What Is a Bubble?



          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



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