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Mathematical physics

US bubble set to burst

07 Jun 2005 Belle Dumé

House prices are rising so fast in 22 US states that they have created a "bubble" that could burst in the middle of next year according to two physicists (physics/0506027). The same team previously predicted that the UK housing market would crash in mid-2004.

Bubbles are formed in markets when large numbers of investors – often taking their lead from traders – start to buy more and more stocks and shares, forcing prices to artificially high levels. Such bubbles can also form in the housing market. And like real bubbles, these financial bubbles often burst.

After the “new economy” bubble burst in 2000, the US Federal Reserve decided to cut interest rates to just 1% in an effort to kick-start the economy. However, such low rates have historically been associated with an increased demand for houses. Two years ago, Didier Sornette and Wei-Xing Zhou at the University of California at Los Angeles (UCLA) analysed the US housing market. They concluded that although house prices were increasing rapidly, there was no evidence for the faster-than-exponential growth that often leads to the growth of a bubble.

Now, Sornette and Zhou have revisited their calculations, taking into account the latest data on house prices. The physicists analysed quarterly average prices for the US as a whole as well as in the Northeast, mid-West, South and West, and also in all 50 states and the District of Columbia (DC). They then formulated models to fit the data and identified clear-cut signatures of fast growing bubbles in 22 states. Moreover, the models were able to predict the critical turning point at which these bubbles might burst – after which time the high prices may slowly start to come back down to more realistic levels or stabilise at their current levels.

The scientists performed a similar analysis for the UK in 2003. “In that paper we identified an unsustainable bubble in the UK housing market and predicted that the critical time might be around the end of 2003 or mid-2004,” Sornette told PhysicsWeb. “The UK house price index has experienced a drop since July of 2004.”

The UCLA physicists say they will now continue monitoring other housing markets around the world for potential signs of bubbles. “Our work may have broad economic consequences because the real-estate market has played such a major role in the US economy’s recovery,” says Sornette. “For instance, the total real-estate debt for private home owners in the US is now higher than the federal debt, which is about 8.5 trillion dollars!”

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