The Economist Blog links to a post by Casey Mulligan on the housing bubble:
Inflation-adjusted housing prices and housing construction boomed from 2000 to 2006 and crashed thereafter. Commentators ranging from President Obama to Federal Reserve Chairman Ben S. Bernanke have described that cycle as a “bubble,” by which they mean that, at least in hindsight, the housing price boom was divorced from market fundamentals.
But maybe there was a good, rational reason for housing prices to increase over the last decade.
With this graph:
The point of both posts is more about assigning blame - or not - to the Fed. But I think there's something more interesting here. Imagine if there was a more-or-less step-function in demand for housing in the mid-nineties, sort of like this:
That increase in demand causes prices to rise (correctly). As prices rise, the return to housing as an investment goes way up. As the return goes up, the amount you're willing to pay for a house justifiably increases because of that ROI (the amount you're willing to pay for something should have a term for expected selling price included in it). This increases the return, which increases the amount others are willing to pay, etc.
I think this is the cause of nearly all bubbles - and all busts, fur that matter. That is, a fairly sudden change in supply or demand causes artificial returns. If most people aren't able to measure the actual imbalance in supply and demand, then it's very easy to overshoot, and it's very easy to be proven "right" on your overshooting because of the positive feedback (that is, you predict supply and demand are in greater imbalance than they are, and the proof would be in the price going up more, which it does).
This inability to determine whether a price increase is proof of a supply/demand imbalance, or simply a pyramid scheme, is the exact reason why most people should not include themselves in markets that have this feature.
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