Asset price inflation in real estate – a rational collective action problem?

August 11, 2014 / By  

History tends to view a run up in asset prices as irrational bubbles, produced by illogical investors acting on psychological motivations, named animal spirits by Keynes. In real estate a rapid rise in asset prices can be viewed as a rational collective action problem, much like the tragedy of the commons or the paradox of thrift[1], and not the result of irrational investments.

The question of asset pricing and whether bubbles – which can be defined as irrational price changes – can and do exist is at the forefront of public debate following the unusual monetary conditions that have occurred since the global financial crisis. For real estate an irrational price change would be a capital value rise in excess of the commensurate income stream rise- in short excessive yield compression.  Shifts in real estate asset prices are the result of cumulative actions of rational investor actions, even if the final result may look irrational.

Tuplipmania is usually cited as the classic bubble based on irrational behaviour. The Economist ran an excellent article in October ‘13 on the Dutch tulip bulb bubble of 1637. (see the article here) This article which is based on a series of academic papers suggests that investors in the tulip bubble were acting rationally and that there was no ‘mania’ causing investors to act irrationally[2].

This response can also be observed in the real estate market where shifts in rules or shifts in demand result in a sharp change in pricing. Real estate as an asset class comes in large lot sizes and is in general less liquid than, for example equity, bond or foreign exchange markets. This means that shifts in asset prices are more likely to be based on rational criteria compared frequently traded assets such as shares in a particular company.

The resolution of such a collective action problem is first to gain agreement from the parties that their individual maximisation of value does not produce the optimal outcome for society, and second agree what measures need to be put in place to ensure cooperation.  In the tragedy of the commons, formal rules are put in place to conserve stocks or to implement private property rights.

Solving other collective action problems is not as easy. Following the GFC, to prevent a collapse of aggregate demand the G 20 governments agreed to implement stimulus packages and ultra-low interest rates to keep demand above a point where economies could spiral downward into deflation. The steps taken were the solution to a paradox of thrift problem and in turn have created another collective action problem.

Monetary conditions aimed at easing the paradox of thrift, have created conditions where real estate asset prices have held up; the result of a series of rational decisions- not irrational investment sentiment.

[1] The tragedy of the commons is where individuals act rationally in their own self-interest, however the outcome is contrary to the whole group’s long-term best interests by depleting some common resource. Paradox of thrift is where faced with an economic downturn people act rationally to save more money however then aggregate demand falls leading to a decrease in consumption and a worse economic position.  What is rational for the individual may appear irrational for the whole.

[2] The academic papers argue that there had been a shift in regulations by the Dutch government in 1637 and that investors had each acted rationally in the light of the incentives and information at hand. The market for tulips was an efficient response to the changing financial regulations which meant that ….investors who had bought the right to buy tulips in the future, were no longer obliged to buy them. …The inevitable result was a huge increase in tulip option prices.

Notify of

Inline Feedbacks
View all comments

Talk to us 
about real estate markets.