Comparing Australian and US housing

As mainstream opinion would have it, Australia's housing prices are solidly based upon fundamental valuations or intrinsic value. This position was repeated yet again by Terry Ryder, in a recent article on Property Observer, claiming "current prices are at sensible levels." This view is the stance of the Australian government, central bank, Treasury, the FIRE (finance, insurance and real estate) sector, much of academia, and a legion of commentators, economists and analysts.

Ryder cites RBA governor Glenn Stevens, who is on the record saying the residential property market is not experiencing a bubble. For anyone who has followed the global property market over recent years, it is difficult not to notice that central bankers are possibly the least reliable and most incompetent of all economists when it comes to identifying asset bubbles. Their record is truly terrible, for not only completely missing trillion-dollar bubbles that formed in their own backyard but they have continually put effort into denying these bubbles exist.

Although Ryder believes Australia is different from the US in regards to the relative economic conditions and property markets (more on this below), in one aspect Australia is similar: central bankers at the RBA and Federal Reserve have gone on the record to deny that a housing bubble exists in their countries. In the US, concerns were continually raised before 2006 about the risk of a property bubble. Unfortunately, such concerns were dismissed as nonsense, with these dismissals emanating from all quarters.

This reached truly ludicrous proportions in the US with its two leading economists and central bankers, Ben Bernanke and Alan Greenspan. In October 2005, Bernanke, then chairman of the President's Council of Economic Advisers, testified before the Congressional Joint Economic Committee, claiming "price increases largely reflect strong economic fundamentals, including robust growth in jobs and incomes, low mortgage rates, steady rates of household formation, and factors that limit the expansion of housing supply in some areas."

A few months before Bernanke's testimony, Alan Greenspan, the then chairman of the Fed, testified before the same Congressional committee, detailing a similar analysis to Bernanke. In his testimony, Greenspan noted"Although a 'bubble' in home prices for the nation as a whole does not appear likely, there do appear to be, at a minimum, signs of froth in some local markets where home prices seem to have risen to unsustainable levels. … Although we certainly cannot rule out home price declines, especially in some local markets, these declines, were they to occur, likely would not have substantial macroeconomic implications."

As with the dot-com bubble, the vast majority of economists missed and/or denied the existence of a bubble on the stock market, and did it again with the housing bubble. 12 out of 15,000 professional economists in the US publicly warned of this $8 trillion-dollar Ponzi scheme. This was noted by Dirk Bezemer, a Dutch economist at the University of Groningen, identifying twelve economists who picked both the collapse of the housing bubble and GFC, in a study that is well worth reading (disappointingly, economist John Talbott who wrote two books in 2003 and 2006 predicting the eminent collapse of the bubble was explicitly not included).

Central bankers cannot identify these epic asset bubbles for two primary reasons: lousy economic theory and an unwillingness to take responsibility. The former revolves around a non-empirical form of economics that is taught in universities and practiced in government and industry. This is called "equilibrium economics" and is associated with the neoclassical school of economic thought. It teaches, using many unrealistic assumptions, that markets operate in equilibrium – a state in which economic resources are put to their most efficient use.

Many of these assumptions are patently absurd: all firms are the size of lemonade stands, people can see into the infinite future, know all information about all markets, firms borrow at the same rate of interest, that money, credit and debt does not exist, and so on. It is similar to an astronomer who constructs a model of the solar system without a sun, moons and gravity. If NASA were to attempt another moon landing using such a deficient model, the space shuttle would never leave the planet.

This worldview assumes, because markets operate efficiently, assets are almost always priced correctly – so bubbles cannot occur. Neoclassical theories of equilibrium price statics, rational expectations, efficient markets hypothesis, capital assets pricing model, utility, and so on are doctrines with slim to non-existent empirical backing.

This economic theory does not reflect reality, as has been accurately detailed by economist Steve Keen's bookDebunking Economics and numerous other sources. If it did, why are so many countries generating the largest asset bubbles in their respective histories after undergoing reforms of privatization and deregulation?

The latter reason is simple: if a central bank warned about a housing bubble as it was forming, the market would react by changing its attitude from greed to panic, typical of the pathology of boom bust mania. Economists in the central bank are considered the foremost authority on the economy, so when they speak, everyone listens. This institution's most powerful influence upon the economy is not the ability to print money or adjust the interest rate, but its loudspeaker.

For instance, if the Fed had warned about a bubble forming in the housing market in 2002, and put time and effort into ensuring that everyone heard the message, the market would have collapsed then as property investors would act to protect themselves by selling assets (ensuring a collapse in capital values) and refusing to take up more debt (thus hurting bank profitability). This would have plunged the economy into a recession, though not of the severity the US is currently experiencing after letting the bubble run the course through to its peak in 2006.