Seven Laws of Property Bubbles

This cycle of bubble and bust in housing is drawing to a close. For many the ferocity of the bust and the collateral damage that followed was a shock, but bubbles and busts are not new; chances are there will be more.

1. All bubbles need a catalyst.

Bubbles start in "good times", typically GDP is going up and people have money to spend and invest, so money starts chasing assets and if it takes time for the supply of those assets to increase, prices go up.

2. Easy Money

If credit is available at less than the asset price, people who participate can make money from nothing, and the reason they buy becomes less about getting something they want and more about playing that window. That draws more money to compete for the already limited supply of assets, that's the start of the bubble.

3. Greed starts bubbles, fear drives them.

In every bubble the "Early-adopters" make fortunes, but they are the minority; the real drivers of every bubble are those who came late, that's the way pyramid schemes work; for every winner, there has to be a sucker. Greed of course plays a role, in the beginning the maxim is "those who snooze loose"; then comes fear.

4. Knowing the price of everything and the value of nothing.

Dumb valuations are an essential component of any bubble, first because they convince the suckers to pay, and second because they convince banks (and all the rest), to keep on supplying the credit, which is the essential lubricant of such perpetual motion machines, and when the bankers start lending money without understanding value, that drives the bubble forward.

5. The fatal seduction of New Paradigms.

Remember the Dot.com boom? They had these complex formulas for how you could value a company that had never made even an approximation of a profit, let alone had a coherent business plan. Ultimately it's all about valuation, and if something is new, it's harder to do a valuation.

6. Judging the "Pop".

Judging the pop is the hardest part, but when the rate of increase starts to drop, that's the time.

7. The amount of wealth created by a bubble is always less than zero.

Bubbles create no long-term economic value. Often they encourage people to borrow to spend money on luxuries, rather than investing in capability that might in the future create value that could be used to pay back a loan, for example an education, a technology, a franchise. That "waste" is how bubbles often end up destroying economic value.

What happens next?

The level of foreclosures has nothing to do with the way bubbles dissipate, the price has to go down to the place the market re-starts, how it gets there, and how much pain there is irrelevant to the inevitable progression of the long wave.

One ray of light is that historically there is a strong negative correlation between investment in equipment and the extent of market mispricing (read real job creation rather than creating public sector jobs which is where most of the jobs in UK were created over the past five years).

That's logical, mispriced housing makes it more expensive to operate, so new jobs get created elsewhere, one more reason why allowing property bubbles is pure undiluted irresponsible lunacy.