Identifying Booms and Busts in House Prices under Heterogeneous Expectations

This paper provides a method for identifying when rising house prices are in danger of becoming bubbles on the verge of bursting. As a result, it is a first step towards establishing an early warning system for house price changes that could help prevent important welfare costs. By examining over 40 years of housing market data in eight countries (US, UK, Spain, the Netherlands, Belgium, Switzerland, Japan) we attempt to provide a methodology that links the conditions that lead to dangerous house price movements to policy variables such as interest rates and macro-prudential tools. This is important because by understanding how they are related, policy can intervene at appropriate times to prevent undesirable outcomes. Mainstream macroeconomic models typically fail to allow for abrupt changes or to capture instability driven by self-fulfilling expectations, the mechanism at the heart of market bubbles. In this paper we attempt to identify when instability occurs, i.e. when the economy can become very unpredictable. This type of methodology should be used in parallel with our mainstream models to inform policy makers.