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Is There a Bubble in Home Prices?

Around the world, newspapers trumpet a "housing bubble" about to burst. The Economist has run numerous cautionary articles with titles like "Castles in Hot Air." "Housing Prices Soar, Fueling Bubble Fears," chirped The Wall Street Journal . "The Property Bubble Menaces Growth," warned Le Monde . "Homes Bubble May go Toxic," The Sydney Morning Herald admonished.

Are such fears justified? How do we know if the housing market is in a bubble?

The term "bubble" is widely used but rarely defined. A bubble occurs when public expectations for future price increases become exaggerated, pushing prices up to unsustainable levels. When this happens, many people buy homes to rent out as investment properties, and many more who are buying homes to live in also behave like investors, fearing that if they wait, they will be priced out of the market.

During a bubble, buyers are relatively undeterred by high prices because they think that even bigger price increases will compensate them for spending too much. If expectations of rapid and steady future price increases are important motivating factors, then the price level is inherently unstable, because prices cannot rise forever. The bubble will eventually burst and prices will fall.