A Marriage Made in Hell: Housing and Foreign Demand

In the past couple of years we have seen a surge in the effort to obtain demand from abroad. Current Account negative balances, have provoked many discussions, since in a currency union, in order not to have a Balance of Payments crisis, there is a need for having a stable quantity of money in the economy. The apparent solution of boosting the export sector, as Germany has been doing during the Eurozone crisis, is no solution for the long-run as without strong domestic consumption the country is prone to shifts in foreign demand. Yet, in the short run, this dependence on foreign demand appears to be great if demand keeps going up. 

The problem is that the same principle does not hold for housing. Picture the following scenario: a person from country Y buys a very affordable home in country X. It goes without saying that most probably country Y is richer than country X, or at least house prices in the latter are lower than the former. (The rationale behind this is that it wouldn't be easy for someone to purchase a home in a country where prices are much higher than in his own country - unless he or she is very wealthy which is what has been happening in London nowadays). Now, if the house is really affordable, others will also want a piece of the housing, and from the supply and demand law we know, prices will rise in the country.

Is that necessarily bad? The answer is unfortunately yes, most of the times. If the rise in foreign demand occurs during a relatively short period of time (as it usually manifests), then house prices will rise by much more than national inflation rates. The case of Spain is very enlightening:

Yellow line is the price of housing per square meter while the green one is the inflation rate

The first question which arises is why doesn't the inflation rate rise by as much as foreign demand if that is the main driving force behind the increase. The answer to this is inequality, but not in the Piketty sense: it is not that everyone in Spain benefits from the rise in prices. The "representative" Spanish household has no intention of selling its house and living somewhere else just because prices have gone up (I know that many economists believe that this is what "rational" agents would do, but that is not very realistic). It's the land developers who benefit the most from this expansion of prices, which is followed by an expansion in credit as banks see its profitable to lend to them. Money is still distributed along the economy in the form of credit or increased consumption (the rising trend of inflation in the above graph is indicative of this) but not by as much as the rise in property prices.

The second question is why does it matter that much. What most fail to see at the time is that this expansion in foreign demand hurts the nationals by much more than we believe. If the average price in Spain was around 1000 euros in 1997, and a part of the population could not afford to purchase a house, then who would argue that in 2008, when it nearly tripled many less would really afford it. If someone doubts this then the following graph should remove all doubt:

The increase in wages was less than 70%, when house prices rose by almost 180%. House price in 1997 was approximately 14 times the wage index, while in 2008 it was more than 28 times. Foreign demand for housing has an even nastier side: it assists in the creation of a credit bubble as locals have to borrow more money for property purchasing and land developers borrow more as profit opportunities rise. Spain is again indicative of this behaviour as credit rose by more than 400% since 1998, mostly driven by these developments.

So what makes housing so different?

The simple answer is that housing is immovable. You cannot really take a house or an apartment and leave the country as you can do with other types of goods.That makes all the difference since it means that locals and foreigners compete for the same goods. If a producer can sell a banana at home and the same one abroad, then prices are charged accordingly and, if possible, charges foreigners more, given the extra trouble that is required. In the meantime, the producer cannot really charge the foreign price to the local market because there are many other substitutes: buy from another producer, buy an imported banana or buy some other fruit. In contrast, the house is stuck where it is built and there is no local nor foreign substitute for it. In addition, the developer has a very good alternative for local demand: sell it to a foreigner at an inflated price. Which is more profitable? Obviously the latter, and the locals will just have to meet the price if they want to purchase the property.

Thus, simply put, increased foreign demand for real estate is almost always bad news for the locals. The phenomenon has not just taken place in Spain, housing bubbles have appeared in the Netherlands, Greece, Cyprus and even London as it appears nowadays. So next time you hear about rising foreign demand for real estate in your country be wary, very wary.

When do Bubbles Burst? Or how do we know that we have hit the ceiling?

There has been a wide talk about the determinants of the financial crisis as well as our ability to forecast it. Many neoclassical economists argue that we could not have predicted anything; yet some of their colleagues did (with varying degrees of success). Keynesians, (or more likely Minskyans) such as Steve Keen are said to have predicted the credit crunch and the crash that followed. Austrian economists have also had their share of predicting as well, again with various degrees of success.

This paper by Dirk Bezemer, presents a list of people who have "anticipated" the financial crisis, as early as 2005 (page 9 of the said paper). Notable names include Robert Shiller (2006), Nouriel Roubini (2005 and 2006) and Steve Keen (2006). Some of the common reasons of analysts/economists behind their predictions are:

1. “a concern with financial assets as distinct from real-sector assets,
2. with the credit flows that finance both forms of wealth,
3. with the debt growth accompanying growth in financial wealth, and
4. with the accounting relation between the financial and real economy.”

Yet, the reasons behind their estimations do not seem so clear. For example have a look at the following graph, obtained by Keen's blog:

With no intention of being disrespectful to neither of the economists/analysts whose views were proven to be much better (to be exact here would be to use infinitely better) than their colleagues, I cannot help ask the following: why should it happen in 2008 and not earlier?

Have a look at reason 3. Debt growth accompanying growth in financial wealth. How can we know that a ceiling has been reached? We can know when we are exceeding the "normal" levels but why not in 2001 when the debt-to-GDP ration was higher than the one in the Great Depression of the 1930's? (the careful reader will see that at the initiation of the Great Depression the debt-to-GDP ratio was less than 175% of GDP, approximately the same as in 1995-1996)

The next graph indicates the level of home owners in the red line (i.e. the percentage of people who choose to buy a house instead of renting one) and the percentage of sub-prime loans compared to overall loans in the US economy.

Home ownership began its decrease in 2004; yet, sub-prime loans boomed during that period. One really has to wonder who the bankers were lending to. Less people willing to buy a house in addition to more sub-prime loans... This might just be the answer, yet why didn't the break happen earlier?

Prices in the US cannot point to the answer as they are not the ones causing the crunch, but the ones receiving it. The Case-Shiller index, however, may state otherwise:

Here, it appears that the index peaked in 2006, dropped lightly until 2007 and started a free-fall in 2007. Could we have known that 2006 was the peak year of the index, ex ante? I have no definite answer to that question. Surely, some people believed that then. And history proved them right. Yet, a prediction on its own is not enough. We have to understand the rationale behind these forecasts. Why wasn't the peak of the debt-to-GDP ratio in 2004 or 2005? Foreclosures were also increased after 2007. But not before it.

Correlations, co-movements or links are easy to find ex post. We know what happened, thus we can find what we are looking for. Yet, we are subject to what is called as Survivorship Bias. We concentrate on the people or things that "survived" some process and inadvertently overlooking those that didn't because of their lack of visibility. 

In other words, we can see more clearly looking back. Keen is right that most macroeconomic models do not account for the four factors mentioned above. Yet, even if they did could they have predicted when we would reach a ceiling? Not really. We are still unaware of many issues which help in lengthening a bubble's life. These are our known unknowns. Each case is somewhat unique in its determinants and evolution, not to mention length. We could have suspected that we were experiencing one when prices exploded for a large period of time. Nevertheless, we could not know when it would burst.

Could we have know whether we were experiencing a bubble as early as 2006? Probably yes. Could we have known when it would burst? Probably not.

To quote Keynes: "Markets can remain irrational much longer than you can remain solvent"

Property Market: Cheap or not so Cheap?

A direct consequence of the EU crisis is that housing prices in South Europe have began to fall. For example take a look at the graph for Greece:

The downwards trend which started in late 2008 still holds strong pushing residential housing prices down. The same holds for Spain and Cyprus (Unfortunately I couldn't find data up to 2012 for Italy. All data and graphs are from the ECB)

Cyprus residential prices

Spain residential prices

The above and all current developments indicate that the severe inflation of housing prices which had occurred during the early and mid-2000's was something of a bubble. Mind you, these are data just for the first quarter of 2012. You may only imagine how lower the prices of the second quarter will be.

The housing bubble seems about to burst in the EU (it already has in some countries) and it's not just prices in the South that have gone down. UK prices have fallen for the first time in 3 months as Britain's economy shrank by 0.7% in the second quarter of 2012, the most in 3 years. (for more details on the UK's housing market read here)

If one looks at ECB it seems that housing prices all over the EU are either stagnant or falling, with a few exceptions. So, many people are faced with a dilemma? Should you buy or should you keep on renting? The answer is not so obvious. The reason is that during a crisis rents are higher while housing prices are lower, since most people cannot afford to buy (fall in demand, thus prices fall) but they have to live somewhere (rise in demand, thus prices rise). In more distressed economies like the South, many still choose to live with their parents and thus both rent and property prices seem to fall, although the latter seem to take the most hits.

True, prices have fallen dearly since last year. This, however, is only the beginning of the downwards spiral which will run its course for at least the full 2013 in strong economies and last even more in the weaker ones. (I hope you can tell which is which!) Moments of a rise in the indexes may occur but these seem more like an slight upwards move right before a severe downwards movement in the stock market.