Real estate may be one of the oldest assets around. It has a long history of manias and crashes and surely was at the core of the recent financial crisis. If another property bubble is building in China, it will have consequences for us all.
The bursting of the recent housing bubbles in the US, the UK and Spain is still being felt today, four years after markets peaked. For most of these recent victims, the markets haven’t even started to recover. Remembering Japan’s long hangover after its housing and real estate bubble burst in the late 1980s, we have to face facts: this latest crash could take decades to undo.
When they burst, real estate bubbles inflict particularly vicious damage to a country’s economy, gutting broad swathes of the population. Since they are often fueled by dramatic credit and monetary expansion, when prices do collapse and liquidity dries up, seemingly overnight, it can lead to widespread bankruptcies and crippled financial intermediaries. Nasty deflationary tendencies lurk in the wings, waiting to strike while the patient swoons. This is the big, ugly fear of many economists for the US today. A replay of Japan’s deflationary stagnation in the world’s largest economy is not a pretty picture to contemplate.
But if they are so dangerous, then why do housing bubbles occur in the first place? Why don’t government officials combat them in the early stages? A straightforward answer is that they are surprisingly difficult to spot. The current Federal Reserve president and his predecessor, Messrs. Bernanke and Greenspan, are highly accomplished economists and they both failed to spot the US housing bubble, even in late 2005, when prices were skyrocketing. Some would say they didn’t miss the house price bubble; rather, they willingly ignored it because it didn’t match their policies and worldviews. Other, more conspiratorial minds might suggest that they saw the bubble but naively assumed the costs of the cleanup, once it burst, were manageable.
We would argue that despite extreme price movements a real estate bubble can be hard to recognize. Consider China. A recent paper from the US National Bureau of Economic Research notes that Chinese house prices “increased by 140% since the first quarter of 2007 and by a record 41% (annualized) during the first quarter of 2010.” This is obviously an extreme increase. But there are some crucial differences between the housing bubble that inflated in the US (and elsewhere) earlier in the decade and China’s current housing market dynamic.
The price evolution in China’s property market stems from a shortage of supply rather than from excessive demand due to cheap credit, that is, leverage. While housing prices have risen substantially in the past years, so has average urban income. Moreover, according to the International Monetary Fund, the value of outstanding mortgages is only around 14% of GDP in China. This needs to be compared with 76% in the US or almost 90% in Australia. Most Chinese economists acknowledge pockets of excesses, especially in the fashionable cities like Beijing and Shanghai, but they usually also point to the fact that, in aggregate on a national level, property prices have moved in sync with the national income.
And there is another significant difference between the laissez-faire US during the past decade and China today: The Chinese government has so far been relatively vigilant, openly expressing concern about a potential property bubble and taking measures to reduce precisely the kind of credit growth that could fuel such a bubble.
Whether China will ultimately face a burst real estate bubble, with all its dreadful consequences; or whether the current price rally, which has lately slowed, merely reflects fundamentals, cannot yet be known. However, given our experiences with similar real estate market developments, we should at least monitor the situation closely and acknowledge it as yet another risk in our post-financial-crisis world.
Let’s be clear: if it were to transpire, a burst Chinese house price bubble would have serious global consequences that could threaten recovery in the still unsteady developed economies. The world has indeed become one big house, with many interconnected rooms. It casts some very long shadows.
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