Are Housing Prices a House of Cards?

The first big city to boom was London, starting around 1996. Boom mentality spread to Los Angeles, New York, and Sydney around 1997, to Paris in 1998, to Miami, Moscow, and Shanghai in 2001, and Vancouver around 2002. These and other cities have been booming pretty much ever since; prices in most are up at least 50% in real terms since 2000. This has been a big windfall to homeowners, but has hurt anyone planning to buy.

Now growth in home prices is weakening in some of these cities. The rate of price growth in London and New York slowed sharply over the past year, to only about a 1% real increase in the second quarter of 2004. In Sydney, home prices actually fell in the second quarter.

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Has the boom ended? Will no other cities benefit? Worse still, could the mood in housing markets soon lead prices in downward?

No one predicted this boom, so predicting its end is risky. Housing prices have shown tremendous upward momentum in the face of previous warnings that the party is over.

Any prediction concerning the boom's end requires understanding why it occurred in so many places. Surprisingly, there is no well-received explanation, because this boom's ultimate causes are mostly psychological. Economists would rather talk about interest rates or unemployment statistics - factors that are concrete and knowable. Of course, these indicators do have a legitimate role to play in explaining housing markets, but they are simply not adequate to account for the recent booms.

Three psychological causes stand out: first, a change in people's perceptions about the source of value in a changing world economy; second, increasing public faith in "glamour" cities with international name recognition; and third, the plain giddy dynamics of speculative bubbles. Each factor deserves greater attention if we are to understand current housing market conditions and discern future price trends.

First, the world economy does look more chaotic than it did a decade ago. The crash in equity prices since 2000 in most countries has made financial assets look less secure, spurring a "flight to quality" - in this case, housing. Moreover, terrorism is now viewed as a problem for everyone, with major tragedies in Indonesia, Spain, and Russia. People feel safest investing in their homes, and there is little reason to expect imminent change. Fear and upward momentum in home prices go together.

Second, the public's faith in glamorous international cities has increased with the explosive growth in global communications due to the Internet and the cell phone. Just as people increasingly admire international celebrities, so they believe that world famous centers of business, technology, and culture - whose names are household words to people everywhere - are uniquely valuable. As with fear of terrorism and suspicion of equities, geographical celebrity appears resilient, if not self-reinforcing: the more famous New York, Paris, and London get, the more glamorous they become.

Third, and no less important, is the speculative contagion that underlies any bubble. The current boom has seen contagion within markets and across markets, as rising prices fuel popular excitement - and hence further price increases - in the same city, and then in other cities, even on the other side of the globe. People in Shanghai may not talk about London home prices, but Shanghai's opinion leaders know what is happening in London, and the boom there makes it seem plausible that there should be a boom in Shanghai, too.

In contrast to the other two psychological causes, speculative contagion has a natural end. A speculative bubble, sustaining itself solely by reaction to price increases, cannot go on forever.

So, where does this leave us? Two of the three psychological causes suggest continued upward momentum in housing prices, while the third suggests that the momentum will come to an end some day, but does not pinpoint when.

I am betting that some high-flying glamour cities will continue to see decelerating growth in home prices - and eventually decreases. Historically, housing prices have shown a lot of momentum, and prices in all these cities are still going up at a brisk rate, though usually somewhat slower than a year or more ago. Based on extrapolation of growth trends, it looks safe to predict that prices will go up substantially in most of these places for another year or more, even as the rate of increase continues to decline.

The psychological factors are more important for longer-term forecasts, beyond a year, where momentum no longer plays an important role. At this point, there is likely to be some downward instability in prices, because enthusiasm for investing in houses is likely to wane in line with declining price growth.

Prices in glamour cities are likely to drop sharply the next time there is a serious recession, or if the local economy suffers a severe shock, or if interest rates rise too fast. Then, contagion within and across markets can work in a downward direction, propelling prices lower for years.