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.