I was going through the annual reports of the Central Bank of Ireland there yesterday when I came across an article on fundamentals and non-fundamentals in the Irish housing market. The quote below spells out why the prices of assets, such as property, are not always set by supply and demand. Later on in the article the author says that although Ireland in 2003 showed all the signs of a property bubble, just because there was strong, detailed evidence of a housing bubble, that was not enough to prove that there was a housing bubble. Go figure on the logic behind that.
Anyway, here’s the quote outlining why, with assets, demand rises as price rises, and falls as price falls.
The market is self-correcting in the sense that excess demand (supply) will put incipient upward (downward) pressure on prices, but this will encourage additional supply (demand) which, in turn, will tend to stabilise prices. If the property market did in fact function in this smooth way, the type of inefficient pricing associated with overvaluation would be less likely to occur. When there are s peculative forces at play in the market, it does not operate in this smooth self-stabilising fashion, since price increases tend to increase, rather than decrease demand, and therefore, per se, would tend to geneate further price increases.
There are a number of reasons why the propety market does not operate efficiently and smoothly, First, since it takes time to build new units, supply is very inelastic in the short term. The supply of available land on which to build may, in some cases, present an even more severe constraint and can mean that supply can remain inelastic even in the medium-to-long term. Lags in supply mean that increases in demand have large effects on price. Speculators may be attracted into the market by these price increases in the expectation of further price increases. The additional demand coming from speculative influences can render these expectations self-fulfilling with prices becoming progressively more misaligned. By the time the construction industry is fully geared up to respond and new units begin to come on to the market, the initial demand may not prove to be as sustainable as initially appeared resulting in over-supply and sharply declining prices.
Secondly, the acquisition value of property tends to be a large multiple of disposable icome, or even of accumulated savings, since it is typically the biggest single purchase in the life cycle of households and is usually incurred at a relatively young age. It can, therefore, only be purchased on the basis of considerable financial leverage. But the loan market is generally understood to be subject to informational imperfections, inhibiting its smooth functioning and leading to rationing of some loan applications. This also restricts the flexible functioning of the property market and its ability to self-correct speedily following a shock to supply or demand.
A third factor which is related to the second, is the fact that property price increases provide collateal for further borrowing which may, in turn, add to demand in the market contributing to further price increases. This effect can also work potently in reverse with falling collateral values possibly leading to a credit crunch putter further downward pressure on prices. The use of propety values as collateral in the mortgage market can, therefore, exacerbate the volatility in house prices over longer horizons.
Other factors having a long-term impace on the housing market are financial market liberalisation, but more especially the impact of liberalisation on the banking industry, and fiscal policy. Financial market liberalisation can have the effect of releasing pent-up loan demand and facilitating a large influx of new participants into the property market over a short period of time. A credit boom could then instigate a property price boom. Fiscal policy is another factor that can also, and does, impact on the market, typically adding to demand. (p.55)
Central Bank & Financial Services Authority of Ireland , “The Irish Housing Market: Fundamental and Non-fundamental Influences.”Financial Stability Report 2004. Dublin, 2004. 51-76. NLI Reference: 1K 582, yr 2004.