The debate over land and housing prices in Australia presents us with a curious spectacle. Economists of all persuasions are convinced that an unsustainable bubble is in progress. The Reserve Bank has said so, in steadily louder and more strident tones, for at least a year. The Treasury has been more sotto voce, but Ken Henry's recent slip (or, perhaps, stage whisper) shows that the view there is the same.
Commentators with views as diverse as those of Ken Davidson (The Age) and Alan Wood (The Australian) are of one voice on this subject. The views of domestic analysts are echoed by international observers, notably including The Economist magazine and the International Monetary Fund.
The economic arguments suggesting that current prices are unsustainable seem almost irrefutable. In a country where land is anything but scarce, prices for residential property have risen to levels that are unparalleled in our history, even when income growth is taken into account, and higher than in many more densely settled countries.
Household indebtedness has also reached record levels. It is hard to see how prices could be sustained in the face of an increase in interest rates of even a couple of percentage points, which would merely take them back to a level generally regarded as neutral.
Because of lower interest rates, debt-service ratios are still marginally below the levels of the late 1980s. But those levels occurred when interest rates were at a short-term peak and when inflation could be counted on to reduce the real burden of debt service over time. In any case, the boom of the late 1980s was followed by a nasty recession, largely precipitated by high debt service ratios.
For most economists, arguments of this kind provide fairly conclusive evidence that Australian houses are overpriced, perhaps by as much as 30 or 40 per cent. Some expect the bubble to burst and others anticipate a slow, drawn-out decline, but few think the prices can be sustained or even validated by inflation.
There is a paradox here. In a country with a longstanding suspicion of market forces, economists have normally been among the few defenders of the market. Even relative sceptics put more weight than the average Australian on seeking rational economic explanations of market outcomes. Yet in the case of the housing boom, ordinary Australians have shown a faith in the market that would put the most devout Chicago economist to shame.
Fortified by decades of experience, Australians believe that no investment is better than a home of your own, with the possible exception of a negatively geared rental unit. The brief flirtation with shares of a few years ago has been forgotten, except by those unfortunate believers who missed out on the chance to get into the housing market when a basic home was still affordable.
The implicit model held by the majority of the public is an optimistic version of that arising from the efficient markets hypothesis. Market prices reflect all available information and are therefore the best estimate of future prices. On the other hand, house prices can be expected to rise, in the long run, at a rate that is at least comparable to that of any other asset.
Sceptics have warned that it will all end in tears. But, as in all sustained bubbles, the sceptics have been discredited by their own premature announcements that the end of the boom is imminent.
The stakes in this debate are high. The prospect of falling house prices (and of households being forced to cut consumption in order to keep up with interest payments) is the only apparent threat to the continuation of our near-record economic expansion, now well into its second decade.
In theoretical and policy terms, the stakes are equally high. A bad end to the boom would mark the failure of the separation between monetary policy and prudential regulation introduced after the report of the Wallis committee. The whole program of financial deregulation would be called into question.
The implications would be even more striking if the putative bubble turned out to reflect a sustainable increase in underlying values. If the doubling of house prices over a few years is not a bubble, then it is clearly impossible for economists to recognise one when it is in progress. It would be hard to imagine a more triumphant vindication of the efficient markets hypothesis than this.