Mauro F. Guillen
Director of the Lauder Institute at the Wharton School

Bubble Essential Part of Market Economy

Characteristically, they are based on assumptions that at some point turn out to be unrealistically optimistic or otherwise at odds with a supposedly ``hard'' reality.

When a bubble finally bursts, people always ask two questions. First, why did it last so long? And second, why are the effects so severe?

Obviously, the two are related to one another.

Of all bubbles, those involving real estate have the potential of lasting for a long time and having devastating effects.

The reasons are that people tend to be extraordinarily optimistic about real estate prices, they tend to participate in the creation of the bubble with borrowed money, and when the first signs of trouble appear, it is always easy for new buyers to wait and see, thanks to the existence of a relatively well-functioning rental market.

Much has been written recently about the existence of real estate bubbles in several European, Asian and North American markets.

Central banks, governments, international agencies, lenders and mere observers have pointed out that the combination of several years of hefty price increases and tighter credit conditions as of recent might bring about a self-reinforcing spiral of decline in real estate prices. While I do not wish to ignore the signs of trouble ahead, it is important to put things in perspective.

The market for real estate is a peculiar one.

People buy real estate because they need a place to live or to vacation. They also buy it as a store of value or, yes, to speculate.

Moreover, in some economies, the real estate sector has come to play a very important macroeconomic role.

Cheap credit guaranteed by real estate has made it possible for people to leverage themselves as investors or as consumers.
In the United States, the on-going ``sub-prime'' crisis is scary because so much economic activity is driven by consumption itself fueled by borrowing against real estate assets.

As a recent study by the International Monetary Fund states, one should only be concerned about rising real estate prices when incomes do not grow at the same pace.

Between 1999 and 2006 real estate prices in the U.S. rose by about 6 percent annually. Incomes rose by just about 2 percent annually over the same period.

Given that foreign purchasers of U.S. real estate account for only a tiny fraction of all transactions, the trend cannot be sustained, especially now that credit is not as cheap as a few years ago.

In most East Asian countries, by contrast, incomes have grown faster than real estate prices.

For instance, over the same time period, China saw an annual hike of 2.6 percent in real estate and a whopping 9.5 percent in incomes.

In South Korea, the corresponding figures were 2.2 and 3.7 percent.

True, during 2006 prices went up by 12 percent, and by as much as 20 percent in the Seoul area.

Based on this figures, The Economist magazine declared that the fear of a real estate bubble in much of Asia is exaggerated.

Reasonable people may look at the same set of figures and reach different conclusions, depending on their assumptions about future trends and events and on their attitude towards risk.

I believe that in a country like South Korea the most serious risk right now is not so much that there might be a correction in real estate prices but rather that the government and key economic agencies might overreact to the threat.

Although inflation remains low, the Bank of Korea seems to be inclined to raise interest rates at the first sign of trouble. Such a move would increase payments on existing loans and depress asset prices. As a side effect, it might reduce consumption enough to affect the rate of GDP growth. At a time when the South Korean economy is growing more slowly than it used to, the central bank needs to carefully weigh the consequences of its actions.

Governments, including the South Korean one, can also change regulations, especially taxes, in order to ensure a soft landing of real estate prices.

An important factor to keep in mind when designing such regulatory changes is to aim at the right target.

Changes in taxes or real estate rules should not discourage first-time homebuyers; they should target speculators. But they should be carefully calibrated so that even speculators in real estate have a way out. Eradicating speculation in the short run causes a bubble market to crash. The change has to be gradual so that all actors involved can adjust.

Perhaps the most important role the government can play in the middle of a real-estate bubble is to ensure that banks are making the appropriate provisions to protect themselves against the potential negative impact of non-performing loans.

As long as profits during good times are set aside to cover losses during bad ones, the financial system will remain a solid pillar of economic growth. This should be the utmost priority. Hence, governments and government agencies need to carefully assess the combination of measures _ monetary, regulatory and others _ that facilitate the smooth development of markets, including the market for real estate.