One of the key aspects of the current economic difficulties is the crash in the housing market. Before discussing exactly how this has contributed to our problems, it is worth asking how far prices have to fall. Is it a good time to buy a house or will prices fall further?
The graph below shows my attempt to answer this question. It shows the price of an average second-hand house in Ireland over the last 30 years. The “Market” line is the actual price (adjusted for inflation) while the “Eqm” is price that reflectects the true underlying intrinsic value of hosuing (or the “equilibrium” price in economics-speak).
By the height of the boom, according to these figures, the actual market price was almost double what it should have been.
How is this equilibrium price determined? The idea is that the price of houses (or anything for that matter) is related to economic fundamentals. In the case of housing these fundamental determinants would be people’s income; interest rates; and the size of the housing stock. As these “fundamentals” change, the price of housing should also change. We can use statistical methods (Linear Regression — for the initiated) to predict how changes in the fundamentals relate to changes in the price. We think of the price predicted by these fundamentals as being the “intrinsic” value of housing.
As can be seen from the diagram, the intrinsic and actual market prices were pretty close up to about 1997. After 1997 the intrinsic value started to increase. This reflected the rapid increase in incomes in Ireland. But note that the market price increased by way more. By the end of the boom, the market price that people were actually paying was almost double what the intrinsic value of the house appeared to be.
So not surprising then that prices have fallen. But will they fall further? And why did they rise so far above intrinsic value for so long? Tune in tomorrow for the next thrilling episode of “Revenge of the Mutant Ninja Estate Agent”.
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