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Bubbles, Bubbles Everywhere

I can calculate the motions of the heavenly bodies, but not the madness of people.

— Sir Isaac Newton, 1720, observing the frenzied speculation over The South Sea Company and reflecting on his own enormous losses.[1]

Having seen what a bubble looks like in Canada, we can compare that situation to other bubbles around the world to see how house prices react before and after they burst. We have lots of examples to look at. There are a number of other countries that are still experiencing bubbles such as China, Australia, Belgium, and Norway. There are many more jurisdictions that were in a bubble and now are in the process of correcting the excesses of a past bubble (United States, Ireland, Portugal, Iceland, Japan, and Spain, to name a few).

Bubbles are all different in the details but they are all very similar to each other in a few important ways. When they finally burst, the associated financial and economic difficulties are transmitted through the banking system in a process of unwinding or deflating of the bubble. This process of unwinding can take years or even decades. So it’s not like trying to observe a Higgs boson particle that exists for only a millionth of a second. The events surrounding bubbles and their aftermath unfold in slow motion.

The U.S. Housing Bubble and Its Aftermath

We needn’t look far for examples: the United States experienced both a housing bubble and a crash, all in the past decade. Their housing bubble started to form about the same time as Canada’s, and the two bubbles tracked closely until 2006. As mentioned, Robert Shiller received the 2013 Nobel Prize in economics for his work that involved proving that bubbles in many different forms do exist and cannot be explained by random fluctuations. Of course he completed his work long before the global financial crisis but only received his prize after the U.S. housing bubble burst.

As Shiller shows, real estate bubbles in residential housing are a recent phenomenon.[2] He examined housing markets and pricing trends through history back to 1890 and could not find any examples of nationwide bubbles in house prices other than a surge in home prices in the United States and Canada during the decade immediately after the Second World War.

Land speculation bubbles (not housing bubbles) are common throughout history. Those bubbles were usually identified with a particular event or development, such as a Florida land boom and bust in the 1920s, which left new cities built and abandoned within a few years. Land bubbles were isolated to a specific place. As an example, Shiller cites Chicago from 1877 to 1931, when prices increased much faster than the rate of inflation. That was an isolated bubble related to the arrival of the railway. Winnipeg was a major hub of population growth and land speculation at one time for similar reasons. When the Canadian Pacific Railway reached Calgary, speculators made and lost fortunes on the ensuing land boom.

Widespread individual–family home ownership is a relatively recent development dating from the late 1940s. This evolution in home ownership moved closely with the emergence of a large and growing middle class after the war. Shiller’s database of housing prices only goes back to 1890. No earlier index or long-term record of U.S. home prices exists. Apparently nobody cared enough about a national measure of housing as all booms and busts were local, according to Shiller.

U.S. Real Home Prices Flat for 108 Years

The most remarkable fact from Figure 3.1 [3] is how little growth in home prices, adjusted for inflation, there was from 1890 to 2000. The index (U.S. prices) was at 100 in 1890 and today is at about 130, close enough to a zero increase that we can call it unchanged. The index peaked at 198 in 2006. The recent bubble period started in about 1998, when the index was at 115. This action seems to prove the claim by GMO analysts that all bubbles burst and are fully deflated, although it remains to be seen whether “reversion to the mean” is complete, as it is just as likely that prices would fall well below the long-term trend line for a while before starting to trend back higher.

This graph is striking in several ways. The recent bubble in home prices, from about 1998 to 2007, stands out as this spike shows a doubling in prices over a ten-year period while the index remained unchanged after more than one hundred years even though the population tripled from 100 million to more than 300 million.

We can see also that for about twenty years, from 1920 to 1940, there was a distinct slump in prices of homes. So much for the statement that some of us heard many times just before the housing crash that there had never been a nationwide drop in house prices!

Bubbles All Over the World

No one with a weak stomach should dare to take a peek at the housing boom (and collapse) in a country like Spain. Perhaps Canadians will look at Spain and say that it couldn’t happen here. A big push for the boom in real estate construction there came from the insatiable appetite among foreigners for ownership of condos and villas in the sun. Many foreign buyers were German and British.

One of things about Spain that jumps out is the fact that government debt was only 36 percent of GDP before the crisis started, a level identical to Canada’s current federal government debt. Ireland also had a very low government debt burden before the crisis hit and there, too, it was a real estate crash and the need to bail out the banks that pushed the government debt much higher.

During the Spanish bubble household indebtedness rose sharply due to rising housing prices. In fact there are few countries in the world where household debt can rise to unsustainable levels without a real estate boom since the collateral for household loans worldwide is housing. One exception to that would be the student loan crisis in the U.S. where the government backstopped the loans, which have ballooned to more than $1 trillion now. Without a house or a government guarantee backing the loan, banks will not let households or individuals get into large amounts of debt. According to the Spanish ministry of housing, residential real estate prices tripled from 1996 to 2007. That was quite a boom, and it’s an absolutely torrid pace. Figure 3.2 [4] shows that Spanish house prices soared to a peak in 2007 and then corrected almost the whole advance, similar to the U.S. house-price bubble and crash. Whether or not Spain’s difficulties are over remains to be seen; deflation is a real risk in Europe and house prices seldom hold their value in a deflationary environment.

In Spain, as in most jurisdictions, a borrower who defaults must pay the bank back for any deficit that arises on the sale of a foreclosed property. Closer to home in Alberta, on the other hand, the homeowner (under certain circumstances) can just hand the house back to the bank with no residual liability. Some U.S. states allow the homeowner to walk away from the post-foreclosure debt. In Ontario the laws are more onerous; the homeowner (borrower) must pay the difference (deficit) after defaulting. In Spain this requirement has led to protests and squatters occupying empty apartments. According to the National Institute of Statistics in Spain, more than 13 percent of properties are vacant. Of course, extraordinarily high unemployment in Spain forced many borrowers to default on mortgage payments (and even rent payments). Spaniards are reluctant to declare personal bankruptcy since there is no debt discharge. “All the present and future income of the debtor must be used to pay back ... debts.”[5]

In the United States, unemployment rates never reached the highs in Spain and other peripheral European countries of over 25 percent, but the United States still experienced a dramatic housing collapse. The debt levels associated with housing surged and then house prices fell, leaving the borrower to sink underwater — meaning they owed more on their mortgage than the house was worth. As recently as 2011 more than 50 percent of mortgage-carrying homeowners under the age of forty were underwater. Of course the measure of underwater is somewhat subjective as appraisals during a real estate crisis are just estimates. There is no way to know what the house would sell for in a distressed market with so few buyers.

According to Zillow, a company that operates the largest home-related online marketplace in the United States, at the end of 2012 about 27 percent of mortgaged homes in the United States had loans greater than their value, an improvement from 31 percent at the end of 2011.[6] Another 18 percent of homes carried mortgages that were 80 to 100 percent of the home value, which made them dangerously close to going underwater if the market slumped again due to a recession. The housing recovery in 2012 moved a number of homes into the positive column from the negative although it also makes them more likely to be put up for sale, which threatens to slow the recovery in house prices.

These numbers in Spain and the United States are merely statistics to those of us in Canada who are used to consistently rising house prices punctuated by the occasional brief pause or slight decline in the price trend. It can’t happen here, people believe, since it hasn’t happened for more than twenty years going back to the 1990s. But why couldn’t it happen here? It’s obviously happened in the United States and Spain. Are we really that different? As well, it did happen here in the early 1980s and the 1990s, so it could happen again. Or, as the saying goes, “perhaps this time it’s different.”

The U.K. Experience

Figure 3.3 [7] shows that housing prices in the United Kingdom soared to bubble levels as values tripled from 1998 to 2013. This British bubble, like Canada’s, grew to be even bigger than the 2006 peak in the United States. Speaking about his home country of England in March 2014, Roger Bootle, chief economist of Capital Economics, told the Daily Telegraph: “It is easy to persuade people that property is a one-way bet and for speculative behaviour to take hold. This is happening now. It isn’t only about greed. It is also about fear — the fear that if you don’t buy now, you will never be able to afford to. This feeds on itself and a bubble inflates.”[8]

The fevered behaviour he cites, which seems to be widespread among former colonies, might be related to the English common law structure of land ownership or central bank policies, or to the view that British Commonwealth countries are a safe haven. Whatever the reason, home prices in the United Kingdom, Canada, Australia, and New Zealand seem to be leading the way in overpriced housing bubbles that have yet to correct in the early part of the twenty-first century.

Bootle goes on to say: “For the next year or so at least, the housing market is cast in its time-honoured role of creating an illusion of prosperity and helping the governing incumbents to win the next election.”

A well-intentioned but misguided program in the United Kingdom is adding fuel to the fire. The help-to-buy program allows people to get into real estate that they couldn’t afford without help. Here is what economic commentator Francis Coppola said, with some sarcasm, about the scheme in September 2013:

The latest crackpot scheme for helping people to buy ridiculously overvalued property is the U.K.’s help-to-buy scheme. The first version of this scheme was effectively a subsidy to house builders, since it guaranteed part of the mortgage on new build houses only. Not surprisingly, house builders loved it and almost everyone else hated it. It was panned by the Chancellor’s own department, and the IMF and the Organisation for Economic Co-operation and Development (OECD) both expressed concern about its possible effect on an already overblown housing market. So of course the Government is now extending it — to buyers of existing houses and remortgages.[9]

In September 2014 the U.K. government added a 20 percent discount on home purchases for first-time buyers to the scheme.

Mark Carney, former head of the Bank of Canada and now governor of the Bank of England, brought with him Canada’s penchant for using housing as a stimulus for the economy while risking an unsustainable bubble in the process. Of course, the housing bubble in England is observed mostly in London and is driven by the city’s elite status as the world’s leading financial industry centre.

But what about a country very similar to Canada, where every major city has house prices that are unaffordable?

The Bubble Down Under

In January 2000, according to the Reserve Bank of Australia (RBA), bank lending to persons for housing as owner-occupiers was A$165 billion. In September 2013, bank lending to the same category reached a total of A$800 billion, an increase of five times. This runaway growth in debt leverage makes Canadian speculators look timid. To accomplish this mind-boggling increase in debt there are four banks, all ranked in the top twenty in size in the world, which is odd for a country of just twenty-three million. According to Lindsay David, author of Australia: Boom to Bust, “the banks have ‘bet the bank’ on Australian real estate and natural resources.”[10]

We saw in Figure 1.2 that the Australian house-price-to-income ratio is more than 35 percent above the long-term trend line, an overpriced housing market that is very near to Canada’s ratio. Recall from Figure 1.1 that Australia and Canada stood out as two markets with the most rapid house price increases in last forty years.

Incomes failed to keep pace with house prices in Australia, meaning that Australians devote an ever-larger portion of their disposable income to housing. Obviously, they must enjoy their houses a lot or, similar to Canadians, they believe that prices will keep rising indefinitely and they don’t want to miss out on speculative gains. Certainly it wouldn’t be a shortage of land causing the price increases, since, like Canada, Australia is one of the least densely populated countries in the world. In fact it’s a great irony that three of the most sparsely populated countries in the world — Norway, Australia, and Canada — have such expensive housing.

In September 2014, the RBA reported that “the composition of housing and mortgage markets is becoming unbalanced. This has been evident in the current strength of investor activity in the housing market … the apparent increase in the use of interest-only loans … might also be consistent with increasingly speculative motives behind current housing demand.”[11]

Australia’s central bank, like the Bank of Canada, issues warnings but there is little they can do to restrain speculation short of jacking up interest rates. Australia enjoyed a decade-long surge in incomes due to favourable terms of trade as an exporter of commodities such as iron ore. Even more than Canada, Australia is dependent on one country as the buyer for its exports. In their case China consumes most of their commodity exports. In both countries future income will depend on commodity prices although the mix is different. In Canada crude oil and bitumen are most important; in Australia base metals such as iron ore and coal will provide income growth. In 2015 weakness in China’s economic growth, collapsing iron ore prices, and especially the important steel-making sector cast doubt on the short-term future of Australia’s commodity exports.

China’s housing bubble operates in a world of its own. According to a paper by Kaiji Chen and Yi Wen, of the Federal Reserve Bank of St. Louis, China’s average real house prices “have grown at an annual rate of 17 percent for the past decade, far exceeding the 10 percent average growth of real GDP … associated with … housing boom is the growing number of empty or ‘ghost’ apartments across major cities in China.”[12] That pace of growth implies that prices are doubling in less than five years. While many have written about China’s ghost cities and apartments referring to investors’ penchant for buying units and leaving them empty, the real estate boom in China defies all predictions of eventual collapse. As discussed in chapter 14, the inevitable slowdown or collapse of China’s housing construction industry will impact Australia and Canada through the drop in demand for the building materials that go into housing, especially copper, steel, nickel, coal, and iron ore.

There are a few house-price bubbles in the world, like Canada’s, that continue to grow more stretched and Canada ranks right up there with the best, probably tied with Australia in first or second place for the most advanced bubble. How did much of the planet come to a point where so many people became obsessed with home ownership and real estate speculation?