The Case for The Bubble

Almost daily, the international financial press and local newspapers contain articles and opinions that question whether real estate prices worldwide have reached so high a point that a fall in prices is inevitable. Many of the articles allege that a sharp, rather than steady, increase in asset prices over a short time period ultimately leads to a collapse in those prices. These allegations seem to have a considerable amount of merit and one can point to numerous instances in the past where asset prices suffered sharp and severe declines after appreciating at a fast and unsustainable rate. The recent collapse of tech stocks in the beginning of the decade, after unprecedented gains in the late ‘90s is only one example. Other examples of bubbles going bust include that collapse in the stock market in 1987, falling gold and metal prices in the early 80s and the plunge in bond prices in 1994, to name only a few in recent history. In addition to severe stock, bond and commodity price corrections, bubbles have formed and popped for real estate prices as well, though not always on a global or national scale.

One of the most spectacular real estate bubbles and subsequent crashes occurred in Japan in the late ‘80s and early ‘90s. Just prior to the collapse of real estate prices in Japan, one square foot of property reportedly cost over $1 million. Supposedly, at one point during the boom years, the aggregate price of all of the real estate in downtown Tokyo had a value that was greater than the value of all the real estate in the state of California. There are many reasons why property values initially rose and then collapsed in Japan. Essentially what happened though was that the rising equity market in the 80s created huge sums of Yen for the Japanese banks, which then lent out the money to real estate investors. When the stock market fell, the corresponding lack of liquidity caused bank lending for real estate to come to a standstill, and prices fell dramatically. Luckily for real estate owners and investors in this country, the example of the Japanese collapse, and the way it collapsed, is not completely analogous, since many of the causes of the run-up and run-down of property prices were due to unique characteristics to the Japanese banking system. US banks, for example, have generally not relied much on stock market returns to generate cash to lend to property speculators.

Although the current real estate bubble in this country differs from the Japanese bubble, both, at least initially, were fueled by cheap money. In the Japanese example, a rapidly rising stock market resulted in swollen bank assets, and the banks capacity to lend, to sky rocket. In the current US bubble, US banks are similar to the Japanese banks it at least one respect, which is their own access to cheap capital. Almost paradoxically, the US banks access to cheap money might be a result of the stock market collapse of the late 90s.

American banks access to cheap capital is made possible by their ability to borrow at low interest rates. Low interest rates are determined by the market’s anticipation as to what level the rate of inflation will be at various points in the future. Part of the reason why the inflation outlook has been tame for about the past 3 years, is because of the huge amount of spending on capital projects that occurred when companies could fund their capital spending projects with the sale of their stock during the internet stock bubble days. More succinctly (hopefully), the internet bubble created huge amounts of funds; the funds were invested in factories, except more factories were created than actually needed; the excess capacity in the factories resulted in too many products and not enough demand; too many products resulted in the lowering of prices; the lowering of prices meant that inflation would not occur soon; finally, interest rates fell because of no fears of inflation.

As interest rates fell, houses became more affordable. House buyers, who could previously only afford a $500,000 home at an 8% mortgage rate, could at a lower interest rate of 6%, afford a $600,000 home. (The seller of the $500,000 house of course knows this and raises their asking price to the $600,000 level.)

In summary, the low inflation rate of the past three years resulted in lower interest rates, which resulted in home sellers raising the price of their house. Conversely, the opposite should happen when inflation starts to rise, as it is already doing.

Higher Interest Rates Are Here

Since the rate of interest rates is determined by the expected rate of inflation, it is necessary to determine what can cause a higher rate of inflation. The root cause of inflation is when too much money chases too few goods. That is, if people or companies have more money to spend, and the providers of the goods are not capable of manufacturing enough products demanded, then the providers have the ability to raise the prices of the products that they are selling.

As shown in the first section, there were too many factories that were built with internet bubble money. This meant that there was an ample supply of goods and services and the manufacturers had little or no ability to raise prices. These conditions still persist. However, as the broader economy improves, demand for the products also increases. This means that factories, which only two years ago were producing goods at rates that were much lower than what they were capable of, are now producing at levels which are closer to total capacity. As the plants and factories reach full capacity they will have to choices, which are to expand capacity or raise prices. The easier of the two choices is to raise prices, especially since competitors are almost invariably in the same boat.

The fact that companies are moving towards full capacity is becoming more evident. Aside from lesser known statistical indexes and surveys that measure capacity, the evidence that factories and businesses are busier now than they were last year is reflected in the declining unemployment rate. Factories and businesses are hiring new employees to do more work, regardless that the Democrats want you to believe otherwise. The hiring of additional workers also leads to higher inflation rates, as potential employees, who maybe had zero choices of where to work in the past, might have more than one choice, and therefore can demand higher wages.