International Capital Flows, House Prices, and the Euro

Free Exchange’s weekly reading list includes an excellent recent paper by Jack Favilukis, David Kohn, Sydney C. Ludvigson, and Stijn Van Nieuwerburgh: “International Capital Flows and House Prices.” Lots of observers (including me) have noted the suspicious correlation between surges in international capital flows into certain countries in the early 2000s (e.g. the US, Ireland, Spain, Greece, Iceland, Australia) and simultaneous or near-simultaneous surges in house prices in those countries. This paper addresses the question of whether there is in fact a systematic relationship between capital flows into a country and house prices. Were the house price booms of the 2000s caused by international financial flows?

The answer provided by this paper is no, or at least not directly. When different possible macroeconomic explanations for changes in average national house prices are considered, it turns out that by far the most important factor is the ease of bank credit. In other words, rising house prices in the 2000s (as well as their subsequent fall) probably had much more to do with the willingness of banks to lend than any other factor. When banks are happy to lend money and they relax lending standards, house prices go up. When banks reverse course, house prices go down.

The importance of bank lending standards to the US housing bubble has been well documented and discussed, but this data suggests that the same may be true for a number of other countries as well. On the other hand, countries that did not experience a general relaxation in lending standards in the early 2000s did not experience house price booms. Once changing lending standards are taken into consideration, changes in international capital flows seem to have little additional explanatory power for house price changes.

This raises an obvious question: why did credit standards change in certain countries in the early 2000s? Bank lending standards are surely partly endogenous (as the paper discusses) – when banks expect house prices to continue rising, they are more willing to lend, which helps to push house prices higher. That sort of self-fulfilling logic is exactly why changes in house prices (first up and then down) were so extreme in the boom countries between 2002 and 2009. But this story doesn’t explain how the cycle got started in the first place in those countries.

For that, we need to look for some factors that can affect bank lending standards that are external to the housing market. Surely, general prospects for macroeconomic growth must play a role there, as well as overall risk tolerance. When a country seems to be headed for better economic times and risk tolerance grows, banks become generally more willing to lend. And that is where we come to the euro. (Were you wondering when I would bring that into the story?)

The peripheral euro countries benefited in specific tangible ways from adoption of the euro in 1999, not least from surges in international capital flows that reduced interest rates. Yet this research demonstrates that there is no direct connection between those capital flows and house price booms. So how is the euro involved?

This paper provides some evidence that in addition to truly exogenous changes in the supply of bank loans, expectations about future economic growth also have an impact on house prices: all else being equal, when growth prospects improve house prices go up. And more generally, bank lending standards depend heavily on their perception and tolerance of risk.

Now consider the likelihood that the adoption of the euro by the peripheral European countries (e.g. Spain, Ireland, and Greece) created expectations for higher growth (and lower interest rates) in those countries, and helped persuade banks to become less risk averse. House prices start to rise and banks become more willing to lend. House prices rise more. Banks respond by relaxing credit standards further. And the bubble begins to inflate.

Surges in capital flows don’t directly create house price bubbles. But this paper does help us understand a mechanism by which the adoption of the euro could have indirectly caused house price booms: by changing expectations and altering the perception of risk in the eurozone periphery, a self-reinforcing cycle of easier credit was sparked in those countries. That’s not all there is to it, of course – other factors surely must have also caused changes in risk aversion and bank lending standards in the housing bubble countries – but it does seem to be a likely piece of the puzzle for the peripheral eurozone.

Putting it all together, we now have a plausible contributing explanation for why almost all of peripheral Europe experienced a house price boom following the adoption of the euro, while the euro core (Germany, Austria, Benelux) missed it. It’s yet another way in which adoption of a common currency by economically dissimilar countries may have vastly important but completely unforeseen consequences.

China in the News

While 2011 was a busy year for Europe-watchers, I suspect that 2012 is going to be a big year for China-watchers, at least when it comes to developments that will have the potential to dramatically affect the world's financial system and economy. And as has been the case with the eurozone debt crisis, the most significant developments will probably be purely internal. (Note that I don't mean to suggest that we're done with the euro crisis, by any stretch of the imagination.)

After years of seemingly unstoppable growth, China's economy has shown some sign of cooling off in recent months. But as always, the sharpest dangers to China's and the world's economy are fundamentally financial. China's property boom seems to be coming to a sputtering halt, and the big question is whether this will turn into a full-blown bubble-burst. But in China such things have an additional layer of significance, because in addition to potentially causing financial disruptions, falling property values could create political disruptions as well. From Marketwatch:

China faces social unrest from housing woes

HONG KONG (MarketWatch) — Irate Chinese homeowners are among the top policy concerns for Beijing this year, according to analysts who say weakening house prices are stoking serious tensions.

...City University’s Cheng says tensions over the housing market are emerging, even as authorities are proving more adept at defusing conflict in other areas. He points to December’s protest in the southern costal community of Wukan as one example.

Frustrations in Wukan over corrupt land deals by the village elite — and the death of a protester there — boiled over when 13,000 Chinese citizens took to the streets, sending the local Communist Party officials fleeing and beating back attempts by police to retake the town.

Not exactly the reaction we would expect in the US or Europe to events in local property markets. So while the Chinese government has substantial resources (both financial and adminstrative) that it can throw at this issue if it becomes a serious problem, this is something that we'll have to keep an eye on.

Note that one important way that events in China impact the rest of the world is through its exchange rate, which is substantially controlled by China's central bank. With that in mind, Caixin Online recently published an interesting interview with the governor of China's central bank (the People's Bank of China), Zhou Xiaochuan. I admittedly know relatively little about him, but based on what I do know about him Zhou strikes me as a relatively thoughtful policy-maker who has softly but consistently pushed for market-oriented reforms. I encourage you to read the whole thing, but here are a couple of interesting tidbits:

Regarding prospects for China's economy in 2012:

Caixin: China's macro-economic policies were adapted to fit changing economic situations in 2011. How do you see the economic situation in 2012 and corresponding policy options?

Zhou Xiaochuan: The Central Economic Work Conference clearly articulated macro-economic policy, taking into account two considerations: Efforts to prevent an economic downturn, and efforts to restrain inflation.

First, we are encountering concurrent issues in the international arena, including an evolving European debt crisis, U.S. economic uncertainty, and slowing growth in emerging economies. More importantly, the international economy is changing rapidly, and its outlook remains uncertain. Thus, we must be prepared to respond to new situations.

On the other hand, looking at China's domestic economy, local governments will have leadership reshuffles in 2012 and the capacity for growth in the Chinese economy is still great. At the same time, the consumer price situation has changed for the better, and the need to control inflation is not as pressing as it was in early 2011. Of course, there are still uncertain factors, such as the impact that the real estate market will have on the national economy.

And regarding continued yuan appreciation against the dollar:

Caixin: Is the current two-way volatility of the yuan a temporary phenomenon, or does it fundamentally indicate that the yuan exchange rate has already been overshot?

Zhou Xiaochuan: In the past, people said expectations for the yuan were one-way appreciation. Until close to the equilibrium level, it would experience two-way expectations and two-way volatility. This sort of natural, bi-directional floating state is the goal that reform has pursued. But to truly reach this state may take more time. The movement in the current foreign exchange market is still mainly related to the external environment.

That's as close to an explicit statement as you could expect from the PBOC's governor that the yuan has quite a bit further to go in its appreciation against the dollar. I'll have more to come soon regarding recent developments in the yuan-dollar exchange rate.

More House Prices and Current Account Deficits

Continuing to think about the relationship between house prices and the current account deficit, I put together the following chart showing house price changes in the US (measured by the FHFA's house price index) alongside the US's current account deficit over the past 30 years. Even though I was expecting them to be somewhat correlated, I am still surprised by how incredibly closely the two track each other...



...And given the relatively close coincidence of the two series, the idea that the causation runs both ways between them seems quite plausible to me.

House Prices and Current Account Deficits

A new Economic Letter put out by the Federal Reserve Bank of San Francisco, "Asset Price Booms and Current Account Deficits", by Paul Bergin, addresses a subject that I've been thinking a lot about lately. The question is this: is there a systematic relationship between current account deficits and booms in housing prices, and if so, why?

The picture to the right (from Bergin's paper) summarizes why many people think that the answer to the first part of that question is yes. There are exceptions, of course, such as the recent boom in property prices in China (which has been running current account surpluses), but looking across countries there's clearly a significant correlation between the house price appreciation and current account deficits. And looking across time within a single country, the relationship is also easy to see -- for example, the biggest boom years in the US housing market (2002-06) coincided perfectly with the largest current account deficits in modern US history. Many European countries experienced the same coincidence in timing.

So if we believe that there is indeed a causal relationship between house price appreciation and current account deficits, what's the explanation? Bergin mentions a couple of possibilities:

1. Rising house prices make consumers wealthier, so they spend more, which causes an increase in imports.

2. Rising house prices give consumers more collateral against which to borrow, easing credit constraints and allowing more consumption, which causes an increase in imports.

A third possibility, discussed in a paper by Pedro Gete, is this:

3. Rising house prices cause a reallocation of an economy's productive resources away from manufacturing and into construction. The country must therefore source more manufactured goods from elsewhere, leading to an increase in imports.

All of these mechanisms are probably at least part of the story. But notice that these explanations all assign the role of cause to the house price boom, and leave the widening current account deficit as an effect. But in some cases at least, it is entirely possible that the causality could go in the opposite direction.

When a country experiences a surge in capital inflows -- and yes, I'm thinking particularly about the periphery eurozone countries during the years after euro adoption -- that capital flow itself may have a substantial impact on house prices, for a couple of reasons:

4. Capital inflows reduce interest rates, which has the effect of driving up the value of long-lived assets like houses.

5. Capital inflows require offsetting current account deficits, which imply a real exchange rate appreciation. With fixed exchange rates (e.g. within the eurozone) this will typically happen through a rise in price levels in the recipients of the capital inflows, and such price increases will disproportionately affect non-traded goods like real estate.

This is certainly not an exhaustive list; I think that this is an important area for additional research, both to explore other possible mechanisms as well as to better understand the relative importance of each. Just as importantly, better insight into how capital flows can affect asset prices will be crucial to understanding how policies that affect capital flows might impact house prices, or might even be used to dampen real estate bubbles. And as a bonus, this line of research will also help shed crucial light on how the flow of capital from the core to the periphery in the eurozone, by contributing to real estate booms in the periphery countries, may have done much more to sow the seeds for the eurozone crisis than commonly believed.

Keeping an Eye on Banks

Banks. They're so easy to hate. And yet they're so important to the functioning of the economy. If the euro crisis is going to have a significant impact on the US, the channel through which it will do so is the banking sector. We're not in a full-fledged banking crisis, but the signs of stress are real, and growing.

Return of the credit crunch: caught in the grip

Banks are the traditional suppliers of credit – to governments whose debt they hoover up; to rivals through interbank lending; to companies, from sole traders to corporate behemoths; and to individuals. Banks provide the oil needed to run the economic machine; without that lubrication the machine seizes up. But to carry out that role, the banks themselves need money. And that is where the whole model is breaking down.

...As fears over the integrity of the eurozone have deepened, European banks have found it expensive, difficult or in some cases impossible to raise funding in the bond markets. So far they have covered barely two-thirds of the amount of outstanding funding that falls due in 2011. For most banks, the bond markets have been closed for months.

...The few banks that have plenty of money are holding on to it, or depositing it with super-safe institutions such as the US Federal Reserve or the ECB. That means the third key mechanism for bank funding – interbank lending – is also drying up.

...The nervousness surrounding many European banks is rooted in fears about losses they face, particularly on their sovereign debt holdings. Bankers recognise the concerns but complain that the effect is being compounded by regulators’ insistence that the banks should meet tough new capital ratios. The European Banking Authority, which oversees bank regulators across the continent, has identified a total €106bn ($143bn) gap at 70 banks that it stress-tested for their exposure to eurozone sovereign debt. Rather than raise fresh capital in turbulent equity markets to bridge that gap, many are opting instead to shrink their balance sheets and comply with the capital ratios that way.

Regulators, policy-makers, and most observers agree that in order to boost confidence in the banking system (as well as to reduce the odds of a major bank going bust), many of Europe's banks need to increase their capital ratios, which is the amount of core capital they have to work with divided by the amount of loans they have made. But there are two ways to get to a higher capital ratio: by increasing the numerator, or by decreasing the denominator. Bankers argue that given the amount of capital they currently have, calls to increase their capital ratios force them to reduce their lending activities and shrink their loan portfolios. But that is exactly the opposite of what policy-makers intended, of course: the hope was that banks would maintain their portfolios of loans while raising more capital.

In the absence of specific, enforceable requirements that banks meet capital ratio requirements by raising more capital, there's no reason to expect Europe's banks to reverse the current tendency to try to meet capital ratio targets by reducing the size of their loan portfolios. After all, it's expensive to raise capital, and the current ethos of risk-aversion means that extending new loans is not at the top of the list of things that banks want to do. The depressing similarities with the events of 2008 continue...

When the Euro Was Good for Germany

During the good years, the economic benefits of the common currency in Europe were fairly easy to recognize. The countries on the eurozone's periphery -- Spain, Portugal, Greece, and to a lesser degree Italy -- had improved access to international capital markets, enjoyed lower borrowing costs, and experienced substantial investment booms as a result. Meanwhile, the countries in the eurozone core such as Germany, France, and the Benelux countries enjoyed a surge in exports to the rapidly-growing periphery. Importantly, they also enjoyed the higher returns that they could earn by investing in companies, assets, and projects in southern Europe. The gains from the common currency were shared by north and south.

Now, of course, Germany is pondering just how much it is willing to pay to keep the currency union intact. An important part of that calculation is an understanding of what the benefits to Germany were during the good years. There's been some debate about that in recent weeks, for the most part focusing on whether and how much Germans benefited from the export boom of 2004-08. But another element of the calculation should be the higher investment income that German individuals and corporations earned from the new investment opportunities afforded by the common currency.

The following charts illustrate the surge in investment income earned by the core eurozone countries during the 2000s. The first expresses foreign investment income in billions of euro, while the second shows that income relative to GDP. (Data is from Eurostat.)





A couple of important caveats. First, this data is from national balance of payments statistics, which measures foreign income earned by each country from the entire rest of the world. We don't have an easy way to directly measure how much of the increased investment income earned by these countries was specifically from the eurozone periphery. However, given everything else we know about the pattern of capital flows within Europe during that time, and the timing of the surge in investment income (the euro was adopted in 1999, and the boom really happened right after the economic slowdown of 2001-02 ended), it seems a safe bet that the much or most of this increased investment income was from southern Europe.

Second, we don't know what the pattern of investment income earned by the core eurozone countries would have looked like in the absence of the common currency. In the absence of the counterfactual, we can only make an educated guess about the impact of the euro. In this case, however, I think there's every reason to believe that the massive capital flows from core to periphery, the associated investment boom in the periphery, and the surge in investment income enjoyed by the core during the years leading up to the crisis would not have happened without the euro. I would therefore attribute the vast majority of the increased investment income earned by the core from the periphery during the 2000s to the euro.

Given that, this data suggests that the euro enabled Germany to enjoy increased investment income of perhaps €30 to €40 billion per year, or between 1% and 2% of GDP. The Netherlands also enjoyed an income boost of up to 2% of GDP during the best years of the 2000s, while the euro helped France to earn higher investment income equal to perhaps 1% per year.

Are these figures large enough to justify substantial additional spending by Germany to keep the eurozone intact? I have no idea. Keep in mind that this does not tell us anything about the economic benefits that the core eurozone countries enjoyed thanks to their increased exports to the periphery. And most importantly, the benfits of the common currency have always been perceived to be at least as much about politics as economics, and I'm not sure how we would go about quantifying those political benefits. But this sort of analysis does at least give us some rough sense about the magnitude of one specific type of benefit that countries like Germany and France enjoyed from the euro during the good years, and therefore puts a floor on our estimate of the overall benefits of the euro to those countries that are now considering whether to save it.

Italy and Japan

Consider the following differences between Italy and Japan. Italy has a history of lower budget deficits, as well as forecast budget deficits for the next few years that are dramatically lower than those forecast for Japan:

(All data is from the OECD; figures for 2011 and 2012 are forecasts.)


Italy's debt to GDP ratio has remained roughly constant over the past 15 years, while Japan's has climbed steadily higher:



Both countries have had relatively poor economic growth over the past decade, with little difference between them:



And yet, despite all of this, yields on Japanese 10-year government bonds hover around 1.0%, while yesterday the Italian government was forced to pay nearly 8.0% to borrow money for 10 years. Given how much worse Japan's public finances look when compared to Italy's, it seems unlikely to me that investors are demanding higher interest rates from Italy simply because they are worried about excessive budget deficits or debt.

So what explains the dramatic disparity in investor willingness to lend to Italy compared to Japan? There are three crucial differences between Italy and Japan that, when put together, create a coherent story about what lies at the heart of this crisis:

1. Japan has the ability to create its own currency, while Italy does not.
2. Japan has been running current account surpluses, while Italy has had a current account deficit for the past several years.
3. Japan can borrow at 1.0% while Italy must pay much more to borrow.

Item #1 on this list has helped to cause the crisis for the reasons noted by Paul DeGrauwe: by giving up its own currency, Italy lost the important backstop on its government borrowing costs that countries that can borrow in their own currency have. This was a key prerequisite for this crisis to take hold.

Item #2 on this list is important because at its heart, this crisis can be seen as a balance of payments problem. Italy (along with the rest of southern Europe) has been dependent on capital flows from northern Europe to meet its borrowing needs, as reflected by the large current account deficits Italy has experienced in recent years. But private capital flows are notoriously fickle, and when they stop, a balance of payments crisis can ensue. What we're seeing in southern Europe right now is a variation of that.

Item #3, you'll notice, is simultaneously cause and effect. This is the self-fulfilling downward spiral that Italy has become trapped in. Once the necessary conditions were established by item #1, and once Italy became vulnerable to a stop in private capital flows thanks to item #2, the dynamics inherent to self-fulfilling crises took hold -- and events have mercilessly followed that unforgiving logic to the point in which Italy finds itself today.

On the other hand, government deficits in Italy had little to do with getting it into this mess. Which is why all of the stern talk in Europe about setting up firm and credible ways to discipline countries into being fiscally responsible will do nothing to end the crisis in the short run, and nothing to prevent it from happening again in the long run.


UPDATE: I should have mentioned that item #1 goes hand-in-hand with one additional ingredient to Italy's current predicament: the lack of a flexible exchange rate that could adjust in response to the stop in private capital flows. Such an exchange rate adjustment would improve Italy's external competitiveness and reduce its relative income, which in turn would help Italy bring its current account back toward balance. Again, the point is that this crisis is primarily a balance of payments problem, not a budget deficit problem.