Project Syndicate, June 13, 2013
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Since the economic collapse of 2008 there has been considerable effort devoted to redrawing regulatory rules to protect the financial system from future instability. The extent to which the new regulations implemented to date enhance stability is debatable, but if the purpose was to prevent asset bubbles of the sort that gave us the current downturn, arguably they have already failed.
There is a fundamental issue here that is not sufficiently appreciated. While the public’s attention was focused on the financial crises that brought most major banks to the edge of insolvency, and pushed quite a few over, the primary reason for the prolonged stagnation of the last five years was the deflation of housing bubbles in much of the world.
The case for this is clearest in the United States. The housing bubble was driving the economy in the years leading up to the collapse. The unprecedented run-up in house prices led to a record pace of construction in the years 2002-2006, even as the demographics would have predicted a slowing. When the bubble burst, construction not only fell back to normal levels, it dropped considerably below as a result of the enormous overbuilding during the bubble years. This led to a loss in demand in residential construction of more than 4 percentage points of GDP, or $640 in annual demand in the current economy.
The bubble also led to an extraordinary consumption boom, due to wealth effect from $8 trillion in bubble-generated housing equity. The saving rate fell to nearly zero in the years 2004-2007. When the bubble burst and this equity vanished, the U.S. economy lost close to $400 billion in consumption demand, 2.5 percent of GDP in today’s economy.
This is the story of the downturn in the United States; there is no magic potion that will replace this lost demand, especially when the Fed is constrained by the zero bound. It is difficult to see how anything would be very different today if there had been no financial crisis. For all the talk of troubled banks, few small businesses cite lack of credit as major problem. Furthermore, credit is available at record low cost to larger firms, who clearly do not see many investment opportunities.
If the proximate cause of the economy’s troubles are burst asset bubbles, and not over-leveraged financial institutions, then it would make sense to focus more of our attention on the former than the latter. Unfortunately, the picture here is not very encouraging.
The bubble in the United States has deflated with house prices now more or less in line with their trend levels. However this is not the case everywhere. In several countries house prices have at best partially deflated from bubble peaks.
This is most clearly the case in Canada and Australia where inflation-adjusted prices are at above their pre-crisis levels. The story is not much different in the United Kingdom. Prices are down by 25 percent from their bubble peak, but still more than twice their mid-1990s level. Homeowners in France might also have some grounds for concern given that prices there also are at pre-bubble peaks and close to double the mid-1990s levels.
Of course a run-up in prices doesn’t necessarily mean a bubble; it could reflect an increased demand for housing relative to other items. This doesn’t seem to fit with the fact that all of these countries have seen a sharp rise in the sale-price-to-rent ratio over the last two decades. In this respect it is also worth noting that median house prices in all of these countries are now 50-100 percent higher than in the United States. Given their lower per capita incomes, this would imply a willingness to spend a much larger share of income on housing than in the United States.
Some analysts argue that current house prices are justified by the extraordinary low interest rates of recent years. In this view, if the implicit rental value of owning a home is viewed as comparable to interest on a bond, then we would expect a strong inverse relationship between house prices and interest rates.
There are two points to be made on this argument. First, we have not generally seen this pattern in the past. House prices have not been hugely responsive to interest rates in most countries over the last four decades. This means that if house prices now fluctuate like bond prices in response to interest rates, it marks a change in the behavior of this market.
The other more important point is that if house prices now fluctuate like bond prices, then this view also implies that house prices will tumble if interest rates return to more normal levels as the economy recovers. If we think of house prices moving like long-term bonds then a doubling of interest rates will cause house prices to fall by roughly 50 percent. This view implies the same sort of future plunge in house prices as the bubble story, albeit for a different reason.
This sort of plunge in house prices would be no big deal if homeowners thought of their houses like bonds, with the corresponding response to fluctuations in interest rates. However, this is probably not the case. For example, if overnight rates go from near zero to 2.2 percent in three years, and 10-year Treasury rates rise from a recent low of 1.6 percent to 4.5 percent, as projected by the Congressional Budget Office in the United States, then will people in Canada, the U.K., and Australia expect their house prices to fall by 50 percent?
Assuming that most homeowners do not anticipate this sort of plunge in prices, and have not hedged themselves against this possibility, we may be in for another round of very bad news if interest rates ever return to more normal levels. It is remarkable that the latest run-up in house prices has received so little attention from people in policy positions. There may be an enormous price to pay for the continued lack of attention to housing bubbles.