from The Conversation — this post authored by Timo Henckel, Australian National University

The b-word is doing the rounds, barely a decade after the United States house price bubble burst spectacularly, setting in motion a global financial crisis. As Australian real estate prices continue to break records, many wonder whether this is sustainable.

Economists disagree on how to define a bubble, or even whether bubbles exist. Intuitively, a bubble (and this applies to any asset, not just real estate) exists when the price of an asset is over-inflated relative to some benchmark. And here’s the rub: no one can agree on what that benchmark should be.

The benchmark could be an estimate of the asset’s value based on a collection of variables that plausibly affect its supply, demand and price, so-called fundamentals. For houses, these fundamentals include population growth, tax policy, household size, household income, and many others.

But economists cannot agree on what fundamentals determine an asset price, or how important each fundamental is. As well, the value of these fundamentals can only be estimated, not observed. It’s subjective to the point that someone will always be able to concoct a story based on fundamentals to rationalise why house prices are at the level they are.

Some economists propose alternative benchmarks to measure a bubble, such as historical long-run averages or an estimate of the underlying value of a trend. If asset prices are greater than these averages or the trend, then we have a bubble. However, this definition is too simplistic because the economy is dynamic, ever evolving, and both long-run averages, as well as trends, do change.

Price hikes and bubbles

It’s only when asset prices reach outrageous heights that a majority of people, economists included, agree that it is overpriced and due for a major correction (a bubble burst). Even then some economists will deny the existence of a bubble.