Examining ‘Bubble Economics’ in Silicon Valley
Is the Bay Area Poised for Another 2008 Crash?
Severe market corrections in 2000 and 2008 have engrained the term ‘economic bubble’ in minds across the United States. Articles are being written describing the Silicon Valley’s housing market to be more bubble than boom and are advising would-be homeowners against buying real estate. In fact, rapid price shifts have wreaked havoc the world over including the Asian Financial Crisis of 1997 and here in the U.S. in 2007. Experts are in continuous disagreement over when the next bubble will be, if there is one now, and speculate on future price levels ad nauseum. However, the very existence of bubbles is a hotbed for debate amongst economists and investors alike. This article examines the nature of bubble economics and the unique factors of the Silicon Valley to determine if the housing market is truly in a bubble period.
An economic bubble is characterized by a period when trade in an asset at a certain price range far exceeds its intrinsic value. Simply put, a bubble is another term for when something is overpriced due to any number or combination of factors. Perhaps the most bizarre example of a bubble in history is Tulip Mania which occurred in Holland during the 17th century. When Tulips were introduced to the Dutch they were instantly a status symbol due to their rarity and beauty. Prices for these flowers would often double in less than 24 hours and Dutch homeowners were selling their homes to capitalize on this market. These investors were taken aback when the seven-year flowering period came to a close and bulbs that had been planted years prior grew into tulips and flooded the market. Nearly overnight the bubble collapsed and Tulip Mania had cost nobility, investors, and homeowners alike dearly. The most notable features of bubbles is that they are caused by implausible or inconsistent views of the future and can only be identified retroactively. Could something this strange and dangerous be occurring in the heart of the Silicon Valley?
Silicon Valley at a Glance
As of August 2015, experts agree this is not the case. The housing market correction in 2008 coincided with a larger financial crisis caused in part by subprime lending, derivatives, and other factors beyond the housing market itself. Additionally, housing market gains in the Silicon Valley are largely rooted in the success and prosperity of the local economy- primarily the Tech Industry. The local economy is shattering records, with job growth rate exceeding 4.1% the highest since 2000. Venture capital investments in the region are also higher than any year but 2000 at a staggering $9.9 billion. Topping it off are the 17,000 new patent registrations, higher than any year on record. The strength and momentum of the Silicon Valley economy clearly insulate it from the price irregularities of a bubble situation, but how can we be sure that prices are not exceeding intrinsic value? Let’s examine how pricing in the Real Estate industry is determined- through a modeling technique called Hedonic Regression.
Calculating True Home Values- Introducing Hedonic Regression
Hedonic Regression determines value by calculating the sum value of each factor or input present in a complex good such as a house. Factors range from the obvious such as square footage, fixtures, and amenities to more intangible factors like location and climate. Determining the intrinsic value of a good such as a house is important to see if prices have exceeded the true value of the property. What’s perplexing is that the Silicon Valley presents confounding factors into typical supply and demand models for determining price. Let’s examine these unique attributes to determine if homes in the Bay Area are overvalued.
For years, the Silicon Valley is a hotspot for both foreign and domestic investment, ranging from software startups to large commercial development projects. Additionally, the tech sector is hiring talent at increasing rates- and these jobs pay comparably large salaries. The average salary of the Bay Area resident exceeds $100,000, placing upward pressure on prices in the region. What separates this upward price pressure from a trend creating overvaluation is that these forces have been consistently at play in the Silicon Valley for decades. Simply put- the technology sector is here to stay, and so is the strength of the Bay Area local economy. As an industry hub and culture capital complete with a mediterranean climate, the Silicon Valley will continue to attract wealth, talent, and the next generation of innovators.
Price bubbles occur when the exchanged value of a good exceeds its intrinsic value. When examining the Silicon Valley for an indication of being overvalued, it becomes apparent that a number of factors including the tech sector, job rates, and patent registrations make the Bay Area a vital hub of commerce in the United States and abroad. Confounding factors for standard supply and demand pricing models make it difficult to pin down a home’s true value in the area, especially considering factors unique to the area. In sum there is not currently a bubble in the Silicon Valley market though it is unclear how much farther prices can be pushed up before a natural settling at true intrinsic value.
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