Thursday, December 08, 2011

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.

Wednesday, December 07, 2011

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.

Friday, December 02, 2011

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...