Sunday, 26 July 2009

The Seven Immutable Laws of Bubbles: Example, Housing in USA, UK & Dubai

The cycle of bubble and bust in housing is drawing to a close. For many the ferocity of the bust and the collateral damage that followed was a shock, but bubbles and busts are not new; chances are there will be more.

I got interested in bubbles in early 2008 trying to figure out why my model of real estate prices that had worked perfectly for ten years was saying that prices in Dubai which is where I was at the time, "should" have been 30% less than where they were.

This is what I found out:

Law #1: All bubbles need a catalyst, like a stone to throw into a still pond.

Bubbles start in "good times", typically GDP is going up and people have money to spend and invest, so money starts chasing assets and if it takes time for the supply of those assets to increase, prices go up.

For example, the fundamental price of housing long-term is exactly equal to nominal GDP per house divided by a function of long-term interest rates ( When nominal GDP goes up a lot faster than the supply of housing does, then the price of housing goes up; that's supply and demand, there is nothing wrong with that but it's the pebble in your hand; just you didn't throw it yet.