Following the collapse of the “new economy” bubble of 2000, the Federal Reserve aggressively lowered its discount rate from 6.5% to 1.25% in less than two years in an attempt to coax a stronger economic recovery. But there is growing apprehension that this rate reduction is creating a new bubble in real estate.
The young science of complexity, which studies systems as diverse as the human body, the Earth and the universe, offers novel insights. The science of complexity explains large-scale collective behavior, such as well-functioning capitalistic markets, and also predicts that financial crashes and depressions are intrinsic properties resulting from the repeated nonlinear interactions between investors. Applying concepts and methods from statistical physics, several colleagues and I have developed mathematical measures to successfully predict the emergence and development of speculative bubbles. This led us to predict the recovery of the Japanese Nikkei in 1999 by 50%, to detect a speculative anti-bubble in the U.S. and global stock markets and, recently, to predict that the U.S. stock market will continue to weaken until summer 2004.
While the economy has generally been contracting over the last two years, real estate has been growing: House prices have been rising at about 2% a year faster than income gains. Since, according to the Federal Reserve, home values have twice the impact on consumer spending that stock values have, the housing boom has offset almost two-thirds of the stock market losses on the economy.
What is the risk of a real estate crash? The real estate bubble is part of a general huge credit bubble that has developed steadily over recent decades; it includes the U.S. federal money supply and personal, municipal, corporate and federal debts, estimated to be as much as several tens of trillions of dollars.
Recent research in the field of complex systems suggests that the economy, as well as stock markets, self-organize under the competing influences of positive and negative feedback mechanisms, such as momentum investing in stock markets. Positive feedbacks lead to such collective behavior as herding in buys during the growth of bubbles and sells during a crash.
Using this theory and its specification in the mathematics of fractals, my colleague W.X. Zhou and I have been searching for specific mathematical signatures of bubbles. Speculative bubbles are observed in all assets at all times and locations in history, from the tulip mania in Holland, culminating in 1636, to stocks, commodities, currency and real estate markets, past and present.
Our analysis finds that there are no significant risks for a crash in the U.S. real estate market this year. But two unambiguous signatures show that an unsustainable bubble in the United Kingdom housing market started even before the end of the stock market bubble in 2000. These signatures have been reliable predictors of past crashes in financial markets.
Investors should remain watchful for indications of a possible spread to the U.S. real estate market. Such signs would include an increase of correlation between real estate markets and the growth of patterns similar to those found in the United Kingdom.