Housing Booms and Busts

I was unable to address the housing paper in my end of my seminar commentary at the RBNZ Professorial Workshop on the Current Financial Crisis (17 June 2009). This covers some of the things I wanted to say. By way of background Luci Ellis, whose paper this note covers, is Head of Financial Stability at the Reserve Bank of Australia. She has also worked on these issues at Bank of International Settlements. Hers was one of the best papers, at a seminar noteworthy for the excellence of all its papers.

Keywords: Macroeconomics & Money; Regulation & Taxation; Social Policy;

The paper by Luci Ellis “Only in America? Must Housing Booms Always End in Housing Meltdowns?” argues that institutional differences substantially affect the evolution of the housing market and the required responses of policy-makers concerned with the stability of financial institutions which lend to housing. In particular the institutional arrangements for house lending in the US make it particularly prone to what she calls ‘meltdowns’, that is major collapses in the price of houses, whereas different institutional arrangements elsewhere (especially, given the seminar focus, in Australasia) mean that this sort of housing price collapse is less likely, and therefore the lenders (mainly banks) are in a different situation.

I want to wholeheartedly agree with the thesis, but put it in a wider context, before making a few remarks on the housing market.

Economics has too readily ignored institutional differences, not only in housing but everywhere. A particular version of this vice is to assume that the US institutional arrangements are some kind of norm, and adapt analyses and policies in other countries as if they had the institutions of the US.  I illustrated the point in my seminar commentary when I pointed out that macroeconomic arrangements  in recent years in New Zealand (and elsewhere) have taken as a given that monetary and fiscal policy cannot be co-ordinated, Given the peculiarities of the US constitution and government arrangements, they cannot be easily coordinated there. But other countries have different economic governance. John Singleton’s interesting paper which argued that there is likely to be changes in the way which Central Banks operate  could have been written from the perspective that there is an increasing realisation there are models different from what American experience suggest are optimal (or did, until the Global Financial Crisis began).

Ellis’s paper beautifully illustrates the thesis in regard to housing, as it details the differences between the US housing arrangements and elsewhere. It argues, I think correctly, that  as a result there is not likely to be a collapse in housing prices in Australasia and so the banks here are more financially stable than their US counterparts, as far as their mortgage lending is concerned. In particular far fewer (proportionally) of the mortgagees are likely to find the value of their property fall to the point when they will walk off it. Some will, of course, but it will happen slowly and not in catastrophic proportions; I am more concerned that high unemployment may cause the  abandoning of mortgages. (I also observe this analysis does not apply to farm mortgages.)

There is a downside. If house prices are overvalued and they do not fall quickly, the housing market will be out of equilibrium for a long time during the downswing. Thus while the financial system may be more robust, it is possible that the labour and related market will carry the burden of adjustment with a consequent loss of efficiency and a prolongation of the downswing. Labour will be less geographically mobile, and those retiring or wanting to purchase their first home will find the transaction even clumsier. (The slow adjustment to reduce transport energy use by better location of housing is likely to be even slower too.)

My view is that the payments system (in the widest sense) is so fundamental to the modern economy that a less efficient housing market may be a small price for the financial stability the institutional arrangements generate. Even so, we need to think about how we can improve the efficiency of the housing market.  I will not pursue here what should be done to improve the housing market, but the Ellis paper properly points out that – unlike the US in the past – we need to bear in mind how any changes might impact on financial stability.

Finally, and as a footnote, I mention that among my juvenilia there is a publication ‘The New Zealand Housing Market’ (New Zealand Economic Papers 10, 1976, p.1-29; not on the web).  It uses some of the analytic devices in the Ellis paper to conclude that with both demand and supply very inelastic, the housing market will work rather imperfectly. (It did not look at the financial stability.) I have not really gone back to the topic over all these years, but I have observed the housing market for macroeconomic purposes. My conclusion is that housing prices in New Zealand will at best by falling slowly in nominal terms or stagnate while  other prices rise so they fall in real terms – as occurred in the 1970s. That was the underlying model in my April 2007 forebodings about the housing market.

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