventional wisdom (or maybe it’s no longer conventional wisdom) that the recent real estate boom is insulated from the kinds of speculation that drove the stock market to perilous heights.
Two factors in particular, they argue, are particularly out of proportion. The price/earning ratio, taking the form of price/rents, is steadily rising, now in the U.S. at 16% above historical average. Meanwhile, the price/income ratio, based on median income, is 14% above long-term average, confirming what many homebuyers already know: that owning a home takes more of one’s income than it used to. Individual homebuyers may justify the increased burden of homeownership by saying it is a good investment. But the Economist has a way of reformulating that logic: “The fact that prices are rising much faster than rents suggests that homes are being bought in the expectation of capital appreciation rather than underlying fundamentals. That is the definition of a bubble.”
As an interesting sidenote, one of the myths they tackle is the money illusion of cheap interest rates:
However, the cruder-and more widely used-argument that lower interest rates make homes cheaper to buy is badly flawed, because it ignores inflation. If interest rates are low only because inflation is low, then although initial mortgage payments are smaller, the real burden of mortgage debt will be eroded more slowly over time, and payments will remain high in relation to income for much longer. Lower inflation shifts the profile of payments over the life of a loan-you pay less in the early years and more (in real terms) later on-but the total real cost is the same. Home-buyers who think that low interest rates make buying a house cheaper are suffering money illusion. It is as foolish as thinking that a car loan paid off over five years is cheaper than one paid off over only two years.
Given the difficulty of factoring inflation into daily economic decisions, we should remember this kind of behavior as an exception to economists’ assumptions of rational agents.
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