Markets, Housing, Debt and Price: The Fundamental Importance of Appreciating Continuous, Dynamic Price Discovery

When most people contemplate supply and demand, and the balance of supply and demand market price for an item, they tend to consider Demand as if it were merely “desire”, and neglect the financial ability of the potential buyer to actually afford the current market price.

Here is where simple desire to buy is shown to insufficient – I know this should be obvious but the “means” or “ability” of buyers to afford/demand the market price is so infrequently discussed. Why?

I, and many others, believe it is because access to plentiful, overly cheap credit has been so taken for granted, for so long, that there is an ingrained mentality that potential buyers can pay just about any price they want to.

Consequently, mere desire is somewhat approximated with genuine financial market Demand.

But is it really “demand” in economic reality? No.

In the expectations and the “herd’s” euphoric boom mentality? Heck, yes!

But since the Global Financial Crisis (recession) in late 2007, access to plentiful cheap credit has come to an end.

Why? Debt-based, speculative bubbles began to pop, as loans went sour – and a chain reaction rippled through the worlds’ globalised economy.

Consequently, economic sectors that have “boomed” on the back of excessive amounts of overly cheap credit/debt (such as real estate) were/are confused that mere desire is no longer equating to real market demand, and the subsequent increasing, or even just propping, of market prices.

This “confusion” is demonstrated in such assertions that “land shortage”, “housing shortage”, “high population growth” and other things like “high influx of wealthy immigrants” are proving insufficient to keep the property sector prices propped.

This has been exactly the scenario in a large number regions/states/countries that have had all these factors going for them, but have still nonetheless suffered severe price drops, particularly in highly leveraged real estate.

Yes, many of the hardest hit real-estate locations in the world are the ones that have actually had the above-mentioned “positive” factors in their favour. The desire was real; the ability to keep demanding, via cheap credit/debt was real…But the sustainability of the real financial demand wasn’t.

And consequently, prices came down the hardest in those places where the bubble had been inflated the most (with debt) – when the “easy” debt dried up and/or no new “players” could afford to come in at the bottom of the Ponzi Scheme any more…the assumed returns diminished, then stagnated, then hopes evaporated, fear and panic set in, and then the house of cards collapsed. And everyone is left scratching their heads.

And what was the main thing reason it happened, we were told? Liquidity (ie. access to plentiful, cheap credit) dried up…therefore, the solution is more plentiful, cheap credit. So let’s get govts to borrow more and “stimulate”, print more money, where needed, and further cheapen debt by dropping interest rates. Great! More plentiful cheap credit!

Otherwise expressed: the drunk is getting sober…and that hurts…and we can’t have any pain (on our watch at least!)…so give him more alcohol. Fixed! Yey! ….Not!…the problems that caused the actual problems in the first place are still there…

But the problem is that people are either maxxing out, or maxxed out, on their ability to service debts, so all the stimulus isn’t really doing anything like it was supposed to…because people, largely, are (or are starting to) act economically rationally and actually try to stay solvent. Otherwise known as living within their means.

But does it make sense to actually live within one’s means? Of course it does. But why then did we – and do we still – tolerate so much contrary thinking and action in ourselves and our society?

Perhaps we can start to get a better perspective on why the measures of governments and central banks in the world are failing in many economies around the world by bringing little more than short-term respite; and why they will continue to fail until ridiculous levels of debt are dealt with.

Anyhow, i digress slightly…back to the property market and associated debt levels and practices…

So, the drying up of cheap, plentiful, quality credit and creditors equated to a decreased ability to demand. And since Price Discovery is a continuous market mechanism, and demand had fallen, then the sellers – who were mostly leveraged to the hilt, expecting “certain” asset price (capital) increases – financially speaking, HAD to sell.

But they, the sellers, had to accept what buyers could pay – or else just keep bleeding money from servicing their large debts – and accept less money for the sale than they hoped for….and so on, so forth, right down the chain, and it is still occurring today…continuous Price Discovery.

And, i assert, it is starting to happen in Australia, as we speak. Web sites such as REFind – Property Advertising History (an Australian site) are good for tracking this. (My own site, The ‘BurbWatch Project, has been doing exactly this for a little while, with charts, etc)

In summary: all this simply means is that debt enables an economic entity to “demand” more; but when many entities are highly leveraged, and depend on continuous, debt-backed increases in capital gains, and when the cheap debt dries up, and the ability of demanders/buyers to service debt is reduced, and is then maxxed-out; then the net demand is reduced, and Price Discovery simply works the agreed buy-sell price according to the new supply-demand balance.

That is: down to where to buyer i) can and ii) will pay what the seller is asking.

Simple.

Now, regarding many property investors and other spruikers : it is probably fair to briefly discuss the bewilderment of many real-estate vested interests, who do not grasp that demand in real-estate over the past 3 or so decades – the last 2 in particular – has largely been due to the large-scale access to cheap credit, and the ability of entities (people, households, businesses, etc) to keep servicing larger and larger debts with increasingly large proportions of their revenue.

That is, that the real-estate price cycle has been following the credit-cycle – booming house prices are driven by booming credit levels, not simply by supposed land and population pressures on the supply side, and desire, “wealth” and other population pressures on the demand side.

Effectively: increased debt allows for a relative increase in demand, without a shrinking in available supply!

And many have missed the crucial part of the equation on the demand side: that the ability to keep meeting higher and higher expectations of price has been the access to cheap credit AND, what’s more, to continue to service the loan, else it go “bad”…

…and that, just as the real-estate prices have ridden the wave of cheap and easy credit on the “up side” (debt-based relative increase in demand), they must ride the wave of tightening, increasingly expensive credit on the downside (relative decrease in demand from reduction in debt growth), coupled with demanders/buyers maxxed-out on their ability to service debts – with Price Discovery giving all of them the ups and the way up, and the downs on the way down.

Simple, really.

Another way of expressing it is this: if cheap and easy credit were not available, the prices would never have got to where they are, simply because no one could have afforded for it to get there in the first place. Any idiot can work that out icon_wink.gif (that’s why i can!)

Truly, if you understand the notion Price Discovery, you’ve just about got all you need, in a broad sense, to work out how markets work (and debunk how they do NOT work….)

I know many will not like the “simplification”. But at the end of the day, all interactions in the market place are basically just complex systems made up of very basic components: one of which is Price Discovery.

So, is my analysis “too simple”. Well, on one hand, yes, as I have deliberately chosen to omit all the intricate details, and “more precise” causal mechanisms.

But on the other hand, no, as even the intricacies can always be reduced down to their most basic components.

And in that sense, the complex things are not really as complex as they seem, are they?

Indeed, understanding Price Discovery is critical for understanding Economics; and even the property boom and bust (and bust again?) can be well understand and even predicted with the basic comprehension of how human minds interact.

Hope that was enjoyable reading and contemplation!

Regards,

Stewart

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3 Responses to Markets, Housing, Debt and Price: The Fundamental Importance of Appreciating Continuous, Dynamic Price Discovery

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  2. Pingback: Real-Estate Case-Studies at a Glance: Fitting the Rodrigue Bubble Curve? | Angles on Economics

  3. Pingback: Aussie Officials and The Aussie Housing Bubble (“not”) « Angles on Economics

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