An Interview with John P. Calverley, Author of Bubbles and How to Survive Them General Q How can you be sure that the rise in house prices is really a bubble? A Overall the US seems to be in the early-to-middle stages of a housing bubble. The bubble in other countries, particularly the UK and Australia is much more advanced. The book provides a checklist for identifying bubbles (page 13). Rapid price rises and high valuations are always present, but a good test for a bubble is to look for other typical factors such as a relaxed monetary policy, rapid lending growth, a prolonged economic upswing, falling savings rates and large-scale media and popular interest. The housing bubble qualifies on all these criteria in some regions of the US, though not all are affected. Some of the most bubbly areas are in Massachusetts, New York, New Jersey, Florida and California. Q How can you be sure an asset is valued too high? A The book proposes broad ranges for stocks and houses, within which valuations can be seen as reasonable. For example a price-earnings ratio of between 10-20 and a house price-rental yield of 6-10% (i.e. the annual rent divided by the house price). If prices take these valuations above the range then we can start to say that it is probably a bubble. The book shows that these ranges are well-grounded both in past history and on an analysis of risk premiums. Realistically, we may not ever be able to identify a bubble with 100% certainty, but the further outside the range market valuations go and the more items ticked on the checklist (see above) the more likely that it is a bubble. Q Why are housing bubbles a threat? A At present Americans wealth is high in relation to income, despite the collapse of the stock bubble a few years back. This is largely because of the rise in value of housing. If the economy slows down for some reason, perhaps because of a slump in investment, or an outside shock or because monetary policy is tightened to head off inflation, there is a risk of a slump in house prices. This would reduce household wealth, hurt confidence and might severely complicate the downturn. Q The collapse of the stock bubble in 2001-2 had only a limited impact. Why should housing be any different? A The collapse in stocks only had a limited impact because it was offset by large cuts in interest rates and a huge fiscal stimulus. A new fiscal stimulus is not possible given the deficit levels today. And official interest rates are much lower than in 2000. Between 2000 and 2003 the Fed cut Fed funds rate from 6.5% to 1%. Today rates are only 1.75%. Moreover, the impact of the fall in stock prices was limited precisely because lower interest rates stimulated the housing bubbles, partly offsetting the loss of wealth in stocks and helped to keep consumer spending buoyant. Finally, it should be remembered that the stock bubble has left a legacy of problems for company pension schemes which have not gone away. Q Could house prices fall on their own? A spontaneous fall in house prices, leading to a slowdown in consumer spending and a weaker economy is certainly possible. The risk is greatest where house prices have reached extremes and where there has been substantial speculative activity, such as in the UK and Australia currently. US valuations are not yet so extreme. In practice, however, a fall in house prices is unlikely to be completely spontaneous. There is usually some sort of trigger, such as a rise in interest rates. But past experience with bubbles suggests that the trigger can often be something quite small. Q How much could house prices fall? A Based on past averages house prices could easily fall by 15-20% in the US on a nationwide basis but that would imply 20-30% falls in the most bubbly regions of the country. If accompanied by a severe economic downturn, a still-greater fall is possible. Q But US house prices have never fallen in the last 40 years. Why should they fall now? A The big difference with the past is that underlying consumer price inflation is much lower now. Taking out consumer price inflation, "real" house prices fell by 10% in the last housing downturn from 1990-95, but consumer price inflation of 3.3% pa, meant that nominal house prices moved up slightly. However, with inflation running at lower levels now, and house prices set to reach higher valuations than in 1990, there is a much greater chance of an outright fall in house prices. Moreover, if house prices fell in the context of a weaker economy, there is a risk of deflation (falling consumer prices) which would make the potential for lower house prices even greater. Q Why does a fall in house prices matter? A It obviously matters to individuals who have bought recently, since they will lose a large chunk, if not all of their equity. Some could find themselves with negative equity which, as well as being particularly painful, can make it difficult to move house. But it will also be of concern to people who bought some time ago, if they were relying on high and rising house prices to help fund their retirement. Q How does a fall in house price affect the economy? A the main effect is through a rise in the household savings rate as people save more and borrow less. So-called cash-out financing (or "mortgage equity withdrawal") has played an important role in sustaining consumer spending in recent years. Falling house prices would bring that to an end and the household savings rate would move up. The US household savings rate is currently only about 2%, which makes perfect sense given the strength of balance sheets. But strong balance sheets is reliant on house prices staying high. Higher savings rates mean slower growth of consumer spending, which accounts for around 70% of GDP.