Can Economic Theory Predict Real Estate Bubbles

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Can Economic Theory Predict Real Estate Bubbles?

• Chuck Hicks, RES
• Mecklenburg County

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Fallacy vs. Fact

• Fallacy No one could foresee this downturn in
  the economy in general, or in real estate in
  particular.
• Fact Economic theory could predict and explain
  what was happening in the market, and some
  economists were sounding the alarm 3-4 years
  before the bubble burst.

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Theory vs. Policy

• Economic theory explains the purposeful actions
  of individuals seeking to maximize well-being in
  a world of limited resources.
• Economic policy often tries to obtain optimal
  results in the general economy by stimulating
  or manipulating aggregates.
• Whether an economy is free or managed, human
  action is universally the same and predictable.

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The Tyranny of Good Intentions

• When most policy-makers discuss economics, they
  have in mind aggregate numbers and policy
  prescriptions. They are concerned about what
  ought to be.
• But good intentions often lead to unexpected and
  unintended consequences.

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A Natural High

• Economies grow at a natural rate as consumers
  save some of their incomes. Savings lay the
  foundation for future expenditures. Savings
  create more loanable funds, which lowers the
  price of using money, i.e. the interest rate.
• As savers save, entrepreneurs interpret lower
  interest rates as an opportunity to invest in
  long-term projects. Builders, for example,
  receive a market signal to build more houses.

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The Effect of Savings on Capital
InvestmentSource Roger Garrison, Ph.D., Auburn
University
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Something/anything

• Following the 9/11 attacks, there was general
  concern that the U.S. economy would slide into a
  protracted recession.
• From late 2001 on, the Federal Reserve pursued a
  monetary policy of relaxed credit in order to
  stimulate the economy.

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The Needle and

• The FED reduced its Federal Funds Rate (5.5 in
  2002 to 1 in 2004) and purchased bonds from
  commercial banks, which injected reserves into
  the banking system.
• This had the effect of creating more loanable
  funds available from primary lenders.
• As the supply of loanable funds increased, the
  price of using money (interest) decreased. This
  wasnt a natural decrease it was artificial.

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the Damage Done

• Artificially lower interest rates have two
  effects
• A) Consumers save less of their incomes. They
  become more present-oriented, and will borrow at
  lower rates to satisfy immediate wants.
• B) Entrepreneurs invest in long-term capital
  projects. They become more future-oriented.

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The Results of Relaxed Credit Source Roger
Garrison, Ph.D., Auburn University
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Go on, take the money and run

• Artificially lower rates entice consumers to save
  less, and spend more on immediately consumable
  luxury goods (dining out, gadgets, entertainment,
  etc.) using credit lines.
• Lower rates entice entrepreneurs to react the
  same as if savings had been the cause to embark
  upon capital-intensive projects for future
  consumption goods (e.g. new houses, shopping
  centers, machinery, etc.)

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Not So Tiny Bubbles

• From a real estate standpoint, the lower rates
  encouraged many existing homeowners to refinance
  and/or do home improvements.
• Builders, however, thought the lower rates would
  mean more buyers for new houses (others read
  surging retail sales as a signal to build more
  retail space).

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Unintended Consequences

• Eventually, consumers could borrow and spend no
  more. Many defaulted on loans.
• Entrepreneurs discovered (too late) that
  potential buyers had not been saving for the
  products they were making. Many projects had to
  be abandoned. Real estate vacancies rose, as did
  inventories of unsold properties.

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Dazed and Confused
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Pop! Goes the Bubble

• The great real estate boom of 2002 06 became
  the great bust of 2007 08.
• A boom is actually an unhealthy phase of
  misplaced investment. The inevitable bust is
  the recognition and correction of erroneous
  economic behavior.
• A number of economists (and a few policy makers)
  did see this coming. But their warnings went
  unheeded.

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Blame it on the juice

• The correction is called a recession. The
  media typically blame a recession on falling
  consumer demand. But consumers hit the wall and
  need to save for the future.
• Entrepreneurs must liquidate unprofitable
  ventures and readjust their productive activities
  to where real needs will exist.

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We wont get fooled again (?)

• Assessment staff should brush up on sound
  economic theory.
• Develop a critical eye towards trending data.
  Surging sale prices and rental rates may be
  indicative of an unnatural and unsustainable
  boom. Learn to recognize a distorted market.
• Beware of construction cranes! Doug French
• Pay attention to interest rates they influence
  investment decisions. Milton Friedman once said,
  Money is all that matters.