Letter to the Editor that appeared in the Financial Times on August 11, 2005; it's quite long for a Letter to the Editor, but apparently they thought I had some important points to make.
This is how the real estate bubble will end
From Mr Bruce Steinberg.
Sir, It was fascinating to learn how Meg Whitman, eBay president and chief executive, looks 'for markets where there is price and information inefficiency' yet declares 'real estate is pretty darn efficient' ('From Netscape to the Next Big Thing'. Comment & Analysis, August 5) in the face of a much ballyhooed real estate bubble.
In 2001, the Nobel prize for economics was awarded to George Akerlof, Michael Spence and Joseph Stiglitz for their work on how asymmetrical information influences economic markets. Their theory, first described by Akerlof in the 1970s in an essay entitled 'The Market for Lemons' ('lemons' being a colloquialism for bad used cars), explains how when one party in a market has more information than the other, this unequal information can lead to adverse selection and ultimately the collapse of an entire market. Oversimplified, bad products and services chase out buyers seeking good products and services and both buyers and sellers of good products and services suffer.
The full theory can be applied to the efficiency of labour markets as well as the collapse of the IT bubble.
For the former, workers out of work tend to stay that way because potential employers assume those workers are not good enough for a job and tend to offer insufficient pay to attract the best candidates. However, in the case of permanent recruitment services, staffing services as well as temporary employees bring more information to the 'buyer' to enable the potential employer to make a more reasonable job offer than they would offer an unknown candidate. Perhaps the success of job boards can be partially attributed to their providing more labour market information to all parties involved in the employment process.
The theory can also be used to explain how the IT equity bubble burst. Early in the dotcom era, the casual observer or investor viewed all IT companies as more or less identical although in reality their profit potential varied greatly - only insiders knew which were which. Low-profit but over-valued companies tended to follow the path of least resistance to fund their financial expansion by issuing more of their own shares and hence attracted more attention in the early developmental stage of the sector. Although seasoned investors and experienced venture capitalists may have known they were backing shaky high-tech and dotcom companies and knew it was a bubble, they believed they could ride the wave, profit wildly and get out in time. Eventually all investors became more educated, realised the valuations were not based on any profit potential, dumped their shares and prices plummeted.
In the current real estate environment, ultimately there will not be enough inexperienced buyers and real estate speculators - those who do not know the true value of the property they are purchasing - to go around. The educated will ultimately regain control of the market and the current bull real estate market, which at times looks similar to a Ponzi scheme, will end. Then Ms Whitman may reconsider her view of price efficiencies in the real estate sector.
Isn't it nice to see a practical application to economic theory?
Economic and Employment Consultant,
Alexandria, VA 22309, US
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last updated January, 2018