Chaos theory and the economy

We like to believe that the various sectors of the economy believe in rational ways. The “law” of supply and demand: as one side increases the other side decreases. Or, doubling the money supply while holding an asset base static will cause price inflation. Measurable stuff. Predictable.  

I took courses in econometrics, the study of statistical models using data to analyze and predict economic relationships. Given enough data, and given ever-more complex mathematical equations to interpret the data, reliable forecasts could be made. But despite the increased sophistication of the models and the vast deep pools of data, reality had a funny way of not acting rationally. Enter non-linear dynamics, chaos theory, where the deterministic nature of the system does not make it predictable. 

Chaos theory was made popular by Edward Lorenz in the 1960s — a good era for that, ironically.  

“Chaos: when the present determines the future, but the approximate present does not approximately determine the future.” Lorenz coined the expression “the butterfly effect” when he noted that very small changes to the starting point of his computer models resulted in vastly different outcomes.  

In case you are wondering why the weather people on TV are right maybe half the time, Lorenz was a meteorologist. But, within the apparent randomness of complex systems, there are underlying patterns, interconnections, feedback loops, and eventual re-organization.  

The real estate market is right now in full-blown chaos theory behavior, with so many variables interacting that confuse buyers, sellers, experts, and pundits. Everyone agrees there’s something not quite working, but solutions do not materialize. A starter home cannot be $600,000, but apparently, it is not economically feasible to build starter homes anymore for $300,000.  

The year 2024 was the lowest volume for sales in 30 years, which is astonishing given population growth and the dramatic increase in overall wealth in the U.S. When mortgage interest rates went from 2% to 7% that was one obvious parameter that affected sales. But any return to lower rates now would not restore order: there’s pent-up demand and affordability issues that are not going away, that affect the market as much as interest rates.  

I have recently been working with a retired couple moving to North Idaho from the Seattle area. We identified 27 listed properties that initially suited their criteria. That’s a wide range of possibilities, far more than what was out there even a year ago. Half of these possibles were new homes in new subdivisions, an encouraging sign that the development market is healthy, is getting bank financing to build, is responding to the buyer demand side. Another positive takeaway is that the other half were sellers looking to relocate to a warmer climate or downsizing, sellers who were prepared to give up their lower mortgage rate to move on. So, the market is beginning to reorganize.  

We created a spreadsheet with a linear regression equation that predicts the price of a property based on a number of factors: overall square footage, bedroom and bathroom count, single-story vs. multi-story (stairs as a negative factor), distance to medical services, when the home was built, lot size, and so on. I could not come up with quantitative values for the view, the quietness of the street, the quality of the other homes in the neighborhood, and other more aesthetic issues, so there was still some emotionality involved in the rankings. The analysis highlighted properties that were over-priced, or identified discrepancies that were red-flagged for further research.

This was a very interesting exercise, in that I believe the overall market exhibits chaos tendencies, yet when we carefully looked at specific homes, it was clear which properties stood out.

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Raphael Barta is an associate broker with an active practice in residential, vacant land, and commercial/investment properties. He can be reached at raphaelb@sandpoint.com.