According to ScienCentral, a US geophysicist says he predicted the current U.S. housing bubble - and when it would burst.
The USA Housing Bubble:
Predicting Catastrophe - Concept and theory transfer
Those who live in earthquake zones know their houses could one day come crashing down. But UCLA geophysicist Didier Sornette says he used the same theory that can help predict earthquakes, to pinpoint when the U.S. housing market would crumble. He says the warning signs have been building for a few years. As reported in Discover magazine, Sornette studies what's known as "complexity theory" to try to predict how a system will behave in the future. He uses physics and statistical analysis to look at the organization of the dynamic parts of a complex system, and how these parts interact to cause something major to happen.
For example, when a multitude of physical changes affect the organization of the earth's crust to produce an earthquake.
"It emphasizes the whole more than the parts, it emphasizes the interactions and what we call the feedback," he says.
The interplay of the elements is affected by both positive and negative feedback.
Negative feedback is often obvious. For example, when real estate prices are inflated many people decide to sell with the hope of making a nice profit. Eventually more houses are available for sale than there are buyers, so the prices start to drop back to normal.
"Positive feedback is exactly the opposite. A high price pushes the price still higher," explains Sornette. "This is the expectation of people that lead [people] to buy houses at prices that they would never have bought otherwise and taking supposedly big risks… first buyers, for example - you're a young couple relatively at the early stage of your life and you think, 'Well if I don't buy now… .
Very simply put, positive feedback amplifies an effect, while negative feedback dampens it.
'" Applying complexity theory to the interplay within the real estate business, Sornette saw that a housing bubble has been building in 22 states, mostly in the northeast and western U.S., since 2003 - and has now reached bursting point.
He gives another example where doing the seemingly right thing in the short term can have disastrous consequences in the long term:
"Southern California and Baja California in Mexico have nearly identical terrains and climate. In Southern California you have no small fires because the policy is to extinguish them immediately. But once in a while you have a huge, devastating, unstoppable fire. That doesn't happen in Mexico because little fires are allowed to burn corridors of biomass and thus develop the negative feedback of natural barriers. When we get exceptional conditions—dry weather, the Santa Ana wind from the desert, and droughts—I think I'd rather be in Mexico."
In 2005 he predicted that in the first half of 2006 prices would level out or return to normal rather than crash.
"It's absolutely non-sustainable," he says. "This bubble is basically ending now, and has, has ended in some cases… and now the market is transitioning into a more stable kind of plateau."
Sornette defines a housing bubble as a situation when house prices climb continually and unexplainably fast - faster than exponential growth - resulting in market prices that are vastly inflated from the fundamental value of the house.
"The fundamental value of a house, well this is the value, the price, that takes into account all the services, all the income you should get from this house," he explains. "For example we get service from it, of course you profit from it by living in it, or you could rent the house - this would give you a flow of income."But even in a bubble people keep rushing to buy. Sornette says there's one thing that keeps people buying - what he calls "the greater fool" theory. "The faith that you'll be able to sell it in the future to a greater fool than yourself for an even higher price."
Defenders and Doubters
Not everyone accepts Sornette's theory.
University of Houston econo-physicist Joseph McCauley says although the idea of a housing bubble still hasn't been precisely defined.
"Sornette has developed a very interesting model, but it includes too many factors to be fully provable. "The bottom line is that his model has too many parameters in it. That's not, what we call in physics, falsifiable. If you have too many parameters in a model, you can always fit it to the data, and the data can never tell you what's wrong with the model," says McCauley, who is a senior fellow with the Computable and Behavioural Research Axis (COBERA), in the department of Economics at the National University of Ireland, Galway. "I'd like to see him or someone else go back and get rid of the freedom in this model, constrain it… so that it really could be considered hard science." He adds that, "True complexity is based on surprises, and we don't really have any mathematical way of dealing with surprises at this stage."
Sornette agrees his is only one way of defining a bubble. But he says his method has been successfully tested in many other systems - from extreme weather phenomena to stock market crashes. Sornette hopes continued testing of his theory will improve people's trust in it, and offer better understanding of how complex systems work.
Track Record
Sornette says:
"Well, in 2003, we detected a real estate bubble in the United Kingdom, and we correctly predicted the end of the bubble there, around the summer of 2004. But this is only one success, which . . . Could be luck. In science, we never know with 100 percent certainty if we're right."
The Housing Bubble in Ukraine
Could Sornette's methods be applied in other situations?
Many people in Ukraine have predicted a housing bubble, especially in the capital city, Kyiv.
Recently, 5 Kanal's Kyivskey Chas TV news program reported that some rental prices have started to fall in Kyiv.
"Real estate experts explained that the demand for apartments in Kyiv has recently fallen by more than 30%. The demand has fallen for apartments worth less than five hundred dollars rent a month. Realtors explained that the number of people coming to the capital from the country's regions has decreased as of late."
This seems a bit of a paradox, in light of news that Ukraine has the 4th largest population of international migrants in the world, 7 million people, according to UN statistics. Number One is the USA followed by Russia, Germany and Ukraine.
Higher-end apartment rental prices are still artificially propped up by two factors.
First, Kyiv has a deficit of western standard hotel rooms. Knowing this, hotels maintain their price monopoly by keeping 2, 3 and 4 star hotel rooms at 5 star level prices or higher.
Secondly, smart home-owners have converted old Soviet-style apartments with some "Euro-remont' as it's called and offer modern flats to western tourists at $50 to $100 USD a night, high by local standards, but still a bargain compared to over-priced hotel rooms.
This high end bubble won't likely burst anytime soon, as long as there is demand from Western tourists and business people.
Sornette on the Doom and Gloom scenarios for the USA economy:
"These statements are really based not on science but on over-interpreting a very complex system using unscientific methods. There are indeed a certain number of indicators showing that the United States is on an unsustainable path. But the United States also is a very special player, eh? It has the dollar, which is the world's currency. It has the army of the world; it is the Roma Imperial, if you will. So it has a lot of things that are a positive leverage to its clear overspending. Is it sustainable? I don't believe it is. But the correction won't necessarily be a crash."
Sornette on the Future:
If we had a big enough computer, could we predict the future?
"We'd have a better model to predict it. Roughly every two years we double our computing power, and this allows us to put in more and more salient ingredients in our models to get closer and closer to reality. But in doing that we see the horizon receding just as fast, or maybe even faster than our power of computing because the more new ingredients we add, the more complex we see the system is. You know, sometimes you have this impression that the more you know, the less you know."
Source:
Sornette's work was published in Physica A: Statistical Mechanics and its Applications from 15 February 2006, and in Physica A: Statistical Mechanics and its Applications from 1 November 2003, and in a recent issue of Discover magazine.
Funding:
It was funded by the French National Center for Scientific Research (CNRS), the National Science Foundation and Macdonald.
© 2005-2006
Walter Derzko
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Posted by: Bob | December 10, 2008 at 12:21 AM