Do Price Bubbles Always End in Bursts?

The last few years have proved worrisome for economists and policymakers as housing prices in the U.S. increased over 5 percent per year from 2000 to 2006 with some local market increases reaching more than 20 percent per year. The fear is that such increases, otherwise known as price bubbles, will soon turn to busts, resulting in economic contraction. The problem with identifying the presence (or lack thereof) of bubbles in asset markets is the lack of sufficiently long-term data that would allow researchers to identify cases where asset prices significantly deviate from fundamental values.

Recent research from a professor at the Penn State Smeal College of Business looks at the long-run relationship between housing prices and rents in Amsterdam from 1650 through 2005. Brent Ambrose, Smeal Professor of Risk Management, Piet Eichholtz of Maastricht University, and Thies Lindenthal of MIT found that, in a time period spanning 355 years, market prices persistently and substantially deviate away from fundamental values. In addition, their research shows that these “bubble condition” periods do not necessarily end with the bubble bursting, but could be resolved by slow convergence of prices and market values. This convergence may, however, take decades.

“When the rent-price ratio indicates an imbalance, this may persist for a long time before prices and rents correct,” write the researchers. “Furthermore, when they do converge, prices will adjust faster than rents.” The researchers explain that house prices and rents are co-integrated, meaning that the same underlying fundamentals are likely to influence both. Their analysis of the rent-price ratio reveals sustained periods of “bubble” and “crisis” conditions that can continue without a corresponding correction (or crash).

“Our study shows that bubble crashes are not always inevitable in the short run,” write the researchers. “While prices do revert back to market value, this reversion may take decades such that a restoration of balance becomes more of a fading out than a crash. As a result, markets like Amsterdam, that have been characterized by strong price gains in the last decade and were widely thought of as overvalued, may not necessarily experience the free fall seen in other markets.”

The investigation into the long-run developments of house prices and rents has implications for the ongoing debate concerning the recent price increases and subsequent corrections in many worldwide housing markets.

“It’s unwise to use perfect hindsight to criticize lenders who originated mortgages at the peak of the market and subsequently suffered significant losses due to borrower defaults,” write the researchers. “Price bubbles may deflate over an extended period of time such that the losses may not have occurred.”

Additionally, the findings show that lengthy periods of little or no house price appreciation are also possible. According to the researchers, “Those looking for a speedy recovery in the housing market may be disappointed.”

The study, “House Prices and Fundamentals: 355 Years of Evidence,” is forthcoming in the Journal of Money, Credit, and Banking.