International house prices and policy
Here in the Netherlands we are glad that house prices now appear to be stabilizing at last, but the same picture does not apply to many other Western countries. Norway, Canada and Australia have seen a rise in average house prices in recent years, in the United Kingdom the recovery in house prices has been nothing short of spectacular, and in Germany prices have also risen since the start of the financial crisis by an average of more than 20%. How can this be explained? Can we do anything about it? Or is it once again the prelude to a housing bubble?
House prices still fairly high
Much has been said and written in the past few years about the fall in house prices, which in some countries was indeed severe. The average fall in actual house prices in developed countries from the second quarter of 2007 to the fourth quarter of 2012 was 14% (Figure 1). Hardest hit were Ireland (-47%), Spain (-35%) the United States (-24%) and the Netherlands (-23%). Since last year house prices in Western countries have generally been rising again, mainly due to the turnaround in a number of countries from falling prices to relatively strong price rises, as in the United States and the United Kingdom.
In fact, house prices in the Western world have remained at a historic high. Although no-one can say what the right price level should be, and differences between the various countries are considerable, this is certainly remarkable.
Differences in fundamentals
As always, the price fluctuations can partly be explained on the basis of the fundamentals. This is almost becoming a dirty word as everyone wants to explain everything in terms of fundamentals, i.e. economic factors such as income growth and interest rate movements. Often we discover too late that these fundamentals are not as sound as we thought. And that is the moment that bubbles can occur in the housing market.
Fundamentally, the difference between supply and demand affects house price movements. The more inelastic the supply, the more the effects of demand will be felt in the price. But even a relatively elastic supply, such as in Spain or in Ireland, can go together with sharp price rises in times of overconfidence. As well as structural factors such as demographics, the most important cyclical components in demand are movements in incomes and interest rates.
One such fundamental in many countries in the run-up to the crisis was the rise in household debt as a percentage of GDP (IMF, 2012). The cause was a combination of low interest rates and further-reaching financial integration and innovation on a global scale. Volumes have already been written about this. But the extent to which these developments occurred in various countries up to 2008 can largely be attributed to institutional differences between countries. A subsidy on taking out loans (such as mortgage interest tax relief in the Netherlands) and a housing market in which households have become used to pursuing what one could call a 'lifestyle career' (a dynamic housing market, as we see in the USA or the UK) reinforce price effects, in both the upward and downward phases. All kinds of economic developments in the period prior to 2008 also produced differences in house prices.
It is not surprising that the housing market in Western countries which were least affected by the global crisis and also had the lowest levels of household debt has experienced the highest price rises in the past five years (Figure 2). Movements in incomes and unemployment were generally more favourable in these countries, and the housing market was generally not overvalued, at least not to the same extent, before the start of the crisis, as was often the case in countries which experienced significant price falls.
The most important underlying factor is the very low interest rate that has made borrowing relatively cheap for many years. But this is of course precisely the aim of a low interest rate: to get the economy moving again. However, this is a matter of some concern, because if the supply in the housing market cannot be increased fast (which is often the case), this growing affordability will in fact lead to higher house prices. And although that also produces growth with increased wealth, it is not the growth based on actual economic fundamentals that you want to achieve. Consequently, one of these well-known fundamentals which can push house prices ever higher can turn into a factor that forms a risk to the economy, because average house prices in the Western world are still relatively high.
In order to assess whether the housing market is overvalued, often relatively simple ratios are used. The ratio of house prices to incomes (price to income ratio) in Western countries is generally still below the long-term average (Figure 2). But the ratio of house prices to rents (price to rent ratio) is already above the long-term level. And although these ratios should be used with great caution as they do not take account of country-specific institutional characteristics on the housing market, these developments do nevertheless provide an indication for the development of housing bubbles. In a country such as Germany, for example, this cannot be seen based on macro-averages, but in a few metropolitan areas such as Munich the prices are indeed relatively high.
The options for limiting bubbles
There are a number of options for limiting the size of these bubbles. The most obvious one is to raise interest rates. Other factors that affect the price are much more structural in nature (such as supply). However, the interest rate weapon currently has undesirable side-effects and can slow down the growth of the entire economy. The IMF therefore expects that interest rates around the world will remain relatively low for some time (IMF, 2014). Furthermore, it is very difficult, certainly in the eurozone, to tackle housing market bubbles through interest rate policy. For example, interest rate rises may be sensible for the German housing market, but not for the fragile economic situation in large parts of the eurozone and the housing markets which are only just beginning to recover in some other countries.
There are other options. These come under what we refer to as macroprudential policy, which in response to the financial crisis is becoming an ever more important task of national central banks, and certainly in the eurozone. The idea behind this macroprudential policy is a sound one: identify financial risks in good time and try to contain them through policy measures. This framework has been in operation since 1 January 2014 (ESRB, 2014). As the ESRB says, it is above all the strong rise in house prices and an increase in borrowing as a percentage of GDP that are good advance indicators for potential problems in the housing market. This policy has a number of tools at its disposal, such as reducing the value of the maximum loan that banks may provide compared to the value of the house (loan-to-value; LTV), the level of monthly payments compared to income (DSTI), the rules under which mortgages may be granted and the capital that must be retained for granting mortgages. All this is designed to make it less easy to take out a mortgage, without raising the general interest rate. Recent studies (Kuttner and Shim, 2012; Goldman Sachs, 2014) have shown that this policy is being used more frequently and has only a small negative effect on price increases. If one pursues this policy on a countercyclical basis, as in the Netherlands, this will help to achieve the price correction.
Why it remains so difficult
Average house prices in the developed economies are still high, and are rising again. With low actual interest rates for the long term and a slow economic recovery, a macroprudential policy will have to be pursued more and more, particularly in the eurozone, and the coming years will serve as a test case. National policy to tackle economic bubbles will remain necessary, especially as average house prices in the Western world are still relatively high.
But it remains a difficult problem. The set of tools we have for recognizing precisely when the market is overheating is in its infancy. As the ESRB also states, data is often lacking which could give us a good understanding of how potential bubbles develop. Furthermore, housing markets differ not only between countries but also within them. That is why more targeted work is needed which goes further than merely generic indicators. And there are always options to circumvent certain measures. A higher risk assessment for domestic banks, for example, makes it attractive for foreign parties to enter the market. A lower LTV can in some cases be avoided by granting extra loans, as has happened in Denmark. It therefore remains difficult to judge the effect of macroprudential policy (Galati and Moessner, 2012).
But even if the information was available and the measures were effective, it is still a huge task. Employing the necessary measures promptly is a much more politicized process than merely raising interest rates. And policymakers have every reason at present for wanting a housing market that doesn't fall any further, or even recovers slightly, as the only route we have towards growth at the moment is to inflate the bubbles. And if we then deliberately burst that bubble, we are left with very little growth. What we do have, though, is a stable housing market. Or isn't that what we want?
ESRB (2014). The ESRB Handbook on Operationalising Macro-prudential Policy in the Banking Sector, Frankfurt: ESRB.
Galati G. and R. Moessner (2011). Macroprudential policy: a literature review, BIS working paper 337. Basel: BIS.
Goldman Sachs (2014). Global Economics Weekly, 14/16. Goldman Sachs, 30 April 2014.
IMF (2014). Perspectives on Global Real Interest Rates. In: World Economic Outlook 2014, April 2014, Washington: IMF
IMF (2012). Dealing with Household Debt. In: World Economic Outlook 2012,April 2012, Washington: IMF
Kuttner, K. and I. Shim (2012). The Effects of Monetary and Macroprudential Policies on Housing
Prices and Credit, In: Property Markets and Financial Stability, Reserve Bank of Australia