Andrés Nieto Porras

What do Dutch tulips, tech stocks and U.S. residential mortgages have in common? They were all 3 part of the largest asset bubbles in history that eventually exploded after a period of time. Approximately 400 years ago The Netherlands suffered the first irrational asset bubble in the entire history called Tulipmania. After a while, bubbles tend to grow bigger and eventually can pop with disastrous effects on the level of GDP and wellbeing of a country. The same stages where followed in the cases of the Dotcom bubble in 2000, and the Credit crunch in 2007, but explaining them are beyond the scope of this article. I decided to focus on a case that is somewhat recognizable to a large group of students. Some try to find a room to stay at during their study or maybe their parents want to purchase a new house in our main capital. Housing prices have been increasing sharply throughout the last couple of years, especially in Amsterdam. I am going to try to answer the question of what the determinants are that fuel these inflationary prices. Is the Netherlands currently trapped in its second growing irrational asset bubble? It’s getting hot on the Amsterdam property market!

Firstly, it is important to define what an asset bubble exactly is and why it is called irrational. An asset bubble is created when the value of a financial asset is significantly higher than its historical or intrinsic value. In the Amsterdam housing case, we use the taxation value as a proxy of the (fair) market value of a house. This market value of a property has many determinants. One of these determinants are adaptive expectations. Economic agents form their expectations on events in the past. So, if the price of a house increased 2% last year, it should be 2% more this year. Individuals will anticipate on this expected change in price by buying a house and earn a return on it. This will drive demand for houses up and indeed, a building in Amsterdam today is 2% more expensive than it was last year. If people keep forming their opinion on the value of an asset based on adaptive expectations prices will keep increasing structurally, without any reason, until something acts to stop it. This is called inflation inertia. Government intervention with a maximum price or a collapse of the housing market are examples of things that could stop the prices of properties to increase. In Amsterdam, until now there has been no or little intervention from the government to keep prices from increasing too fast. The average Amsterdam property value surged from 250.000 euro to a stunning 295.000 per house in just 3 years. If we look at London, a city well known for its astronomical housing prices there was just a rise of 14 percent compared to 21 in Amsterdam. The housing market in Amsterdam is showing signs of overheating.

However, one of the most fundamental determinants are not adaptive expectations. Like any other financial asset, all the information available to investors and individuals should be already incorporated in the price of that security. The information is used to make optimal forecasts for prices and are called rational expectations. If individuals are indeed rational, and use all of the information available to base their purchasing decision, prices should accommodate on a stable level throughout time. Are consumers indeed using all the information available to them? Does the fair market value of a property truly reflects the intrinsic value of it, or is it just based on adaptive expectations? A psychological bias is a danger when people say that the prices will increase in the future because it has increased in the past. If something would put a needle in the bubble and stop the increase in housing prices it will may cause a deterioration on the balance sheets of corporations who own Dutch property.

Besides this, the primary objective of the European Central Bank is to maintain price stability with an inflation percentage of around but under the 2 percent. The ECB has a mandate that gives them the opportunity to influence the money supply, it can print money until infinity and use it to buy bonds from companies and governments. By buying these bonds it influences indirectly the interest rate, specifically the London Interbank Interest Rate (LIBOR). This is the average interest rate that banks charge each other for interbank lending. This LIBOR rate is tied directly to many financial products such as mortgages and derivatives. If the Central Bank influences the money supply through bond purchases, it will decrease the discount rate, commercial banks can borrow money cheaper at the ECB to fulfil its short term liquidity. These banks now can offer a pool of cash to people who want to buy a home against a low interest rate. If the interest rate is low, it will be attractive for people to buy houses, demand for Dutch property will increase, leading to a sharp increase in prices.

Alternatively, Amsterdam is the main hub for its financial district called ‘de Zuidas’. Many large legal and financial institutions such as ABN Amro, Houthoff Buruma, and Deloitte are located in this area in the south of Amsterdam. Many workers, both Dutch and international, want to buy or rent property near the Zuidas to minimize time commuting from their work to their home. Demand for Amsterdam property will increase, leading to a sharp increase in prices. Also, new housing that comes available gets scooped directly of the market mostly for a price higher than the asking price. This will lead to an ongoing shortage on the housing market and surging prices.
Besides this, a few years ago the ‘schenkregeling’ was introduced in the Netherlands. Individuals with extra cash to spend or parents who are getting older and want to support their children financially could make use of this tax arrangement introduced by the government. Normally when leaving a lump sum for children, parents had to pay a bequest tax based on the amount of money given to their children. The government wanted to stimulate home ownership and decided to leave the first 100.000 euros of the bequest untaxed. There will thus be an incentive to purchase properties. Parents leave money for their children while not having to pay a large amount of tax, and children get a nice amount of money to purchase their first home.

Alternative, the Dutch Loan-To-Value Ratio is one of the highest in Europe. This means that for every dollar of fair market value of a property, consumers can borrow the LTV ratio from the bank. The higher the LTV ratio, the more a person can borrow from the bank and the higher the incentive to purchase a home. In previous years, the LTV ratio exceeded 1 in the Netherlands which means that you could borrow more than the value of your house. People used it to renovate their apartment or to buy a new car. However the Dutch government and the central bank foresaw a sharp increase in accumulated debt of consumers and decided that it wants to bring back the LTV ratio to 1 in 2018.

Consequently, the previous factors helped fuel the prices of Amsterdam residential properties. However it is difficult to answer the question of these factors caused an growing asset bubble that is about to burst. It is a fact that the Dutch government has to intervene if it wants to keep the Amsterdam housing prices from falling out of control. Several ways to do this is to decrease the LTV ratio, reversing the tax arrangement for bequests, building new property and thus increasing the supply of housing in Amsterdam. The danger however is the fact that consumers still form their expectations on the past and not on rationality. If this holds on for too long and investors realize that they are merely holding an overpriced 400.000 euro, 9 square meters bedroom in Amsterdam-West, this could lead to a huge selloff. Subsequently causing a collapse in the value of properties and may bring negative externalities along with it. If the house price decreases, this means that the wealth of a consumer decreases as well and so will consumption. For firms with assets that are recorded against fair market value, the value of the asset side will deteriorate and leaves them with negative equity.