This paper develops and simulates a model to examine whether land speculation is primarily a cause of, or a symptom of, property cycles. The model suggests that the volatility of prices-the biggest purported downside of "speculation"-is strongly related to supply conditions. Moreover, while demand conditions in general, and speculation in particular, contribute to boom and bust cycles in housing and real estate markets, the impact of speculation is dominated by the effect of the price elasticity of supply. In fact, the large impacts of speculation are only observed when supply is inelastic.
Real estate prices are by their nature prone to cycles (e.g., Borio, Kennedy and Prowse, 1994; Abraham and Hendershott, 1996; case, Goetzmann and Wachter, 1997; and Wheaton, 1999). Observers in many countries point to "speculation" in land or real estate markets as a prime mover of such cycles (see Feagin, 1986; Atterhog, 1995; Suiter, 2000; Korea Herald, 2002; Korea Times, 2002; Hong, 2002; and Tan, 2002, among many others). But speculation has many definitions, and there are many other candidate determinants of cycles as well. This paper first discusses alternative definitions of speculation. A conceptual model is then developed of how real estate and local business cycles can be causally related to, inter alia, demographic and economic fundamentals, financial conditions and banking policies, and supply conditions, such as natural geography and the regulatory environment for development (Pollakowski and Wachter, 1990; Malpezzi, 1999; and case, 2000). A simulation model is developed to examine whether land speculation is primarily a cause of, or a symptom of, property cycles. Specifically, the model helps explain how real estate speculation is linked to volatility in land prices, and in turn to the elasticity of supply. Special emphasis is placed on the role played by the regulatory environment for development and the effect this has on the key elasticities.
One striking feature of financial crises associated with business cycle downturns is that the most seriously affected economies often first experience a collapse in property prices and a consequent weakening of banking systems before going on to experience an exchange rate crisis, a financial crisis and a business cycle bust (Renaud, Zhang and Koeberle, 1998; and Herring and Wachter, 1999). Although this sequence does not necessarily imply a causal link, the collapse in land prices is clearly of central importance to recent Asian financial crises, especially in Japan, Indonesia and Thailand (Mera and Renaud, 2000). If banking systems in these countries had not been damaged by the speculative boom in land markets followed by the collapse of land prices, these foreign exchange crises would have been less devastating, and economic recovery in Japan, for example, would have occurred more quickly. The conceptual framework developed in this paper can be used to interpret recent examples of the land price booms and busts leading local business cycles.
On the regulatory front, the model developed in this paper explains how the amplitudes of cycles, and the relationship between cycles and speculation, are affected by the elasticity of supply of real estate. This in turn has several determinants, some of which (like natural constraints) are difficult to modify by changes in government policy.1 But the regulatory environment is shown to be another fundamental determinant of supply conditions, and the results can be used to analyze the impacts of regulatory frameworks of housing markets.2
Fundamentals of Asset Pricing
Housing is an asset that yields a flow of services over time.3 The relationship between house value and house rents is key to the modeling of cycles. Sometimes housing rents and asset prices move in tandem, and sometimes they move in different directions (see DiPasquale and Wheaton, 1992; and Renaud, Pretorius and Pasadilla, 1997). …