If Australia were as densely populated as Hong Kong, it could accommodate all of the world's people seven times over

IT PAYS to pick your drinking buddies carefully. It's nice if they enjoy a pint as much as you do. But if they hold their liquor too well, you may wake up regretting trying to keep up with them.

In the years before the financial crisis, Australia's economy set a hard, fast pace for the rest of the Anglo-Saxon world. Its house prices rose faster than Britain's or America's (although Ireland's outstripped them all) and its current-account deficit gaped wider for longer. But its economy proved strong-livered. House prices fell from March 2008 to March 2009 (as measured by the weighted average of the eight state capitals), then resumed their rise. In the year to the first quarter of 2010, they jumped by 18.8%!

This week in The Economist we will publish our quarterly index of house prices around the world. Australia's homes are the most overvalued in the index. The ratio of prices to rents in the country is fully 56% above its long-run average (see chart).

The question now is whether Australia's hair of the dog treatment will work, or whether the property market will suffer another bite. Yesterday the RP Data-Rismark index showed prices rising by just 1.2% in the year to January. Compared with the previous month, they fell by 1.6%.

Many economists in Australia argue that the country's lofty property prices are justfied by a variety of fundamentals. Immigration has swelled the population, and zoning regulations, infrastructure charges and the like have imposed artificial constraints on the availability of land. (I must confess that I smile when I read about land scarcity in Australia. I am writing this from the 60th floor of an office tower in one of the most crowded places in the world. If Australia were as densely populated as Hong Kong, it could accommodate all of the world's people seven times over.)

These fundamentals no doubt matter. But one of the virtues of a price-to-rent ratio is that it takes them into account. If immigration is putting upward pressure on house prices, it should put upward pressure on rents too. And if developers can't build homes, they can't build rental homes either. Those factors may justify high prices. They don't justify high price-to-rent ratios.

The difficulty in using these ratios (or any other) as a measure of overvaluation is knowing what the ratio should be—what counts as an equilibrium? In our house-price index we take a simple historical average from 1975 to 2010. But perhaps something has changed in Australia in that time that now warrants a higher ratio. The chart above is certainly suggestive of some kind of structural break after 2000*. If you compare today's price-to-rent ratio with its average over the past ten years, it is overvalued by 12%, not 56%. Compared with its five-year average, it is overvalued by just 3%.

If things are different now, why might that be? Low interest rates and financial liberalisation is one answer. But Ireland, Britain and America enjoyed those too. What marks Australia out of course is its extraordinary resource boom. The country's terms of trade (the price it can fetch for its exports, relative to the price it pays for its imports) is at its highest since the 1950s (see chart). So perhaps lucrative exports of iron and coal justify rich valuations for bricks and mortar?

In a recent paper, Patrizia Tumbarello and Shengzu Wang of the IMF show that a 10% improvement in the terms of trade tends to lift Australian property prices by about 5%. What they don't investigate is whether it raises the ratio of prices to rents. I think it's at least possible that a resource boom affects asset prices, like houses, differently from the price of a service, like rental accommodation. The bright prospects in mining and minerals will attract capital inflows into the resource sector, which might bid up the price of other assets in the economy. And in buying a house, the average Australian might see a way to crystallise the future income he expects will trickle down to him from the commodities boom.

Thanks to the improvement in the terms of trade, the average Australian's expected lifetime wealth has increased. In theory, he should be able to enjoy some of that windfall in the present, by borrowing against his future gains. But his bank might prefer it if he borrows to buy a concrete, collaterisable house instead. That way, he can either withdraw housing equity, if he wants to consume his future earnings, or accumulate it, if he wants to save them.

It's a bit like lining your stomach, before you go out drinking.

*Only suggestive. Charts for Ireland before the crisis looked very similar. See Fig III.4.