The ongoing global economic crisis has
made the term "bubble" a common word in the vocabulary of the
ordinary citizen. The steep declines in
the prices of housing all over the world, especially in the U.S. and Europe, have been blamed on the bursting of the so-called
"real estate bubble." With so
much easy money and reckless lending over the last decade or so, it is said
that prices of real estate rose to unrealistically high levels and had nowhere
to go but down when the first big banks failed and credit began to
tighten. The same situation prevailed in
Japan
at the beginning of the decade of the 1990s.
Japan
had a lost decade after its real estate bubble burst in 1990-1991.
It is important, however, to
distinguish between a bubble and the normal building cycle in a free market
economy. It is normal in the building
industry to have a boom and bust cycle because of the very nature of the
business of real estate. As more and
more households are formed with the purchasing power to buy homes, the demand
for residential construction tends to rise.
Real estate developers competing with one another start to construct new
housing units in response to the perceived increased demand.
Since it takes time to put the new homes into
the market and to fully sell all the units constructed, all the suppliers of
homes always tend to overestimate the demand and end up building too many
units. At the start of the cycle, when
demand still exceeds supply, there is a tendency for prices to go up. Once the market realizes that there has been overbuilding
and a glut occurs, then there is a general decline in the market value of
existing housing units. Prices will
continue to decline until all the excess supply is sold.
This boom-and-bust cycle is a normal
part of the market economy in which buyers and sellers of homes freely interact
with one another. The whole economy need
not go into a tailspin when real estate prices are going down during the glut
period. Real estate and construction
companies do not have to go bankrupt as they have learned to sustain the lean
years from the earnings they obtained during the prosperous times. In a growing population, it is only a matter
of time for the demand to start rising again and for the glut to disappear,
thus leading to the next phase of recovery in the cycle. There is no "bubble" bursting in
this cyclical process.
A bubble exists when the demand for a
product is artificially stimulated by a speculative fever, which may be
occasioned by excess liquidity and irresponsible lending as well as a
widespread get-rich-mentality among the masses. What happened in the U.S. in the
years preceding 2007, when the subprime crisis exploded, is a perfect example
of a real estate bubble. The so-called
demand for real estate was to a great extent artificial. Many people taking
real estate mortgages already had their homes.
They were using the proceeds of their loans to engage in conspicuous
consumption, i.e. flashy cars, luxury trips, expensive appliances, etc. Or they were buying second homes which they
would not have been able to afford if the banks had not been overly eager to
grant credit because they were able to transfer their risk to non-bank
financial institutions.
We may be able to prevent future
bubbles by stricter control over the supply of money and the taking of risks by
financial and non-financial institutions.
But we cannot entirely avoid the boom-and-bust cycle in real
estate. The most we can do is to lessen the distance between the peaks and
the valleys in the cycle by improving the ability of the home builders in
estimating more accurately the real demand for housing over a certain period of
time. For comments, my email address is bvillegas@uap.edu.ph.
BERNARDO M.
VILLEGAS
June 19, 2009