Achieving greater economic growth from housing bubbles [Published on November 2016]

One of the most basic models learned in introductory macroeconomics courses was the real business cycle, which shows GDP fluctuating cyclically over time between growth and recession. The graph below illustrates the GDP growth rate (%) for G7 countries, obtained from the World Bank. We can observe that GDP growth rate behaves cyclically, fluctuating between periods of economic growth and decline.

(Source: The World Bank)

One of the strongest indicators of an economy’s performance is its housing prices. Theory says that when an economy is performing well, the rise in income spurs investment/savings in tangible assets. In major cities that are the main driver of the country’s economic growth, that income goes into either buying or renting real estate. We compare the House Price Index and GDP per capita (in USD) from The Economist and World Bank respectively. The dataset spans from 1990 onwards. Apart from Japan and Germany, we can observe that the house price index of the G7 countries is positively correlated with GDP per capita. There are possible explanations for these two anomalies. Japan’s negative correlation between the two indicators was caused by misguided government policies in the late 1980s and external shocks that resulted in the sharp asset price falls contributing to the ‘Lost Decade’, while Germany’s near-zero correlation was due to the German reunification expanding the supply of land that countered demand-side pressure.

(Source: The World Bank)

(Source: The Economist)

Housing bubbles are typically generated from excessive demand for the slow-changing supply of housing resulting from optimism and speculation. This causes house prices to rise due to the natural forces of economics to restore equilibrium. In the current, prolonged low-interest rate environment that facilitates cheap borrowing, investment in tangible assets are popular as opposed to negative-yielding bonds and expensive equities. An article from CNBC reports that housing prices in Vancouver, London, Stockholm, Hong Kong, Sydney, and Munich have risen by over 50% on average since 2011, quoting research from UBS AG. In these cities, predatory behaviour of households is evident; These predators or ‘rent-seeking’ individuals use property effectively as a tax on capital accumulation and reducing a fraction of total output. Resources, time and people, are diverted away from production into protection**.

**Development Economics, Model of Predation – protection refers to the time allocated towards non-productive activities

With the most recent global financial crisis caused directly by the housing market boom and bust, and the association of real estate to the wealthy minority, housing bubbles are perceived to be undesirable. House price appreciations are associated with higher economic growth, reflecting the cyclical nature of GDP growth. However, the subsequent correction after the bubble can either undermine or stimulate economic growth and productivity depending on the depth of the correction and the market environment.

This is part of a recent academic paper by my supervising professor at The Chinese University of Hong Kong. The analysis conducted looks at 19 countries between the first quarter of 1975 to the third quarter of 2013. Depreciation leads to both higher GDP growth and productivity growth. Taking the results from the primary two-stage least squares Instrumental Variable regression, it was found that large housing price depreciation (>10% decline) increase GDP growth by about 3 basis points on average. Meanwhile, moderate depreciations (<10% decline) reduces GDP growth by 3.5 basis points on average. This correlation is consistent in 17 of the 19 countries analyzed, with the two anomalies being Japan and Germany for the aforementioned reasons. These findings hold in the absence of a banking/credit crisis.

The main causal interpretation revolves around the reallocation of resources. Capital gets reallocated from unproductive housing sector into more efficient sectors following house price depreciation, with accommodative policies to prevent a credit crisis. Zombie lending distorts capital allocation and depresses growth. These firms would less likely be able to survive when house prices face steep corrections. The magnitude of this depreciation mechanism on economic growth depends on underwater mortgages, the level of protection for investors, and the country’s legal system. Countries with underwater mortgages, no personal bankruptcy, and/or mortgage insurance, and follow a civil law system are positively and significantly associated with stronger economic growth and productivity growth following steep housing price corrections. Underwater mortgages and a weak ‘safety net’ for investors improve the allocative efficiency of labour.

The nature of housing markets is very similar to the cyclical nature of GDP, experiencing booms and busts resulting from disequilibrium in the market fueled by speculation. Housing bubbles are widely perceived to be inherently dangerous due to speculative behaviour. However, what happens after the housing bubble can lead to a more robust economy driven by stronger fundamentals.


Sources:
http://www.cnbc.com/2016/10/04/these-6-cities-are-at-the-greatest-risk-of-housing-market-bubbles-commentary.html
http://data.worldbank.org/indicator/NY.GDP.MKTP.KD.ZG?end=2015&locations=US-GB-JP-CA-DE-IT-FR&name_desc=true&start=1965&view=chart
http://www.economist.com/blogs/dailychart/2011/11/global-house-prices