Do housing bubbles always cause financial crises?

The Global Crisis sparked a vibrant debate about what factors contributed to the Crisis. One question remains central to the debate:

• Were global imbalances or excessive credit growth the key suspects?

Borio and Disyatat (2011) conjecture that the main causal factor of the financial Crisis was not ‘excess saving’ but the ‘excess elasticity’ of the international monetary and financial system. Obstfeld (2012) has noted that “[t]he balance sheet mismatches of leveraged entities provide the most direct indicators of potential instability, much more so than do global imbalances, though the imbalances may well be a symptom that deeper financial threats are gathering”.

Against this background, we revisit these questions in the context of the real-estate market. The importance of the real-estate market, in terms of the macro, is now well known. A prime example of its importance can be found in the US, succinctly summarised by Leamer: “Housing is the business cycle” (2007).

A priori, one expects that both current-account and credit growth trends should impact the valuation of national real estates. A primary link between real-estate valuation and the current-account deficit follows from national accounting and the absorption approach. Growing current-account deficits is a signal of a growing gap between the spending of domestic residents’ absorption and their output. As long as the demand for key non-traded durable assets, like real estate, is positively correlated with absorption, one expects higher current-account deficits to be associated with higher real-estate valuation. Yet, as most households co-finance the purchase of their dwelling thorough the banking system, greater financial depth and an accelerated growth rate of credit opt to increase the demand for houses, probably increasing the real-estate valuation.

New research

Thus, one expects that both current-account and credit trends matter for the valuation of real estate, and a priori there is no obvious reason which of the two should dominate. In Aizenman and Jinjarak (2009) we take an empirical look at these issues in 41 countries between 1990–2005, investigating the association between lagged current-account deficits and the appreciation of the real-estate prices/GDP deflator. We control for macro factors associated with real-estate valuation (lagged GDP/capita growth, inflation, financial depth, institution, urban population growth and the real interest rate).

We found a strong positive association between lagged current-account deficits and an appreciation of the real estate, where the real appreciation is magnified by financial depth, and mitigated by the quality of institutions. Intriguingly, the economic importance of current-account variations in accounting for the real-estate valuation exceeds that of the other variables, including both the real interest rate and inflation.

A growing literature identified several related channels contributing to the positive association of the current-account and credit growth patterns with real-estate valuation. Tomura (2010) has analysed the roles of credit market conditions in endogenous formation of housing-market boom–bust cycles in a business-cycle model. When households are uncertain about the duration of a temporary high-income growth period, expected future house prices rise during the high-growth period and fall at the end of the period. These developments cause expectation-driven boom–bust cycles in current house prices in his model only if the economy is open to international capital flows.

Furthermore, high maximum loan-to-value ratios for residential mortgages per se do not cause boom–bust cycles without international capital flows. Laibson and Mollerstrom (2010) noted that national asset bubbles may explain the international imbalances – the bubbles raised consumption, resulting in large trade deficits. In their sample of 18 OECD countries, plus China, movements in home prices alone explain half of the variation in trade deficits. Gete’s model (2010) showed that increased demand for housing may generate trade deficits without the need for wealth effects or trade in capital goods, and that housing booms are larger if the country can run a trade deficit. These predictions were found consistent with the pre-crises experience of the OECD countries. Adam et al. (2011) outlined an open economy asset-pricing model with households characterised by subjective beliefs about price behaviour and update these using Bayes’ rule. They show that the resulting dynamics of these beliefs considerably propagate economic shocks and contribute to replicating the empirical evidence of the association between current-account patterns and real-estate valuations. Belief dynamics can temporarily delink house prices from fundamentals, so that low interest rates can fuel a house-price boom.

As there is no reason that the relative importance of the current account and the credit patterns in accounting real-estate valuation should stay stable overtime, we study the degree to which the pre-Global Crisis patterns continue to hold after the Crisis. Specifically, we explore the following questions:

• Stability of the key conditioning variables accounting for the real-estate valuation before and after the crisis (specifically, the relative importance of the current-account and credit growth patterns).
• The importance of ‘momentum’ in the pricing of real estate, as measured by the impact of lagged real-estate appreciation in accounting for the present real-estate appreciation, controlling for other macro factors.

This issue is related to concerns about possible ‘bubbly dynamics’, where lagged appreciation is reinforcing expectations of future appreciation.

• Symmetry of the patterns during real-estate appreciation versus real-estate deprecation.
• The possible two-way causality between current-account and real-estate valuation patterns.
• The degree to which the valuation of equities is accented by similar conditioning variables.

Overall, our paper reveals a complex of time varying patterns, yet it validates the robustness of the association between real-estate valuation of lagged current-account patterns both before and after the Crisis.

Conclusions

Our results support both current-account and credit growth channels – with the expectation and animal-spirit channels playing the most important role in the boom and bust of real-estate valuation.

This effect is large: a real-estate appreciation of 1% in a given quarter was associated with a projected real appreciation of more than 1% in the next three quarters. This result is consistent with Shiller’s (2000) concerns regarding ‘Irrational Exuberance’ in the US in the early 2000s.

Importantly, our results were derived in a sample of 36 countries, suggesting that Shiller’s concerns apply globally.

The painful adjustment in the real-estate markets of the US, Spain and other affected countries in the aftermath of the crisis of 2008-9, and the key importance of momentum effects call for further research on policies that would mitigate possible bubble dynamics.

This article first appeared in voxeu.org

Authors: Joshua Aizenman, Dockson Chair in Economics and International Relations, USC, and Research Associate, NBER. Yothin Jinjarak, Senior Lecturer in Banking & Finance, Department of Financial & Management Studies, University of London, SOAS.

Image: A woman is seen walking past unfinished apartment blocks in Spain REUTERS/Sergio Perez