Why Did Only Some Countries Develop Housing Bubbles?

Spanish version   

A simple explanation for the occurrence of the recent real estate bubbles across the world can be had from two simple facts: First, home price appreciation can make homeowners happy, as the increase in value of their assets can only benefit them. Second, this can lead policymakers to be tempted to promote such appreciation, and more so in countries with lots of homeowners.

The housing bubbles of the 2000s were widespread –countries in the Anglo-Saxon world, Southern Europe, Central and Eastern Europe, even Scandinavia, saw bubbles– which means that any explanation for their occurrence cannot rely on idiosyncrasies of the American, Spanish, or any other individual political or economic system. On the other hand, looking across a broad spectrum of developed and emerging economies, there was a lot of variation in the extent to which individual countries developed bubbles, ranging from cases such as Switzerland, Japan, and Germany, which saw zero or negative price appreciation, to the enormous price increases in, say, Spain or the UK. Why was it the case that some countries managed to avoid this damaging phenomenon, while others did not?

In a recent paper I propose a simple explanation for why some countries developed bubbles while others did not: House price increases, even temporary ones, create an increase in wealth for home owners. The temptation for politicians to enact policies that lead to such an increase in perceived wealth for their constituents is obvious. The more homeowners there are, the bigger the electoral return for the politicians will be. Indeed, my evidence shows that during the global housing boom of the 2000s, the more homeowners there were inside each country at the beginning of the bubble period, the larger the ensuing bubble was. This is illustrated in the two figures below: a larger share of homeowners in the population predicts a bigger bubble, going both by the amount of price appreciation during the boom, as well as by the amount of price depreciation during the bust.

How might policymakers generate such temporary price appreciation? The set of policies that were used in each country varied, and included loose regulation of credit markets, tax incentives towards homeownership, public guarantees on mortgage lending, loose monetary policy (for countries with an independent central bank), and many other things. What is important is that all these policies allowed the development of excess credit for home buying, which naturally raised the price of all homes. Financial institutions accepted to participate in this excessive lending because in the short run it brought them large gains, and in the longer run they correctly anticipated that any major losses will be nationalized by taxpayers, as allowing generalized bank failures was never going to be the case in any advanced economy. Indeed, my paper shows that large homeowners' groups inside each country predict the generation of more unsafe lending in the boom years of the 2000s, and this unsafe lending in its turn naturally predicts larger bubbles.

Why would this process happen in the 2000s as opposed to other time periods? A confluence of international-level factors facilitated the development of bubbles by lowering the cost of borrowing in this time period. In countries where it paid off electorally for policymakers to allow the development of bubbles, these lower borrowing costs allowed the development of excess credit and the price increase in the 2000s. A main international-level factor was the development of large current account surpluses in countries such as the oil exporters and China. In the figure below, I illustrate the huge increase in these surpluses after about 2001, which meant a lowering of the cost of borrowing across the world.

Similarly, acting as a facilitator for the excessive borrowing was the development of complex financial products that allowed banks to spread and disguise the risk of participating in these dynamics. Perhaps most relevant for countries inside the Eurozone, the introduction of the common currency saw a convergence of borrowing costs for governments and citizens inside the monetary union to a low level, a phenomenon which has been pointed out by many researchers before.

Given the lack of fundamental changes in legislation, attitudes, or behavior after the crisis, it is natural to expect that such negative dynamics will be encountered again. As pre-tax income inequality increases in countries across the world, and as traditional redistribution via the tax system fails to make up for this, the temptation to provide a temporary illusion of wealth for middle-class voters through the appreciation of the price of their assets will continue to remain strong for politicians. A generalized lack of understanding of the distinction between investment and consumption can only contribute to this process: In the distorted worldview that became popular in the 2000s, gains in wealth obtained through changes in the price of non-productive assets such as homes are seen by the asset-owners themselves, the media, and even academics, as equivalent to increases in wealth coming from labor income or returns on productive capital. Grotesquely, homes come to be called an “investment”, for which it is only fair that the owner should obtain a return.

Central banks, as independent and technocratic institutions designed to engender economic stability, would naturally be expected to protect us from such developments. Sadly however, the US Federal Reserve at least seems to have fully embraced the worldview which says that home price increases are normal and desirable, as reflected in Ben Bernanke (in)famous comments on the “wealth effect”. Compounding the problem, anyone who believes this is foolish has every incentive to try and profit themselves from the next bubble, rather than to try to expose the foolishness of the whole boom-and-bust cycle.

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Mircea Popa obtained his PhD at Harvard University and he is now post-doctoral fellow at Yale University.