ETHICS @ WORK: A real-estate bubble?

If we understand why markets usually work well, we can better understand why sometimes they don’t.

By ASHER MEIR
October 10, 2010 22:22
4 minute read.
Apartment buildings in Beersheba

beersheba real estate 311. (photo credit: Courtesy)

In recent months there has been much discussion about whether Israel is experiencing a real-estate bubble. The Bank of Israel has expressed concern over the continuing rise in the prices of apartments, and last week Bank of Israel Governor Stanley Fischer said the central bank would intervene if there are no signs of price stabilization.

What are bubbles, why are they bad, and how can their damage be prevented or mitigated?

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If we understand why markets usually work well, we can better understand why sometimes they don’t. The great thing about markets for ordinary goods and services is that every person needs to know only things that he is expert in, and the price system aggregates that information into an outcome that is good for everybody. Each consumer knows best what goods and services he needs and can afford, and each business establishment knows best what goods and services they are in a position to provide.

The market price will take into account the supply and demand of each individual “expert” and stabilize the market. If the price is too high, then vendors will find there are no customers. If the price is too low, then they will have lines around the block. Prices naturally adjust to a stable level.

But financial assets are not bought for consumption now, but rather for their monetary value in the future. One problem is that the average citizen is not an expert on financial instruments. But a more fundamental problem is that even a true expert does not really know much about them.

The value of an investment depends on the performance of the individual asset and the economy as a whole in the future, and no one really knows what the future will bring. Furthermore, people are not interested in what the asset is going to be actually worth, but only what other people will be willing to pay for it. That means that in financial markets, people spend a whole lot of time looking over their shoulders wondering what other people think of asset values.

This guessing game can make financial markets very unstable. In goods markets, a rise in prices consistently reduce demand because it means that prices now exceed the inherent value of the good. But in financial markets, price rises can increase demand because they demonstrates investor interest. One price increase can lead to another.

In the 18th century this phenomenon was described as a “bubble.” The term is fitting: Market bubbles get bigger and bigger in market value, but they are filled with mere air – with people’s expectations of future price rises. And like bubbles, ultimately these price expansions must burst.

It’s not unlike a Ponzi scheme, where each person who buys in believes he will be able to sell at a profit to some future investor. But eventually the market must run out of new buyers and the scheme collapses.

Such a bubble is bad for the economy in many ways. The first problem is the mispricing. If tulip bulbs (17th century Holland), or Internet companies (the 1990s), or apartments in Nevada (in the years preceding the recent crash) are overvalued, then the price system isn’t working. The resources devoted to these sectors exceeds their true contribution to the economy. And if the bubble is of large proportions, it can threaten the stability of the entire economy.

A bursting bubble leaves people with greatly reduced wealth and thus greatly reduced demand. The result can be a general recession, not just a healthy downturn in the particular sector that was previously overinflated.

Apartments share attributes of both kinds of markets. On the one hand, each family knows best what kind of apartment and neighborhood suits its needs and its budget. But houses are also bought as an investment and with an eye to resale value, so the housing market is not immune to bubbles. Indeed, many researchers believe a housing bubble made a major contribution to the financial crisis that shook the world economy two years ago.

But agreeing that a bubble is bad is easier than agreeing one exists. Are people paying more for apartments in Israel now because they believe that they will be able to sell them for even more in the future? Or do they have fundamental reasons for bidding up the prices? Perhaps people foresee a wave of aliya, or increased government aid to home buyers?

And agreeing that one exists is easier than stopping its growth. Will the effect of restraining measures by the central bank be limited to keeping real-estate prices from spiraling out of control, or will they restrain activity throughout the economy, or perhaps create a bubble somewhere else?

These questions do not necessarily need firm answers. No one can be sure that there is a bubble, and no one is sure that restraint will keep one under control. But since the likelihood exists, and since the potential damage is great, the monetary authorities feel that simple prudence calls for measures that will moderate increases in real-estate prices.

ethics-at-work@besr.org Asher Meir is research director at the Business Ethics Center of Jerusalem, an independent institute in the Jerusalem College of Technology (Machon Lev).


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