Property and Construction Market Fluctuations and Instability Are Driven by Irrational Exuberance - Case Study Example

Property and construction market fluctuations and instability are driven primarily by irrational exuberance” Introduction The global economy was always subjected to high fluctuations in the market, associated with several booms and recessionary phrases. However, since history, till now two main financial crises are marked in the global economic system. The first occurred long back in 1930 and was named as great depression. The second occurred recently in 2008 and it termed as the global financial crisis. The severe negativities of the global financial crisis still persist in most of the nations in the world. Since its occurrence, it is found that the worth and value of the real estate sector has significantly increased in the global economy. The crisis in 2008 is said to occur primarily due to property and construction market fluctuations in many major economies of the world. Especially during that era European nations like Spain, Portugal, Italy and Greece, experienced significant rise in the property prices of the residential real estate sector. Moreover, the soared up prices of properties in such nations were associated with low market interest’s rates. Researchers claimed that such volatilities in the real estate sector were actually caused due to irrational exuberance in these nations. Since globalization, the state of affairs between nations has highly integrated with each other. Thus, the property and contraction market fluctuations in some of these European nations seeped into all the other major economics of the world, hence generating the global financial crisis. This paper, will try to estimate the irrational ways that actually caused the fluctuations in the construction sector in the global economy. However, it should be noted that the context of the essay would primarily focus in one single nation namely U.K. It is found that commercial property was the pivotal factor generating the financial crisis in U.K. The paper will explain the causes for which property and contraction sector of U.K. faced boom in its prices (Benford and Burrows, 2013). Literature Analysis Animal Spirits Researchers and scholars have provided different interpretations regarding the extensive existence of volatility in the commercial property market. It was claimed by Robert J. Shiller that market in reality experiences certain inherent irrational features (Shiller, 2008). John Maynard Keynes added to this and commented that these irrational elements in a market system are often termed as its ‘animal spirits’. However, there were other authors like Eugene F. Fama, who claimed that market is also always perfect and does nor inherent any sort of disturbances within it. In the recent years, the term ‘animal spirits’ is considered to be an economic term that refers to the restlessness, inconsistency, uncertainty and ambiguity of marketplaces. Authors like Shiller believe that the global financial crisis that took place in 2008 was primarily caused due to the ‘animal spirits’ of the market. Money Illusion During this point of time, the individual agents in the economies suffered from the problem of ‘money illusion’, under its regime, houses or real estate’s were traded by them for the purpose of speculative investments. Soaring of the property prices during this point of time was primarily responsible due to the feedback, price and expectation loops in the market system. In such circumstances, the prices rise of houses generated greater income for the property sellers. Higher income of the property sellers in the markets helped in augmenting the overall economic growth. Such improvements ultimately enhanced the expectations of the individuals, who further bided higher prices for the real estates. This process continued and ultimately generated the great recession in 2008 (Akerlof and Shiller, n.d). Depletion of natural resources However, authors also claimed that extensive construction activities with materials like cement and lumber started to deplete and increase the scarcity of natural resources (like limestone, gypsum and quartz) on earth. Fall in the availability of such scare resources also increased the prices of the raw materials used for contraction purposes over time, hence substantially contributed in mounting the real estate prices (Mayer, 1993). Poor Investors Confidence Poor confidence of the investors in the real estate sector also made the situation worse. Many contraction products in major western economies failed during this point of time due to lack of adequate confidence of the investors, who failed to withstand the soaring prices of the construction costs. Corruption Corruption in the construction and real estate sectors of economies also significantly added fuel to the fire of dismay. The mortgage brokers and dealers of the real estate sector charged high prices as fees for each and every commercial dealing made in this segment. Such intermediary fees were huge in amount and often contributed in significant price rise of the final products (property’s). Inelastic Supply of House Prices All the above market irrationalities significantly contributed in increasing the house prices and thereby reducing its market supply. Especially in U.K., the supply was almost inelastic in nature. Such problems further increased the prices of the products in the market. High Regulation The property and construction sector in the western nations were highly regulated. Thus, the costs of maintaining the legal formalities were also high for such markets. Thus, from the above literature analysis it can be summarized that high regulation, inelastic supply of house prices, corruption, poor investor’s confidence, depletion of natural resources, money illusion and animal spirits were all the various market irrationalities or exuberance that generated volatile prices and hence uncertainties in the asset demand trends in the property and construction market of western economies, especially in U.K. The following context of the paper will empirically focus on the exuberances that existed in the market of U.K. and would use graphical analysis to estimate the fluctuations in the real estate sector of the country before and after the global financial crisis. Commercial Property and Buoyancy of the Financial System Since the last century there were almost three fluctuations or swings in the prices of commercial properties of U.K. It was noted that each fluctuation was primarily caused due to extensive commercial property lending and deleveraging in the market. Along with the other irrational factors (mentioned in the literature analysis), such loose lending operations of the banks significantly helped to enhance the level of failed property projects in the market and finally generated the housing price bubble. Figure 1: Commercial Property Debt Valuations in UK (Source: Benford and Burrows, 2013) As denoted by the above graph, the commercial banks in the country generated maximum lending for property related projects, compared to insurers and building societies. The credit appraisal tools of the banks were not rational. From the above graph it can be clearly found that the debt thresholds in the market and the commercial property prices started to increase during the global financial crisis. However, the levels were much lower before and after the crisis Losses in Commercial Property Lending Such exuberances in the market generated high fluctuations in the losses generated from the lending operations of commercial properties. It was noted that during the era of 2000 to 2006 (before the global financial crisis), the commercial property prices in U.K. were significantly increasing and thus, the lenders did not experience any sort of losses from such projects. However, since the period of 2006, corruption, high speculation, poor confidence of the investors, rise in raw materials prices and animal spirits in the markets all significantly caused failure of a large number of construction projects in the country. Such failures significantly started to increase the lending losses of the lenders in such projects. Figure 2: Lending Rates (Source: Benford and Burrows, 2013) As shown in the above line graph, since 2006, the losses of private non financial corporations and commercial property companies had significantly started to increase until 2012, when the prices loss trends are found to fall (Woodford, 2003). In reaction to such circumstances, the company’s lenders started to relax the interests on loans offered and also enhanced the loan repayment facilities. Figure 3: Losses and Non Performing Loans (Source: Benford and Burrows, 2013) Rather since 2008 (period after global financial crisis), the number of implicit bail out functions offered to the banks started to significantly increase, as shown by the above box plot analysis (rise in the median signifies rises in the number of non performing loans) (Tucker, 2010). Strong Volatility in Commercial Property Prices It was true that the values of the rents of commercial properties were highly sensitive to any type of fluctuations in the economic conditions. Figure 4: Commercial Property Prices Variations (Source: Benford and Burrows, 2013) The above graph shows the high volatility in the property and construction market segments in U.K. before and after the global financial crisis. During the recessionary period, the rental values of the housing sector was very high but after the 2009 onwards the rental prices started to significantly fall in U.K. This fall was experienced due to the rises losses of the real estate companies, lowered the production and employment opportunities in the market and thereby significantly lessened the level of household housing demand in the market (lowering the rental rates) (Mankiw and Taylor, 2006). Other Exuberances in the Commercial Property Market Apart from the factors mentioned in the literature analysis, there are also other factors that significantly generated the extensive uncertainty and volatility in the commercial property market. These were: Irrational leverages: the leverage investors in the market generated feedback loops between asset prices and credit growth. The rises in the asset prices helped commercial property companies borrow more fund by selling equity shares. With more fund they started to increase their business. Such credit lead growth was not sustainable and finally generated many failed projects (Baddeley, 2005). Irrational exuberance: the investors and the lenders in the market (who offered money to the companies has overrated the returns of their lending. However, when the commercial property companies serrated to undergo heavy losses, the lenders and investors also faced similar deficits in business. Maturity mismatches: there were some property companies that took loans from investors for purchasing illiquid properties. Under this regime, the investors could easily withdraw their funds in short notice and often created pressures on the property companies to sell or cease their projects (BIS, 2005). Cross Country Variations It can be claimed that the commercial property price fluctuations in the real estate sectors were different in the different countries of the world. Figure 5: Variations between Nations (Source: Benford and Burrows, 2013) The above graph clearly explains that the property prices were not only volatile over time but were also high fluctuating across nations (Marsh, 1992). Among all the selected nations, the real estate price of Ireland increased to the maximum level, followed by Portugal and Spain. This was because, the price bubble occurred in these nations at the beginning. On the other hand Germany was a nation that did not experience any property price bubble (Muellbauer and Murphy, 2013). Role of Investors Figure 5: U.K. Companies Borrowings (Source: Benford and Burrows, 2013) As denoted in the above bar diagram, since 2000, the real estate prices were constantly increasing due to the monetary illusions in the market and this made the lenders believe on the worth of investing in such projects. Thus, overall the lending operations of the U.K. as well as foreign owned banks stated to significantly increase since 2000 (Pirounakis, 2013). Figure 6: Lending Terms (Source: Benford and Burrows, 2013) In around 2007, news of US property market problem transmitted in the entire global economy. As a result of this, the overall availability of property related credits started to significantly fall in the market of U.K. This can be claimed from the above graph that enumerates the falling loan to value thresholds in the country associated with the rising margins on lending’s. Lack of adequate funds forced the commercial property companies to invest less money in the purchasing new properties for speculative purposes. Ultimately in the long run, as the prices of the properties started to fall (due to lower demand) the investors decided not to sell real estate’s for the purpose of speculation (Brakham and Ward, 1999). Role of Financial Policy Committee From the entire analysis made above it can be stated that the fluctuations in the commercial property prices in U.K. was substantially caused due to the irrational lending operations of the banks and the non banking financial institutions. Over time, much of the distortions in the market were reduced by the active initiatives of the statutory regulating company of the country named the Financial Policy Committee. This committee referred to the possible threats that could be associated with any sort of commercial lending operations. The Financial Service Act of the country introduced this organization for protecting and enhancing the resilience of the financial system of U.K. With the active initiatives of this organization, the banks in U.K. are now able to withstand any uncertain losses associated with commercial property lending, as the pool of finances with these baking institution have significantly increased over time (Bernanke, Gertler and Gilchrist, 1996). Conclusion The context of the paper clearly stated that recessions and booms in the contemporary economies primary occur due to illogical actions of the entities the nations. The context of the research paper showed that different types of irrationalities had actually generated the swings in the commercial property market in the global economy. False monetary illusions of the lenders and the property companies, corruptions in the real estate market, significant rises in the prices of the construction raw materials, elastic supply of properties and extensive regulations in the market were all the exuberances that generated high uncertainties in the real estate sectors of the economies like U.K. Though it is difficult to separately focus in details, but still from the analysis made above it is clear that leverage, irrational exuberance and maturity mismatch both by the investors as well as lenders in the market have ultimately generated severe volatility in property and contraction sectors of major economies like U.K. The paper proved that commercial property fluctuations were primarily responsible for the destabilizing losses of the banking institutions of U.K. It is true that factors like long term interest rates as well as the rents of real estate rents significantly create an impact in the prices of commercial properties in a nation. Irrationalities in the market generated significant rise in the number of failed out projects in countries. This enhanced the amount of loss incurred by the lenders and investors in such projects. The public authorities were often found to bail out some of the failed projects. Such high expenditures of the government increased the fiscal deficit of the nation and ultimately lowered the supply of money in the economy, generating strong recessionary trails in the market system. Thus irrationality in the real estate sector was ultimately responsible for slow growth rates of the western nations after the global financial crisis. This had not only lowered the overall business competitiveness of such countries but had also reduced its productive capacities. In the current epoch, most of the nations like U.K. are run by mixed economic principles, where the powers of the private or monetary authorities are substantially tacked by the government regulating bodies. Thus, any type of market failures, distortions or irrationalities can only be sustained with the help of government regulated actions in the economies. It can thus be stated that such problems and irrationalities in these core sectors like real estate of an economy can only be reduced with the active contribution of the government authorities in a nation. The dealings of the commercial property sector and commercial contraction lending must be closely scrutinized by the government authorities in a nation. Thus, the importance of organizations like Financial Policy Committee is priceless at present, where such committees aptly make the public authorities aware regarding any threats of stability in the economies (Dombret and Tucker, 2012). Reference List Akerlof, G. A. and Shiller, R. J., n.d. Animal spirits. Princeton: Princeton University Press. Baddeley, M., 2005. Housing Bubbles, Herds and Frenzies: Evidence from British Housing Markets. University of Cambridge, pp. 1-33. Benford, J. and Burrows, O., 2013. Commercial property and financial stability. [pdf] Quarterly Bulletin. Available at: < http://www.bankofengland.co.uk/publications/Documents/quarterlybulletin/2013/qb130105.pdf> [Accessed 19 February 2014]. Bernanke, B., Gertler, M. and Gilchrist, S., 1996. The financial accelerator and the flight to quality. The Review of Economics and Statistics, 78(1), pp. 1–15. BIS, 2005. Real estate indicators and financial stability. Monetary and Economic Development, pp. 1-394. Brakham, R. J. and Ward, C. W. R., 1999. Investor sentiment and noise traders: discount to net asset value in listed property companies in the U.K. Journal of Real Estate Research, 18(2), pp. 1-22. Dombret, A and Tucker, P., 2012. Blueprint for resolving regulation. The Financial Times, 20 May. Mankiw, G. N. and Taylor, M. P., 2006. Microeconomics. Connecticut: Cengage Learning EMEA. Marsh, D., 1992. The Bundesbank: The bank that rules Europe. London: Mandarin. Mayer, T., 1993. The political economy of American monetary policy. Cambridge: Cambridge University Press. Muellbauer, J. and Murphy, A., 2013. Boom and busts in the UK housing market. The Economic Journal, 107(445), pp. 1701-1727. Pirounakis, G. N., 2013. Real estate economics: A point to point handbook. London: Routledge. Shiller, R. J., 2008. The subprime solution: How todays global financial crisis happened, and what to do about it. Princeton: Princeton University Press. Tucker, I. B., 2010. Macroeconomics for today. Connecticut: Cengage Learning. Woodford, M., 2003. Interest and Prices: Foundations of a theory of monetary policy. New Jersey: Princeton University Press. Read More