housing market peaked in the United States in 2006 at levels that were elevated to an extreme similar to current levels in Canada. The difference is that, since 2006, U.S. home prices have corrected by a huge amount, enough to eliminate most of the excess above the rate of inflation and the bubble completely deflated back to the trend line.
In Minsky’s terms, the U.S. housing market went through all the stage of hedge, speculative, and Ponzi finance, culminating in the collapse of two funds specializing in CDOs and bringing down Wall Street firms like bowling pins. In Canada the finance of houses and condos is in the speculative stage or the Ponzi stage with lots of investors subsidizing monthly payments from other income.
Canadians shouldn’t need to look any further than the financial crisis in the U.S. to see what will be in store for housing markets. However, we know that denial can be unshakeable when it comes to housing. Everyone seems to be an expert and most people have a personal stake in clinging to the belief that house prices can only rise, never fall.
Some Canadians will need more convincing, however, so next we will look at the American Minsky moment as well as booms and busts in housing markets around the world, including Spain, Ireland, and others.
Many people believe that it can’t happen here, or that it can’t happen to me. As we’ll see, not only can it happen, it’s only a matter of time until it does happen.
Chapter 3
Bubbles, Bubbles Everywhere
I can calculate the motions of the heavenly bodies, but not the madness of people.
— Sir Isaac Newton, 1720, observing the frenzied speculation over The South Sea Company and reflecting on his own enormous losses.[1]
Having seen what a bubble looks like in Canada, we can compare that situation to other bubbles around the world to see how house prices react before and after they burst. We have lots of examples to look at. There are a number of other countries that are still experiencing bubbles such as China, Australia, Belgium, and Norway. There are many more jurisdictions that were in a bubble and now are in the process of correcting the excesses of a past bubble (United States, Ireland, Portugal, Iceland, Japan, and Spain, to name a few).
Bubbles are all different in the details but they are all very similar to each other in a few important ways. When they finally burst, the associated financial and economic difficulties are transmitted through the banking system in a process of unwinding or deflating of the bubble. This process of unwinding can take years or even decades. So it’s not like trying to observe a Higgs boson particle that exists for only a millionth of a second. The events surrounding bubbles and their aftermath unfold in slow motion.
The U.S. Housing Bubble and Its Aftermath
We needn’t look far for examples: the United States experienced both a housing bubble and a crash, all in the past decade. Their housing bubble started to form about the same time as Canada’s, and the two bubbles tracked closely until 2006. As mentioned, Robert Shiller received the 2013 Nobel Prize in economics for his work that involved proving that bubbles in many different forms do exist and cannot be explained by random fluctuations. Of course he completed his work long before the global financial crisis but only received his prize after the U.S. housing bubble burst.
As Shiller shows, real estate bubbles in residential housing are a recent phenomenon.[2] He examined housing markets and pricing trends through history back to 1890 and could not find any examples of nationwide bubbles in house prices other than a surge in home prices in the United States and Canada during the decade immediately after the Second World War.
Land speculation bubbles (not housing bubbles) are common throughout history. Those bubbles were usually identified with a particular event or development, such as a Florida land boom and bust in the 1920s, which left new cities built and abandoned within a few years. Land bubbles were isolated to a specific place. As an example, Shiller cites Chicago from 1877 to 1931, when prices increased much faster than the rate of inflation. That was an isolated bubble related to the arrival of the railway. Winnipeg was a major hub of population growth and land speculation at one time for similar reasons. When the Canadian Pacific Railway reached Calgary, speculators made and lost fortunes on the ensuing land boom.
Widespread individual–family home ownership is a relatively recent development dating from the late 1940s. This evolution in home ownership moved closely with the emergence of a large and growing middle class after the war. Shiller’s database of housing prices only goes back to 1890. No earlier index or long-term record of U.S. home prices exists. Apparently nobody cared enough about a national measure of housing as all booms and busts were local, according to Shiller.
U.S. Real Home Prices Flat for 108 Years
The most remarkable fact from Figure 3.1 [3] is how little growth in home prices, adjusted for inflation, there was from 1890 to 2000. The index (U.S. prices) was at 100 in 1890 and today is at about 130, close enough to a zero increase that we can call it unchanged. The index peaked at 198 in 2006. The recent bubble period started in about 1998, when the index was at 115. This action seems to prove the claim by GMO analysts that all bubbles burst and are fully deflated, although it remains to be seen whether “reversion to the mean” is complete, as it is just as likely that prices would fall well below the long-term trend line for a while before starting to trend back higher.
This graph is striking in several ways. The recent bubble in home prices, from about 1998 to 2007, stands out as this spike shows a doubling in prices over a ten-year period while the index remained unchanged after more than one hundred years even though the population tripled from 100 million to more than 300 million.
We can see also that for about twenty years, from 1920 to 1940, there was a distinct slump in prices of homes. So much for the statement that some of us heard many times just before the housing crash that there had never been a nationwide drop in house prices!
Bubbles All Over the World
No one with a weak stomach should dare to take a peek at the housing boom (and collapse) in a country like Spain. Perhaps Canadians will look at Spain and say that it couldn’t happen here. A big push for the boom in real estate construction there came from the insatiable appetite among foreigners for ownership of condos and villas in the sun. Many foreign buyers were German and British.
One of things about Spain that jumps out is the fact that government debt was only 36 percent of GDP before the crisis started, a level identical to Canada’s current federal government debt. Ireland also had a very low government debt burden before the crisis hit and there, too, it was a real estate crash and the need to bail out the banks that pushed the government debt much higher.
During the Spanish bubble household indebtedness rose sharply due to rising housing prices. In fact there are few countries in the world where household debt can rise to unsustainable levels without a real estate boom since the collateral for household loans worldwide is housing. One exception to that would be the student loan crisis in the U.S. where the government backstopped the loans, which have ballooned to more than $1 trillion now. Without a house or a government guarantee backing the loan, banks will not let households or individuals get into large amounts of debt. According to the Spanish ministry of housing, residential real estate prices tripled from 1996 to 2007. That was quite a boom, and it’s an absolutely torrid pace. Figure 3.2 [4] shows that Spanish house prices soared to a peak in 2007 and then corrected almost the whole advance, similar to the U.S. house-price
