Asset price bubbles have been with humanity almost as long as assets – even the venerable Isaac Newton, certainly nobody’s fool, lost his shirt (and ₤20 000) in the South Sea Bubble of the early 1700s. Yet, despite their frequent recurrences, it seems people never really learn from these outbursts of economic exuberance.

An asset price bubble occurs when speculation in a commodity (anything really – property, silver, tech stocks) causes the price to increase, producing more speculation. The price eventually reaches ridiculous levels and the bubble bursts, resulting in a sudden drop in prices.

In a bubble, people buy assets based on the expectation that the price of the assets will increase, rather than on the basis of the return they can earn from those assets. Obviously, this becomes problematic when the price increase fails to materialise, further deepening the crash.

Now, take the current property mania – you can call it a boom or a bubble, depending on your point of view – is it displaying signs of bubblehood? The Economist reports that between 1997 and today, property prices have more than doubled in many countries around the world, including the UK, Ireland, Australia and Spain. The publication estimates that the “total value of residential property in developed economies rose by more than $30-tn over the past five years, to over $70-tn, an increase equivalent to 100% of those countries’ combined GDPs.” In fact, The Economist went so far as to describe this boom in property prices as “the biggest bubble in history” – strong words indeed.

The causes of worldwide robust property prices have been widely discussed and boil down to low global interest rates and public disillusionment with other asset classes as a result of the now-infamous tech bubble. Grumpy people who lost big on stock market speculation have turned to the more tangible asset class of property in the search for returns. But is the resulting property boom sustainable? The Economist thinks not – in its analysis, it argues that things are looking decidedly shaky. In particular, the analysis focuses on the divergence of house prices from rents.

Theoretically, you buy an asset based on the return you can expect – with shares you expect a certain dividend income; with property, you expect a certain rental income (or a saving on rental income in the case of the owner-occupier). Increasingly, property prices are out of proportion to the potential returns an investor can earn. Additionally, the analysis points to the fact that in some of the hotter markets – the UK and Australia in particular – price growth rates are slowing down and even turning negative, perhaps signalling the bursting of the bubbles. The reason this should concern people is that when property bubbles burst the economy feels the pain.

In a study by the International Monetary Fund entitled Housing price bubbles - a tale based on housing price booms and busts, the researcher finds: “The evidence clearly suggests housing price busts in industrial countries were associated with substantial negative output gaps, as real GDP [gross domestic product] growth decreases noticeably. On average, the output level three years after the beginning of a housing price bust was about 8% below the level that would have prevailed with the average growth rate during the three years up to the bust.” In addition, house price busts have an effect on consumer spending, because of the so-called wealth effect; when the value of people’s homes increase they feel richer, and thus spend more.

Losing 8% of output is a knock to any economy, and if the big industrialised nations like the UK and the USA are affected this will have a serious negative impact on the global economy. In addition, the recovery in the US economy following the tech bubble has been driven mainly by consumer spending, rather than an increase in productive capacity. The consumer spending effect of a house price bust would really hurt.

During the period from 1999 to the present, house prices in New Zealand have risen faster than remuneration, with the result that housing has in general become less affordable. The affordability of housing is under pressure owing to sharply rising house prices compared with more moderate increases in remuneration levels, as well as stable (and rising) interest rates. In other words, lower-income and first-time buyers are being priced out of the market by less-affordable housing. This is precisely the phenomenon noted by the Economist in respect of the global bubble: “British and Australian prices have stalled mainly because first-time buyers have been priced out of the market and demand from buy-to-let investors has slumped.

British first-timers now account for only 29% of buyers, down from 50% in 1999. And, according to the National Association of Estate Agents, buy-to-let purchases are running 50% lower than a year ago.” Rising interest rates may trigger a slowdown in house price growth, and the hefty mortgages people are repaying may become too much, forcing people to sell their homes at lower prices. Notes The Economist “contrary to conventional wisdom, it does not require a trigger, such as a big rise in interest rates or unemployment, for house prices to decline.” In fact, a modest interest rate hike can have an effect – as has been the case with the 1,5% increases in the UK, Australia and to a lesser extent New Zealand.

The question is if and when the recent RBNZ rate increases will hurt the housing market and have a knock-on effect through the economy (we have yet to see any strong evidence of this). The local economy has, to a large degree, been fuelled by strong consumer spending, which would be heavily damaged by a house price bust. If the property bubble does burst worldwide, it will be a very loud bang indeed.

Based on an article by Barry Sergeant. Reproduced with permission from HSBC.