Prices only go up, don’t they?
The title of this article combines comments by Alan Greenspan about the stock market boom of the 1990s (”irrational exuberance”) and the title of a book by Charles Mackay. The book, “Extraordinary Popular Delusions and the Madness of Crowds”, is a short but interesting one, covering those aspects of human psychology, sociology and politics that lead to what are known as bubbles. A bubble is loosely defined as what happens when the price of a particular class of item breaks away from fundamentals and, in effect, goes up because everyone expects it to go up.
We’ll rewind a bit here and take a look at the way markets usually work; all markets, not just financial ones. Company A produces a product; it could be a car, a toaster, a cake or a life insurance policy. In order to sell its product, Company A must price it at a realistic point. Too low and it will lose money on each product it sells. Too high and nobody will buy it except the rich and the insane (often the same demographic).
Note that to keep it simple here I’m excluding things like loss-leader promotions, where products are deliberately sold below cost to stimulate demand for related items.
Anyway, in a stable market the price is set at the margins, where the ability and willingness of the buyer to buy is matched by the ability and willingness of the seller to sell. This is a nice little negative feedback loop that keeps prices competitive, assuming competition is permitted within this particular market sector. Shortages of supply - whether real or deliberately created by withholding stock - can lead to increases in price, but higher prices will only be met if the demand is present and if Company A isn’t undercut by Company B.
And, most crucially of all, demand is moderated by the ability to pay. As the old example goes, the demand for Ferraris among 12-year-old boys is pretty much infinite, but that doesn’t have any effect on the market (at least until they grow up) because they have no ability to pay.
Markets that conform to these ‘rules’ are said to be following fundamentals; the price of a product or service matches its utility or usefulness at any given point in time.
OK, enough background. What could go wrong here to cause market stability to cease and a bubble to form? What tends to happen is that a particular market suddenly has an influx of new and often naive potential buyers. These buyers either didn’t know the market existed previously, or - more usually - were not able to participate before because they did not have the means to pay: imagine what would happen to the price of Ferraris if you gave every 12-year-old boy a million pounds, for example.
The last bubble that burst in the UK was the dot-com bubble, which deflated rapidly in the year 2000. This bubble is interesting because the market literally didn’t exist beforehand, so there were, five years earlier, almost no investors at all. People saw the Internet as a hugely influential new communications and commerce medium (which it is) and also as a new, almost limitless supply of revenue for all (which it is not).
Site ‘hits’ were confused with pounds and, even though most large sites were making massive losses, share prices rocketed, making a few people very rich… assuming they got out in time. People bought shares because they were going up in price. But the reason they were going up in price was because people were buying them on the expectation of them going up in price, without understanding the market. Fundamentals had been left behind, irrational exuberance had taken over and the few commentators who knew it couldn’t last were denounced as fools by the crowd.
The bubble burst for a number of reasons, but ultimately because fundamentals reasserted themselves. There was simply no way that all those dot-com companies could be profitable. The laws of supply and demand hadn’t changed; they never do. As the editor of this site would state it, for most of the companies involved the business plan was something along the lines of:
1) Launch web-site.
2) ???
3) Profit.
And for most, number 3 was never reached, nor ever likely to be reached. When investors realised that, share prices crashed and for a long time nobody touched dot-com shares with a barge pole (as usually happens after a bubble bursts; for a while the stocks in related companies are extremely cheap).
The dot-com crash was an example of a lot of investors piling into a new market because they hadn’t known about it before, in this case because it hadn’t existed. But we’ve also had bubbles where investors pile in because they suddenly have the means to pay, which they didn’t have before. Arguably, in fact, we’re in one now.
It’s been scientifically proven that if you laid all the column inches written about the UK property market end to end, they would reach from here to boredom. Nonetheless, the oft-quoted reason for the dramatic rise in property prices is ‘the law of supply and demand’, sometimes summarised in the vernacular as “Well, they ain’t buildin’ no more land, are they?”
Which is true. Supply and demand do play a major part. But, as stated above, demand is moderated by the ability to pay. Give everybody in the country a maximum £50,000 mortgage and house prices will hover around £50,000. Give them a maximum £200,000 and prices will hover around £200,000. Banks dicate what people can borrow, so in turn banks dictate what houses cost (leaving aside, as before, the insanely rich and the richly insane).
A decade of cheap credit - the source of which I’ll cover in another article - has allowed banks to lend a lot of money. Add in a heady mix of nesting instincts, fear of being left behind (”We’ve got to get on the ladder at all costs”), peer pressure, the smugness of those who have ‘made’ money on their houses, television property programmes offering unregulated financial advice and an impressive collective amnesia about the last two house price crashes, and it’s not hard to see why prices have risen so fast.
The era of cheap credit has come to an end; whether temporarily or permanently remains to be seen. If, as many market commentators believe, a large proportion of UK property price increases are due to speculation that they will continue to rise, we’re in for quite a shock as that speculative froth gets blown away.
The irrational exuberance appears to be over. It’ll be interesting to see whether the crowds were mad after all.
(c) Alex Cruickshank 2007
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