When the global house-price bubble deflates, the economic consequences will be painful, says Pam Woodall
From London to Los Angeles, from Melbourne to Madrid, house prices seem to have lost touch with reality. Never before have there been simultaneous housing booms in so many countries. But the bigger the boom, the bigger the eventual bust.
The boom in house prices is one of the main reasons why most economies held up better than expected after the stockmarket bubble burst in 2000. By slashing interest rates after equities crashed, America’s Federal Reserve and other central banks helped to inflate a housing bubble. Rising prices made homeowners feel wealthier and encouraged them to take out bigger mortgages in order to spend their capital gains. The exceptions to this trend are Germany and Japan, where prices have been flat or falling; it is no coincidence that consumer spending has been weak in both countries.
Since 1997 house prices have more than doubled in Britain and Australia and virtually tripled in Spain and Ireland.
In comparison, the average price gain of 80% in the United States appears modest. However, in real terms the increase in prices there has been three times bigger than in any previous housing boom. The average price of American homes rose by over 13% in the year to mid-2005 – the fastest annual increase for more than a quarter of a century.
The total value of residential property in developed economies has risen by more than $30 trillion over the past five years, an increase equivalent to 100% of those countries’ combined national income – larger than the global stockmarket bubble in the late 1990s or America’s stockmarket bubble in the 1920s. In other words, this could be the biggest bubble in world history.
According to The Economist’s global house-price indicators, prices have hit record levels in relation to incomes and rents in America, Britain, Australia, New Zealand, France, Spain, the Netherlands, Ireland and Belgium. Homes appear even more overvalued than at previous peaks, from which prices typically fell significantly in real terms. America’s ratio of prices to incomes is 40% above its average level during 1975-2000. By the same gauge, property is overvalued by 50% or more in Britain and Spain.
Housing-market optimists dismiss all the talk about a bubble and argue that high house prices are justified by low interest rates. However, in many countries average mortgage payments are now close to record levels as a share of income, and first-time buyers cannot afford to climb onto the first rung of the housing ladder. Lower real interest rates may justify some of the rise in home prices, but nowhere near all. In any case, with real interest rates at historical lows, they are more likely to rise than fall from current levels.
Further evidence of a bubble is the fact that investors have played a much bigger role in pushing up house prices than in the past. Two-fifths of all American houses bought in 2004 were for investment or second homes, rather than as the buyer’s residence. Investors have been buying property even though rents do not cover their interest payments, purely in the expectation of large capital gains – a worrying echo of the late 1990s when investors bought shares in profitless dotcom firms.
The cracks have started to appear. In Britain and Australia average prices nationwide have been flat or slightly down over the past year, compared with annual gains of 20% or more at the peak of their booms. Prices in London and Sydney are down by 10%-15% from their peak. Housing markets in Spain, France, Italy and Ireland also cooled during 2005 and there are now signs that America’s boom may be fizzling out. Most housing experts still predict a soft landing, with prices flattening off, but not falling. But such forecasts may prove as accurate as that of Irving Fisher, an eminent American economist, who declared in 1929 that share prices had reached a “permanently high plateau”.
It is true that, unlike share prices, house prices tend to be “sticky” downwards. In America average house prices have never fallen for a full year in recorded history. People have to live somewhere and, as long as they can afford their mortgage payments, most will stay put until conditions improve. However, a drop in prices is much more likely this time. After previous booms, high inflation helped to bring house prices back in line with incomes without the need for a sharp fall in prices. Today, with homes looking more overvalued and inflation much lower, house prices might need to remain flat for a decade to regain fair value. Since people eventually have to move and so sell their home, this increases the risk that prices will fall. Another big difference from previous booms is the larger role played by investors. If markets start to wobble, investors are more likely to sell than owner-occupiers, thereby pushing down prices.
House prices will not collapse overnight like share prices. A slow puncture over several years is more likely. But over the next five years or so, average house prices in many countries could decline, by at least 10% in America and by 20% in countries such as Britain, Australia and Spain, where bubbles are more inflated. Prices will drop by much more in housing hot spots, such as California.
America’s housing market is probably a year or so behind those in Australia and Britain, so what lessons might they offer? The first is that, contrary to conventional wisdom, it does not require a big rise in interest rates for house prices to falter. British and Australian prices stalled mainly because first-time buyers were priced out of the market and demand from investors slumped.
Another worrying lesson is that even a mere levelling-off of house prices in Britain and Australia has been accompanied by an abrupt slowdown in consumer spending. The annual rate of growth in retail sales in both countries slowed from 7%-8% in 2004 to 1% last year. As house prices stopped rising, housing equity withdrawal (borrowing against capital gains) plunged, removing a powerful stimulus to spending. In both countries there is almost certainly worse to come.
History shows that housing booms are often followed by periods of prolonged economic weakness. A study by the International Monetary Fund found that over the past three decades, when house-price booms turned to bust in rich countries (with house prices falling by almost 30% on average in real terms), they usually resulted in a recession. In countries such as France and Italy, where homeowners have not been madly spending their capital gains, the economic fallout from a weaker housing market will be modest. In contrast, American homeowners have been cashing out their capital gains at a record pace, so if prices merely stop rising, consumer spending is likely to stumble. If house prices fall, it could push America into recession.
Although America’s housing boom has not been the biggest in the world, the economic consequences of a bust could be among the most severe, because the economy has become so addicted to rising home prices. Over the past couple of years, almost half of all private-sector jobs created in America have been in housing-related sectors, such as construction, real estate and mortgage broking. But the boost to the economy from housing could soon turn into a substantial drag. Even Alan Greenspan now seems to be worried, having warned in several speeches that home prices could fall. But Greenspan retires on January 31. When America’s housing bubble bursts, it will not be him who has to pick up the pieces.
CV Pam Woodall
Pam Woodall is economics editor of The Economist.