G. Ramachandran
V. Sankar

By inferring that the overall value of housing has lost touch with economic reality, Prof Paul Krugman sees homes as separate from the overall savings and investment market. But G. Ramachandran and V. Sankar think that the market for h omes is inseparable from that for physical and financial assets, and that prices of the two components adjust to optimise the returns and risks in the portfolio. That is why the unprecedented rise in liquidity has sent investors looking for more supplies of equities and homes.

When money is easy to come by, and interest rates are low, investing in costly homes makes eminent sense.

HOME PRICES in many parts of the free world have more than doubled since 2000. `Free' in this context refers to those countries where the real-estate market is free. Such markets are neither operated nor manipulated by their governments. Real-estate markets in Britain, India and the United States are among the freest in the world. The price rise in these three countries has been spectacular.

Home prices have also risen smartly in Australia, Brazil, Canada, Mexico, the Philippines and South Africa. It would be right to regard rising home prices as a global phenomenon. It is as if they are acting in globally orchestrated unison. This has caused considerable alarm among some economists and many central bankers. They have chosen to describe the record home prices as an asset bubble that could implode anytime.

They have expressed two fears. First, asset price inflation could distort the intended impact of monetary policy on general price stability and economic growth. But they have yet to provide any proof of such distortion.

Central bankers have not shown what parts of their policies are aimed at curbing asset price inflation. Easy liquidity and low interest rates around the globe are not the prescriptions for compressing the home price bubble.

Second, the bursting of this bubble could ruin many lenders. It is part fact and part assumption that home acquisitions around the world are funded heavily by loans and mortgages. So, when home prices crash, borrowers could choose to stop repaying. Lenders will then be stranded with declining collateral. But lenders have not stopped lending. Home loans and mortgages have risen handsomely over the last five years.

Challenging reality

The economic reality is that the actions of central bankers have yet to reflect their so-called apprehensions. The appetite of lenders and investors for portfolios of home loans and mortgage-backed securities has not diminished. But Prof Paul Krugman, an economist and columnist with an enviable global following, has inferred that the overall market value of housing has lost touch with economic reality (The Hindu, January 3).

Prof Krugman's well-articulated concern over the steady rise of home prices since 2000, especially in the US, is proof that the battles between economic reality and the models of economists are forever fought with unflagging vigour. The fights are aimed at fitting one into the other.

But there is a hierarchy; there is a progression. Graduate students and untenured professors strive to build models that fit reality. Their models are rejected when there is no fit. Reality is right; their models are wrong. They then move up in learning, experience and reputation. They are tenured.

Then reality and models swap places. The fight then is aimed at fitting reality into their models. Reality is rejected when there is no fit. Their models are right; the reality is wrong. Prof Krugman has chosen to challenge reality. He has chosen to regard the market for homes as something that can be separated from the overall market for savings and investments.

Accepting reality

The authors of this article hold the view that the market for homes is inseparable from the market for physical and financial assets. Physical and financial assets are components of the same universe. Asset prices in the two components of this universe adjust simultaneously. They do so towards optimising the total returns and total risks in the portfolio of assets.

The rise in home prices can be explained by that economic model that is a colossus in the theory of asset pricing: The capital asset pricing model (CAPM). The CAPM was developed almost simultaneously but independently by Professors Treynor, Sharpe, Lintner and Mossin between 1961 and 1969. Prof Fischer Black developed it further in 1972.

The CAPM is based on six assumptions. One of the fundamental assumptions is that the quantities of assets are fixed. The CAPM is derived from one axiom. For the total market to be in equilibrium there can be no excess demand for any asset. Asset prices will so establish themselves that the supply of all assets equals the demand.

Impact of high liquidity

Consequently, any global market portfolio will have to comprise all marketable assets held in proportion to their value weights. This is the crux of the CAPM that explains the spectacular rise in home asset prices in the principal market economies of the world.

Let us first apply a gardening analogy. Gardening requires a balanced mixture of sandy and loamy soils. Sandy soil is friendly to the roots and allows water and nutrients to reach down to the roots. Loamy soil is clayey. It holds water and nutrients. It firmly holds the roots in place. If a gardener has an enormous supply of sandy soil, she would require a matching rise in the supply of loamy soil. If every gardener enters the market to buy loamy soil, the price of loamy soil will rise if its supply is fixed. Sandy soil will, of course, become cheap.

Households invest in cash, near-cash money market instruments, equities and homes. They do so directly or through mutual funds, money market mutual funds and real-estate investment trusts (REITs). Now let us take the gardening analogy one step further. Our gardeners may want to regard cash and near-cash money market instruments as the sandy soil of their savings. They would be right in doing so. Equities and homes then become the loamy soil.

First, there has been a spectacular rise in the supply of cash and near-cash money market instruments since 2000. Expansive monetary policies in the US and the United Kingdom have greatly enhanced the supply of sandy soil.

Second, intervention by the central banks of many Asian economies has expanded domestic money supply. The central banks of China and India have intervened to keep the US dollar stronger relative to the yuan and the rupee.

They have provided a continuous and reliable supply of dollars for the funding of US treasury bills. The unprecedented rise in the supply of liquidity (sandy soil) has sent investors in search of more supplies of equities and homes (loamy soil).

Short supply of equities

Domestic and foreign investors have been in need of an enormous increase in the supply of investment opportunities in equities and homes, especially in the US. It would not be too inappropriate to view equities and homes as reasonable and close substitutes of one another in meeting the objectives of their search. Resident investors invest in homes by buying homes and units of REITs. Global investors invest in homes by investing in mortgage-backed securities and REITs.

Three developments have constricted the supply of equities in value-weighted terms. Corporate accounting frauds, the move towards expensing employee options, and the positive features of the US' Sarbanes-Oxley Act have knocked down equity prices and leading price-to-earnings ratios.

No bubble trouble

The burden of making CAPM work has fallen on homes. But the physical supply of nice homes with nice addresses is limited. Hence, home prices have had to rise to match the rise in the supply of cash and near-cash money market instruments. Home prices have had to rise to compensate for the fall in the supply of equities in value-weighted terms.

Rising home prices do not constitute an asset price bubble. It would be apt to regard them with fear and apprehension only if the rise in global liquidity and savings is deemed as a bubble and an aberration. Investors would until then be right to invest in pricier homes, especially if they hold the view that easy money and low interest rates will prevail for a while.

(The authors are financial analysts. Feedback may be sent to indiagrow@yahoo.com and pari@thehindu.co.in)