Identifying House Price Booms, Bubbles and Busts: A Disequilibrium Analysis From Chaos Theory

Abstract

This research has been motivated by the extremes of public policy intended to re-inflate the housing market after the disastrous collapse of house prices from mid-2006 to the approximate beginning of a turnaround in March 2012. Is it even possible or desirable to utilize such a vast amount of public resources to inflate a single sector such as housing that suffered from such a spectacular bubble and collapse? The consequences appear to suggest that, as a way to bolster real household incomes and aggregate output, these policies have been a disappointment if not a failure. We use a concept of “irreversibility” from the analysis of complex physical systems in thermodynamics by Ilya Prigogine when a system is far from equilibrium conditions. We apply this concept to the case of the collapse of house prices after mid-2006 and the policies that tried to restore these prices to previous peaks. At the present time there is a fear that the unprecedented monetary stimuli will lead only to an unsustainable housing price inflation, if not a bubble. I address these questions in the analysis from the standpoint of determining a stable equilibrium and sustainable house price appreciation rates consistent with the growth of household nominal income. The problem of identifying stable house price appreciation is to first identify the major proximate determinants of household demand for housing. A second is to show empirically the movement, deviation, and variation of these factors over time compared to housing prices. I use median household income as the major demand factor for houses and median single family house prices as an indicator of the price. A third is determining the stable equilibrium of the growth of these factors and the appreciation of housing prices consistent with them. And a fourth is the adjustment process when there are small deviations from steady-state equilibrium compared to when deviations are large. It is in this last distinction where nonlinear dynamics of systems far from equilibrium seemingly develop “order out of chaos” and look to be “self-organizing” forming a new type of equilibrium for the housing market that may indeed be chaotic. I conclude that, as of the beginning of June 2016, the evidence is overwhelming that housing price appreciation is unstable and that any adjustment may lead to significant declines in house price appreciation if not in house prices. An important policy recommendation to mitigate the severity of these declines and hasten a house price recovery is to recognize that the burst of the house price inflation bubble is not readily reversed. The euphoria leading to and sustaining the bubble is what is necessary to reverse first. As of early Fall 2018, the weaknesses appearing in the housing market may have begun to slow the rate of house price appreciation. The global expansionary monetary policies have only served to delay house price downward adjustments, have flooded capital markets with liquidity leading to unsustainable house price appreciation and might result in severe price declines if policy adjustments don’t take hold soon.

Keywords: Housing Prices, Chaos Theory, House Price Booms, House Price Busts, Housing Price Steady-State Equilibria, House Price Instability, Economics of Euphoria, System Irreversibility, Dissipative Structures of House Prices

JEL Classification: R10, G20, M10