Right in the long run?

"The hallmark of economics," writes Geoffrey Luck, "is not its ability to forecast the future but to explain things." So when economists or others offer advice about the future of the housing market, is it best to ignore them?

In 1995 economists Steven Bourassa and Patric Hendershott created a model to explain changes in Australian capital city housing prices. And the model seems to have done a pretty good job. But then, in their conclusion, they remarked that "it seems unlikely that the large increases of the late 1980s will be repeated in the foreseeable future."

So perhaps the foreseeable future wasn’t foreseeable after all. In 1997 the Reserve Bank observed that strong demand was putting upward pressure on house prices. It was the first sign of a boom that would dwarf anything seen during the 1980s. But in 1997, the Reserve Bank wasn’t overly concerned. Over time, they argued, "the stronger demand can be met by increased building activity."

By 1999 prices were still rising and some economic commentators warned that Sydney house prices relative to disposable income were approaching those in the UK and Japan before both nations experienced housing slumps. By May 2000, property guru Michael Matusik was warning that property prices might fall sharply.

But later that year the ABC reported that house prices had surged unexpectedly. They continued to increase and in 2002 the Reserve Bank noted a large rise in housing construction. The bank regarded this process as self limiting because oversupply was "bound at some point to limit the scope for further price increases."

In the United States, economists and market commentators were doing a similarly poor job of predicting movements in prices and in the late 1990s, the US boom arrived without warning. The best most could do was explain what underpinned current prices. But as economist Robert Shiller wrote in 2007:

We shouldn’t blame these people for not seeing the boom coming. Nobody did. But those economists who say today that the real estate boom has been justified by "fundamentals" have to explain why they weren’t able to forecast the high home prices we have today based on those fundamentals.

Shiller suggested two possible explanations for this failure to predict. The first was that it may not be possible to predict movements in house prices. This seems plausible. Even with a good model, you still need to know the values of variables that make it work. If these are unpredictable, all you can do is explain movements after the fact. But Shiller’s second explanation suggests something more disturbing. Perhaps it’s possible to predict underlying trends in prices but not short term deviations. Maybe the house prices of the boom years were just an "enormous anomaly that will have to correct downward sometime, if not right away." In other words, the boom might not have been predictable, but the reduction in prices was. The only question was when prices would fall and how fast.

Many Australian commentators, including the Reserve’s Ric Battellino, argue that, unlike America’s, Australia’s house prices are underpinned by a shortage of supply. The promised surge in building activity never arrived so there’s no need for prices to fall. According to this explanation, prices fell in the US because strong demand led to an oversupply of housing. In the end, they say, supply outran demand.

But curiously, some of the US cities where the bubble burst most spectacularly were those where building activity never was able to catch up with demand. At a 2003 conference, the Reserve’s Malcolm Edey speculated about why some housing markets are more prone to large swings in prices:

A plausible explanation is that the more volatile or bubble-prone markets are those where supply constraints on desirable land and desirable locations are the most important, a condition that would exist especially in the large coastal cities. This makes economic sense: it would be hard to have a bubble in an asset where the supply can respond elastically to the higher price. This would also explain why the most volatile markets are also those where the average prices are relatively high.

According to this explanation, supply constraints are likely to make housing markets like Sydney’s more volatile rather than more stable. Changes in interest rates, immigration, unemployment or other variables could trigger sudden shifts in prices. And since nobody can confidently predict how all these variables will move, who’s to say what prices will or won’t do. So perhaps all we can do is wait and see. If something interesting happens, it will be explained in due course.