Housing bubbles come from what’s called speculation. Speculation is when investors buy something expecting to make money off the fact that its price will most likely rise in the future.
The problem with speculation is that, almost like a self-fulfilling prophecy, it creates its own demand. As speculators buy up more houses to make money from price increases, they actually push up the price of houses by increasing the demand. And what happens when the price goes up? More speculators want in, and the cycle continues.
At some point the bubble has to pop. The increasing price reaches a tipping point where it becomes unsustainable—perhaps the economy starts to slow and lots of people find it hard to repay their massive mortgages, or perhaps interest rates start to rise making the debt harder to repay. Whatever it is, when it turns, the cycle happens in reverse – investors start to pull out, decreasing demand and pushing down prices. The decrease in prices scares off potential buyers, and current investors try to sell as they expect prices to continue to go down, which only pushes down prices even more. House prices rapidly decline, and the bubble bursts.
Housing bubbles can cause major problems in the economy. They create instability not just in the housing market, but can lead to huge financial crisis as loans turn bad and people can’t repay. As banks try to take back their money, thousands, even hundreds of thousands of people, can be kicked out of their homes.¹
So what can the government do to try and limit housing bubbles?
The government needs to try and calm people down when they get excited about housing as an investment option. One obvious way to do this is to make it harder for people to borrow and take out mortgages.² By implementing regulation that stops the supply of cheap credit, investors will have less access to funds to buy up property for speculative purposes.
The government can do this by raising interest rates - if interest rates go up, mortgages become relatively more expensive, as debtors need to pay back more for their loans. The government can also implement policy that tries to stop housing being viewed as an investment. This could be through taxing the gains that people make on rising house prices, a more regulated buyers market and by providing other financial assets outside of the housing market, which provide alternative options for people to save and invest.³