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Complexity Theory Makes Housing ‘Quake

In the article Housing Bubble Science [1] UCLA geophysicist Didier Sornette [2] has taken the theories developed in earthquake prediction [3] and applied them to the housing market.

Sornette studies what’s known as “complexity theory” to try to predict how a system will behave in the future. He uses physics and statistical analysis to look at the organization of the dynamic parts of a complex system, and how these parts interact to cause something major to happen.

“It emphasizes the whole more than the parts, it emphasizes the interactions and what we call the feedback,” he says.

The interplay of the elements is affected by both positive and negative feedback. Negative feedback is often obvious. For example, when real estate prices are inflated many people decide to sell with the hope of making a nice profit. Eventually more houses are available for sale than there are buyers, so the prices start to drop back to normal. “Positive feedback is exactly the opposite. A high price pushes the price still higher,” explains Sornette. “This is the expectation of people that lead [people] to buy houses at prices that they would never have bought otherwise and taking supposedly big risks first buyers, for example” you’re a young couple relatively at the early stage of your life and you think, ‘Well if I don’t buy now'”

The results
In 2005 he predicted that in the first half of 2006 prices would level out or return to normal rather than crash.

Housing bubble defined
…when house prices climb continually and unexplainably fast — faster than exponential growth — resulting in market prices that are vastly inflated from the fundamental value of the house.

Greater fool theory
The faith that you’ll be able to sell it in the future to a greater fool than yourself for an even higher price. In other words, buyers in an overheated market may understand that they are over paying but have confidence that others will buy the property from them.

However, his theories, as in most scientific theories, especially those relating to economics have a number of detractors [DigiJournal.com] [4].

Nevertheless, it would seem that housing market predictions are ripe for fresh academic research. I am surprised there has been so little of it.