Where will the next real estate bubble burst? by Chris Matthews @FortuneMagazine June 20, 2014, 3:06 PM EDT E-mail Tweet Facebook Google Plus Linkedin Share icons The economic slump that richer countries have suffered during the past seven years can be blamed on a runaway housing bubble that started right here in the U.S. Sure, there were other issues–like poor oversight of the broader financial system–that led to the crash. But without the real estate bubble, there would likely have been no financial crisis. Which is why the fact that similar-looking bubbles inflating in countries from Canada to the U.K. have economists worried that there might be other catalysts of future crises laying wait for us in the weeds. Last week, IMF economist Min Zhu published an article called “Era of Benign Neglect of House Price Booms is Over,” in which he sounded the alarm over rising global home prices. Zhu explains how he determines whether home prices in a particular country are overpriced: “Theory asserts that house prices, rents, and incomes should move in tandem over the long run. If house prices and rents get way out of line, people would switch between buying and renting, eventually bringing the two in alignment. Similarly, in the long run, the price of houses cannot stray too far from people’s ability to afford them––that is, from their income. The ratios of house prices to rents and incomes are thus often used as an initial check on whether house prices are out of line with economic fundamentals.” The following charts from the IMF show the results of this analysis, with countries like Canada, Belguim and Sweeden appearing to have large housing bubbles on their hands: Unfortunately, this isn’t the first time that economists have warned of housing bubbles around the world. Price increases in Canada have had officials worried for years, for instance. The problem is, it’s difficult to do anything about a growing asset bubble while it’s in progress. Regulators can work to make sure that credit isn’t too widely available and lending standards are tightened, but sometimes the logic of a bubble can overcome even these measures. The only reliable way to eliminate a bubble is to let it burst, which could lead to terrible consequences for the country’s economies in question. Perhaps a more interesting question, and one that could help policy makers avoid these real estate bubbles in the future, is why are there so many bubbles growing in this particular asset right now? For that it is useful to turn to the recent debate over economist Thomas Piketty’s best-selling Capital in the 21st Century. Piketty’s book alleges that growing income inequality is a central feature of capitalist systems, because the returns to capital will almost always be higher then economic growth. The result is that capital becomes ever more valuable, while there is not enough economic growth to make richer those who don’t own capital (like real estate or financial assets). Critics of economist Thomas Piketty’s thesis have argued in recent weeks that his argument is flawed because most of the run up in value of capital in the past 20 years is due to the run up in the value of real estate around the world. If real estate is overvalued, as the analysis above suggests, then Piketty’s claim that the return on capital is growing could be an illusion. But what if real estate isn’t overvalued? What if there is something happening in the economy that’s causing real estate to become more valuable? A growing body of research is arguing just that: As developed economies become less reliant on agriculture and manufacturing, and more reliant on creative industries that thrive on close collaboration for a generation of valuable ideas, land is becoming once again very important. We can see this happening in the U.S., where rents in cities like San Francisco, Washington D.C., New York and other innovative cities are skyrocketing along with salaries. In an environment where the most productive workers are seeing rapidly rising property values, it makes sense that people would want to buy a home rather than rent. After all, what force is going to stop this trend in rising prices? With this explanation, you have reason to believe that the recent run up in real estate prices in developed countries has both a rational component (the evolution of the economy is making location more important) and an irrational component (people think that nothing will stop this trend). It’s difficult to say which force could be a bigger factor pushing real estate prices higher, but it’s important to realize that just because prices have always behaved a certain way in the past doesn’t mean it will continue that way in the future. In other words, perhaps what we think is a bubble is really just the real estate market telling us that policy makers need to do more to allow more housing supply to be built where economies are most dynamic.