Yesterday, once more! Western central banks are fuelling real estate bubbles again


Vivek Kaul

A major reason behind the financial crisis that started in late 2008 was the fact that the Western countries had built many more homes than were required to house their populations. Once the home prices started crashing what followed was an economic catastrophe from which the world is still trying to come out.
Ironically the solution that central banks came up with for mitigating the negative effects of the financial crisis was to get home prices up and running again. This was done by printing money and pumping it into the financial system and ensure that the interest rates remain at very low levels. The hope was that at low interest rates people will borrow money and buy homes. 
Initially people stayed away but gradually they seem to be getting back to borrowing and home prices in Western countries are up and running again. 
As Albert Edwards of Societe Generale writes in a report titled 
If UK Chancellor George Osborne is a moron, Fitch’s Charlene Chu is a heroine “Young people today haven’t got a chance of buying a house at a reasonable price, even with rock bottom interest rates. The Nationwide Building Society data shows that the average first time buyer in London is paying over 50% of their take home pay in mortgage payments – and that is when interest rates are close to zero!…The OECD has recently identified UK house prices as between 20-30% too high (depending on whether you compare prices with rents or incomes – link). To be sure the UK is nowhere near the most expensive, with some of the usual suspects such as Canada, Australia and New Zealand even worse.”
Home prices in the United States have also been rising steadily since the beginning of 2012. The S&P Case-Shiller 20-City Home Price Index has risen by 13.4% since the beginning of 2012. Even with this price rise, home prices in the United States are still 25% lower than the peak they achieved in April 2006. 
Real estate prices in Western countries should not be rising at such high rates. They have huge amounts of land to build all the homes that they need. Hence, real estate prices in a country like America, which is not really short of land have rarely risen at a very fast pace. Housing prices in America had remained flat for a large part of the 20th century. Prices rose on an average at the rate of 0.4% per year (adjusted for inflation) for the period between 1890 and 2004. In fact in many parts of the country the pries had actually gone down.
For smaller countries like the United Kingdom land may be an issue, but the population density is not very high. The United Kingdom has around 255 people living per square kilometre. In comparison, Japan has 337 people living per square kilometre and India has 367. So there is enough land going around given the population. 
But more than these reasons the biggest reason why home prices should not be rising at the rates that they are is simply because the home ownership rates in these countries are very high. In June 2004, at the peak of the real estate boom, 69.2% of US households owned their own homes, up from 64% in 1995. Home ownership in the United Kingdom peaked in 2001 at 69%. Since then home ownership rates have fallen. In the United States, it has fallen to around 65%. In the United Kingdom it is at 64%. 
Even with the falling home ownership rates a major part of the population in these countries owns the homes that they stay in. The falling home ownership rate in the aftermath of the financial crisis only means one thing and that is that there were many more homes built than required. And a lot of homes were bought not to live in, but for speculation. 
The governments and central banks are now trying to get the speculation going again. In the United States this is important because home equity loans were responsible for a lot of consumption. Home equity is the difference between the market price of a house and the home loan outstanding on it. Banks give a loan on this home equity. 
Charles R Morris writing in 
The Trillion Dollar Meltdown: Easy Money, High Rollers, And the Great Credit Crash explains this phenomenon: “Consumer spending jumped from a 1990s average of about 67% of GDP to 72% of GDP in early 2007. As Martin Feldstein, a former chairman of the Council of Economic Advisers, has pointed out, that increase was financed primarily by the withdrawal of $9 trillion in home equity.”
Feldstein’s study was carried out for the period between 1997 and 2006. A study carried out by Alan Greenspan estimated that in the 2000s, home equity withdrawals financed 3% of all personal consumption. But this was a low estimate. Home equity supplied more than 6% of the disposable personal income of Americans between 2000-2007, another study pointed out. In fact, by the first quarter of 2006, home equity extraction made up for nearly 10% of disposable personal income of Americans. 
And all this consumption in turn created economic growth. If home prices keep going up, more home equity will be created and people can borrow against that. Also as home prices go up, people feel wealthier and tend to spend more, which helps economic growth. 
Governments are trying to encourage banks to give out loans so that people can buy homes. George Osborne, the British chancellor of the exchequer (the Indian equivalent of the finance minister) has come up with a “help to buy” scheme. In this the government will guarantee up to 20% of the home loan to encourage lending to borrowers with small savings. As Edwards writes “This means that if a borrower defaults on a loan, the taxpayer will be liable for a proportion of the losses.”
Criticism for this scheme has come in from various fronts. Andrew Bridgen, senior economist for Fathom Consulting, a forecasting firm run by former Bank of England economists, said: “Help to Buy is a reckless scheme that uses public money to incentivise the banks to lend precisely to those individuals who should not be offered credit. Had we been asked to design a policy that would guarantee maximum damage to the UK’s long-term growth prospects and its fragile credit rating, this would be it.” (As Edwards quotes in his report)
This is precisely what happened in the United States as well in the run up to the financial crisis, wher
e the government nudged banks and other financial institutions to lend to people who were in no position to repay the loan.
Central banks can afford to keep interest rates low primarily because of the policy of inflation targeting that they follow. There mandate is to maintain the rate of inflation at a certain rate and do everything required for that. Increasing real estate prices do not get captured in the rate of consumer price inflation, which central banks tend to use for inflation targeting. 
In fact inflation targeting was one of the reasons behind the global real estate bubble of the 2000s. As Stephen D King writes in 
When Money Runs Out – The End of Western Affluence “Take, for example, inflation targeting in the UK. In the early years of the new millennium, inflation had a tendency to drop too low, thanks to the deflationary effects on manufactured goods prices of low-cost producers in China and elsewhere in the emerging world. To keep inflation close to target, the Bank of England loosened monetary policy with the intention of delivering higher ‘domestically generated’ inflation…The inflation target was hit only by allowing domestic imbalances to arise: too much consumption, too much consumer indebtedness, too much leverage within the financial system and too little policy-making wisdom.” 
The same thing seems to be happening right now. With inflation rates too low the central banks have been maintaining low interest rates, so that people consume more and that in turn hopefully creates some inflation. But that in turn means doing the same things that led to the financial crisis. 
Governments and central banks pushing up real estate prices does help in the short term and translates into some sort of economic growth. But it does have serious long term repercussions as we have seen over the last few years. As Edwards writes “What makes me genuinely 
really angry is that burdening our children with more debt (on top of their student loans) to buy ridiculously expensive houses is seen as a solution to the problem of excessively expensive housing…First time buyers need cheaper homes not greater availably of debt to inflate house prices even further. This is madness.”
To conclude, let me quote economist Robert J Shiller from 
The Subprime Solution: How Today’s Global Financial Crisis Happened, and What to Do about It “The idea that public policy should be aimed at…preventing a collapse in home prices from ever happening, is an error of the first magnitude. In the short run a sudden drop in home prices may indeed disrupt the economy, producing undesirable systemic effects. But, in the long run, the home-price drops are clearly a good thing.” 

The article originally appeared on on July 10, 2013
(Vivek Kaul is a writer. He tweets @kaul_vivek)