Bubble Schmubble

by on June 22, 2005 at 7:05 am in Economics | Permalink

Is there a housing bubble?  Some say yes, some say no.  I say who cares?  The real question is not whether there is a bubble the question is, What are the chances that housing prices will fall dramatically?  Contrary to popular belief, knowledge of whether prices are following fundamentals or a bubble tells us very little about this question. 

An efficient market is not necessarily a stable market.  Indeed, an efficient market can be as or even more volatile than a market plagued by bubbles.

Consider the stock market – the price to earnings ratio can be written (using the Gordon Growth Model) as P/E=D/E*(1+g)/(r-g) where g is the growth rate of dividends and r is the discount rate.  Since r and g are small a small change in g can have a large effect on the P/E ratio – so much in fact that it is very difficult to reject a model of stock prices based solely on fundamentals (see my paper with Gary Santoni or the Barsky and DeLong classic Why Does the Stock Market Fluctuate (JSTOR).)

The principles are similar with respect to the housing market.  Do note that only a small fraction of the housing stock is available for sale at any one point in time.  When we hear about the high price of housing prices we think that the stock of housing must have gone up a lot in value.  But in fact all that has occured for certain is that the price for the marginal house has increased.  When the supply is inelastic (as it is on the coasts) and demand is fairly inelastic (as it is for most people who like to live where they work) small changes in either demand or supply can change the marginal price dramatically.  Thus, even if house prices are at fundamental values today and will be at fundamental values tomorrow a small change in say interest rates or the economy could make tomorrow’s price considerably lower than today’s. 

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