I READ the recent article by Sheridan Mahavera, No sign of housing market crash, say economists, in which some of the thoughts I expressed in an interview with Free Malaysia Today are reported.
At the light of Mahavera’s piece, I need to clarify both my thoughts and what I believe to be some misunderstandings regarding the concept of crisis, crash and bubble. In particular, the first lines set the article’s tone and they open doors to misinterpretations.
Mahavera writes: “House prices are not expected to fall sharply next year, said economists who disputed speculation that the property market will crash due to a glut”. These lines linked market crash and sharp price fall as if they were the same thing; such an approach to business cycles is misleading.
From the perspective of economic theory, they are two distinct phenomena: a crash is an eventual consequence of a previous boom and its roots need to be found in the dynamic of the boom; the price fall is an eventual consequence of the crash, but its magnitude (sharp, light, …) depends on a series of factors that need to be closely analysed.
The appearance of an economic boom is always related to a modification in the intertemporal structure of preferences, and it is always related to a specific industry, whose expansion dynamics will drive upward the general economic system.
It can happen that consumers become more future-oriented, increasing their savings and therefore ‘communicating’ to the market that more resource are available for long-term investment projects. Or, as it happens more often, entrepreneurs’ mood is lifted up by positive profit expectations, usually focused on a specific industry, which recently was the property sector for the Malaysian case. It is therefore crucial to emphasize the central role of expectations as the driving force behind entrepreneurial preferences.
When positive profit expectations ignite a boom limited to a specific industry, the positive effects fall onto the economic system. The signals an economist should look at are related in particular with the fact that the first wave of investments is always followed by a secondary wave of imitations and speculations.
The pace of economic growth becomes particularly sustained when the primary wave of entrepreneurial investments is joined by a stage of secondary growth encouraged by the instincts of imitators in search of profit and driven by ‘fashion’.
Why are imitations inevitable? It is easy to imagine how the success of entrepreneurial initiatives is readily followed by imitators looking for success within what at first sight always seems to be a period of growth destined never to end.
The primary stage of growth is characterized by investment set in motion by a limited number of entrepreneurs – those who are able to seize opportunities that go unnoticed by most people and therefore the first to change their expectations. The secondary stage is characterized by the appearance on the market of an exceptional number of imitators, driven by profit expectations arising from observing the ongoing of the boom set in motion by the first innovative entrepreneurs.
If the reality of imitative actions cannot be eliminated, it outlines the character of the growth process by emphasizing development above the initially imagined level. Like the primary wave of investments, the second wave is generated by profit expectations, particularly the expectation that the current situation will not change. From a quantitative point of view, moreover, imitation (secondary) investments might even be greater than the first cycle of investments since they involve a larger number of individuals, whose expectations are ‘over-excited’ by the boom.
The secondary wave of the boom deserves special attention. What form does the imitative desire take? It generates new demand for loanable funds; this means an attempt to extending the boom, thereby also increasing the degree of uncertainty.
The positive sentiment, that becomes ‘incandescent’ at the end of the primary expansion stage, also plays a role in regards to the action of banks. In fact, precisely because of what happens during expansion, it is highly likely that banks make available ‘virtual funds’ that are not backed up by real savings, driven by expectations that the adaptation of consumer preferences (further saving) cannot but occur, precisely because of the enthusiasm generated by the boom.
On the other hand, it is more than likely that the long-awaited realignment does not come about: consumers must also consume, hence their capacity for saving is objectively limited by the necessity to consume. In addition, in all likelihood, consumers will also be influenced by the general enthusiasm of the boom stage and consequently change their preferences in the opposite direction, i.e. by increasing their propensity for consumption.
This is all the more true given the fact that real wages grow during the boom in order to attract workers into the new investment areas or to employ formerly unemployed workers. This leads to pressure in demand for consumer goods, and in turn to incentives for the production structure to return to present-oriented projects (consumer goods).
At this point, the growth of prices and wages and the pressure on prices goods of consumer goods brings about what Hayek called the ‘Ricardo effect’: if the credit expansion boom does not come to an end sooner for some other reason, it must come to an end when consumer product prices advance ahead of wage and resource prices. The Ricardo effect lowers real wages and encourages a shift toward labour-intensive methods of production. A lowering of the real wage of labour makes short-term (labour-intensive) projects appear to be more profitable than long-term (capital-intensive) methods of production.
So, while the first wave of investments can complete its cycle because of the real existence of prior and stable funds (without which the expansion cycle would not even have started), the second wave will be frustrated by a change in consumer preferences and an over-expansive banking policy influenced by profit expectations.
So far I have not mentioned anything about the price dynamics. It is well known that prices raise during a boom and tend to decrease during a crisis. But we do not have to mistakenly identify the crisis with the price fall itself. They are two separate phenomena, the second being a consequence of the first one.
A similar mistake is done by some economists when they identify overproduction as a crash, when instead it is an eventual consequence. Therefore, while we can imagine that the present dynamics in the property market in Malaysia will bring out a crisis (though a precise temporal estimation is a job for fortune tellers and not for serious economists), the potential effect on the price system cannot be precisely identified.
In fact, a big part of the final outcome will depend on subjective reactions by market actors. Will they expect a short and limited crisis? Or a long and widespread recession? The individual mood will play a big role in the developing of the crisis itself. People owning houses for investment might decide not to sell, expecting a positive upturn soon; or they might be caught in panic and running for liquidating their assets. These two different behaviours will have different consequences on price movements, while the crisis itself will remain as a matter of fact.
Finally the response from government, Bank Negara and the credit system will play another pivotal role: if these institutions will try to support the industry via credit expansions, the crisis will turn to be longer (like it is happening in Europe now) and the price fall will be hidden by centrally led inflation, setting the stage for fake recovery and a subsequent deeper crisis. On the contrary, if market forces will be let free to allow the production structure to realign itself to the new scenario, the price shock would be stronger, the crisis shorter, and the new economic fundamentals more sound and stable.
In conclusion, the analysis of the peculiar moment experienced by the property market in Malaysia can be successfully carried out only if supported by an understanding of the cyclic dynamics which characterize capitalistic development. Cycle stages and price movements are linked but distinct phenomena; while we can see a crisis coming, the subsequent price movements cannot be uniquely identified a-priori. – November 23, 2017.
* Carmelo Ferlito is a senior fellow at the Institute of Democracy and Economic Affairs (Ideas).