Should Fischer Puncture the Housing Bubble?

The last survey by the Central Bureau of Statistics, updated for April, shows that prices rose over the previous six months by 2.2%.

There can be no longer any doubt that housing prices are climbing again.

The last survey by the Central Bureau of Statistics, updated for April, shows that prices rose over the previous six months by 2.2%. Prices during the second quarter, based on sales of four-room apartments, rose about 2% according to the chief government assessor. Activity is also feverish: The Bank of Israel reports that the value of new mortgages taken in July hit an all-time peak, jumping 25% from the previous month and 20% higher than in July 2011.

There are many indications that the market is boiling over: The Re/Max brokerage chain reports setting a new record for deals closed in July and being understaffed by 600 agents. Not a day goes by without reading about some wee repulsive apartment in a dilapidated building fetching an extravagant sum. Does this all mean housing prices in metropolitan Tel Aviv, Jerusalem and elsewhere have reached "bubble" proportions? It depends who you ask.

In the past few years, central bank governor Stanley Fischer has insisted at every opportunity that he has his eye on the market and there's no "bubble." Builders, brokers, bankers and mortgage lenders naturally concur, maintaining that the market merely reflects "equilibrium between sellers and buyers," but anyone looking to buy is quite sure it's there. As usual, everyone views the matter though their own perspective.

Defining a "bubble" isn't easy. Economics basically sees it as a market where the level of activity has risen remarkably higher than normal and prices significantly exceed their "real intrinsic value." But this description can be rather vague: "Intrinsic value" is hard to measure, so economics has no official or standard way for measuring a bubble. Some insist that no such thing exists in formal economic terms, while others admit bubbles sometimes develop but can't be identified or defined as such until they burst and suddenly send prices tumbling.

A troubling message to the markets

But identifying a bubble is just the initial and more trivial step. The key question is whether the central bank needs to puncture it the moment it appears. There is actually quite extensive economic literature and research dealing with this issue - some by U.S. Federal Reserve chairman Ben Bernanke himself - with most of it advocating caution and patience.

Arguments vary widely: The difficulty in identifying bubbles, doubts about government and interest rate policies being able to affect their progression, and fear of the economy overreacting to attempts at intervention. Alan Greenspan, Bernanke's predecessor, often warned about bubbles like the one involving high-tech stock prices, but intentionally followed a policy of "sitting back and doing nothing." If a bubble should burst, the policy held: "We'll clean up the damage using all the means at our disposal."

Until recently economists generally believed markets to be quite efficient mechanisms usually capable of dealing with bubbles on their own. In retrospect, they were mistaken. At least one economist, though, sees things otherwise and arrives at radically different policy recommendations: Prof. Nouriel Roubini, the same "Dr. Doom" who foresaw the subprime mortgage crisis and continues predicting a gloomy outlook for the European bloc and the global economy.

In an article written back in 2006 while working at New York University, he surveyed a list of generally accepted precepts, systematically debunking them one by one. First, he says - with few detractors - that bubbles cause enormous economic damage when they burst. Second: Even if a bubble's existence is in doubt, that's no reason not to stabilize a dangerous-looking trend - by fixing target prices in the problem market, for example.

Roubini isn't put off by not being able to decisively identify a bubble, and his reasoning is quite convincing: While economic science always finds it hard, if not almost impossible, to decisively decipher trends or data series, governments and central banks still conduct economic policy on the basis of such partial and uncertain information. Not being able to measure a bubble, in Roubini's view, doesn't justify ignoring it. He also claims the policy of the U.S. Federal Reserve is dangerous because it distorts decision-making: Signaling to markets that prices will keep rising while promising to ride to the rescue if a breakdown occurs.

Intentional burst

Prof. Roubini recommends that central banks intentionally puncture bubbles by raising interest rates and cooling down the problem market. But what about another concern held by many economists: Fallout caused from cooling the entire economy that could far exceed potential damage from the bubble itself? Roubini pooh-poohs this worry too, claiming air could be released from bubbles carefully and in a controlled manner without endangering the entire economy.

Intriguingly, as all this was written over five years ago and before the subprime bubble exploded, Roubini cites three cases of real estate bubbles to prove his claims: In Britain, Australia and New Zealand. In each case the central bank raised interest rates in a gradual and controlled way and managed to stabilize or turn around the property price charts without causing recession or pressure on the financial system.

Had Fischer placed Roubini, a fellow American Jew who studied in Israel and has fairly good Hebrew, at the head of a committee examining housing prices, the conclusions reached would have been clear from the outset: The housing market is a bubble or headed there. The frenzy of activity already resembles an all-out trance party, and prices can't be "real" if a four-room apartment costs over 10 years of wages.

Two ploys already attempted for containing housing prices, limits on mortgages and taxing investors, haven't succeeded. Research in Israel and throughout the world has shown that prices react mainly to just one factor - interest rates.

Conclusion: The Bank of Israel must raise interest - let's assume by 0.25%. This would startle the economy into realizing it's determined to lower prices, exactly like it set out to support the dollar's exchange rate - even at the cost of buying over $50 billion of foreign currency. Such action would once again cause people looking into buying homes to think twice.

The only remaining question now is whether Fischer will adopt the recommendations of the imaginary "Roubini report" or wait for the Iranian missiles to do the job instead.

Stanley Fischer
Moti Milrod