What drives house prices?

By Felix Salmon
January 4, 2010
speech in Atlanta yesterday by presenting two charts. Each one has house-price appreciation in various countries on the y-axis. In the first, it's charted against monetary policy; in the second, against capital inflows.

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Ben Bernanke ended his speech in Atlanta yesterday by presenting two charts. Each one has house-price appreciation in various countries on the y-axis. In the first, it’s charted against monetary policy; in the second, against capital inflows.



Bernanke’s point is clear. In the case of the first graph, it’s that low interest rates didn’t cause the housing bubble: look at all those countries north-east of the USA on the chart, with greater house-price appreciation and tighter monetary policy. Rather, look to the second graph for a more credible explanation — when a country is running a large current-account deficit (when capital is pouring in from abroad), house prices tend to rise a lot. When a country is running a large current-account surplus (when it’s sending its own money abroad), by contrast, house-price appreciation tends to be modest.

So why, then, does Bernanke spend so much of his speech talking about underwriting standards and mortgage regulation? Those countries with enormous house-price appreciation, like New Zealand and France, didn’t have particularly weak mortgage underwriters or exploding ARMs. But the point here is that Bernanke is making a power grab:

The best response to the housing bubble would have been regulatory, not monetary. Stronger regulation and supervision aimed at problems with underwriting practices and lenders’ risk management would have been a more effective and surgical approach to constraining the housing bubble than a general increase in interest rates…

The lesson I take from this experience is not that financial regulation and supervision are ineffective for controlling emerging risks, but that their execution must be better and smarter. The Federal Reserve is working not only to improve our ability to identify and correct problems in financial institutions, but also to move from an institution-by-institution supervisory approach to one that is attentive to the stability of the financial system as a whole. Toward that end, we are supplementing reviews of individual firms with comparative evaluations across firms and with analyses of the interactions among firms and markets. We have further strengthened our commitment to consumer protection. And we have strongly advocated financial regulatory reforms, such as the creation of a systemic risk council, that will reorient the country’s overall regulatory structure toward a more systemic approach.

I’m actually sympathetic to Bernanke here. While weak underwriting might not have been a major cause of the housing bubble, it certainly served to exacerbate the systemic consequences of the bubble bursting. If the pain of falling house prices is felt mainly by individual homeowners, rather than by the banks who lent to them, then you don’t end up having to bail out the entire banking system at enormous public expense.

But I’m also worried about the implications of Bernanke’s second graph. The US continues to run an enormous current-account deficit. When that comes to an end, are we going to have yet another downward plunge in home prices?


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Could the causation be the other way – high house prices lead to greater consumer borrowing and spending on imports?

Posted by mjturner | Report as abusive


Doesn’t that depend on *how* the current-account deficit comes to an end? The graph you include shows very clearly that property values grow far faster when a country is awash in foreign funds seeking assets. But it’s not the strongest correlation I’ve ever seen; there are clearly a host of confounding variables. And there’s no reason why rapid appreciation must necessarily produce equally rapid deflation.

Consider, if you will, some scenarios. If our current-account deficit were to come to an end abruptly and painfully – for example, if we ran out of purchasers for our debt, or the dollar ceased to be the primary reserve currency – one would expect a second crash in values. If, on the other hand, our economy were to come roaring back from the Great Recession with far faster growth than most of our trading partners, and rapid growth in high-value exports were to sharply narrow the current-account deficit, I’d be shocked to see rapid depreciation in real estate or other fixed assets. After all, incomes would be up. We’d just be replacing foreign cash with the homegrown variety. Or, to pose another set of matched scenarios, a country whose current-account deficit soars because of growth in imports is more likely to experience an asset bubble than one witnessing the rapid decline of exports.

So what matters most is not the change in current account alone, but the reasons for that change.

Posted by Cynic | Report as abusive

Perhaps we should look at this issue a bit differently. Would the slope of the demand curve on housing be more gradual over a longer period of time ie closer to 0 than 1 if the only option for financing homes was 30 year traditional financing?

The attraction of capital inflows WAS NOT a catalyst to the housing boom but instead HOW we attracted the capital was our demise. Low interest rates on the short end matched against a long term funding need is a fools paradise. Bernanke still doesn’t seem to understand that the FED, in allowing short term instruments to finance long term housing purchases lead to this disaster. It corrupted the bankers, the mortgage industry and many home purchasers.

What if this country actual offered foreign investors the option to invest in plant and equipment that
provided a respectable return over it’s cash flow generating depreciable lifespan? Would that not also increase capital inflows allowing for industry to expand, to expand hiring, to provide current workers security and a more moderated but SUSTAINABLE consumer consumption expansion.

This isn’t rocket science…it’s economics.

Honestly, no wonder our citizens believe that the adminstrators of our countries leading institutions are still suffering from ‘Greenspanspeak’.

Posted by csodak | Report as abusive

Well, it depends how far they fall now. Housing prices are still historically high when compared to rents and when measured by the home price to median income ratio. But with the shadow inventory, falling rents, and declining median income they seem likely to start falling again in the near future. So an eventual contraction of the current account deficit might present a chicken and egg syndrome: which came first, a double dip recession leads to a further fall in the dollar, a decline once again in imports, and severe problems for the remaining banks balance sheets, or a renewed contraction of the current account deficit.

There still seems quite a bit of denial in Ben Bernanke’s speech, denial he seems to share with Larry Summers and Tim Geithner about what happen the last 10 years. Perhaps because they were such central players in creating the circumstances that led this Minsky moment, they still seem to think of it as primarily a liquidity problem, not a solvency problem and that if they can partially (just partially!!) reinflate the bubble all will be well and self-sustaining growth will return. This policy of extend and pretend probably will not go on indefinitely. Credit and M3 apparently started contracting in August, Fiscal stimulus will pretty well fade by the end of the 2 qtr 2010, and the FED intends to end QE by March. This will not end well.

Posted by rickstersherpa | Report as abusive

Greenspan noticed the correlation awhile ago! http://www.federalreserve.gov/boardDocs/ speeches/2005/20050204/default.htm – “Interestingly, the change in U.S. home mortgage debt over the past half-century correlates significantly with our current account deficit.” :P

Posted by loph4t | Report as abusive

Well, one has to de-assemble this a little bit. The current account deficit is in principle the difference between the national savings rate and the rate of investment. It goes up or down whenever the gap between the two changes through either a fall in savings or a rise in investment and vice versa. A persistent deficit is not necessarily indicative of a problem, it may simply indicate an abundance of investment opportunities. Australia, for example, has been running a deficit (and a large immigration program, which is related) for decades now.

Problmes arise when there is an unusual rise in the deficit for no good reason, indicating hot money flowing in. Carmen Reinhart and Graciella Kaminsky have done some good works on this. Some of the money went into the housing market with the all conseqeunt problems.

Currently, as Felix’s other post indicates the US national savings rate has collapsed. not sure what’s happening on the investment side but one would have to assume that the danger is not a gradual unwind due to a readjustment of the savings v. investment equation but a sudden collapse as per cynic’s comment. Then there is a big problem I think. But that takes a collapse in investor cofidence and so we are back to what should be teh starting point: fixing US’s fiscal position in the long-term.

Posted by IlyaSerov | Report as abusive

The question remains: where is our country placing the sources of its investment funds whether acquiered through domestic savings or capital inflows? It seems that no one knows.

In the recent past investment funds have been used to make certaint that AIG insurance policies are honored, that overvalued housing is refinanced, that insolvent banks have no cost of funds to speculate with while regulators allow them to neglect the deteriation of their assets class and that automobile inventories are depleted. Todays corporations are cash rich but R&D idea poor.

Tell me where our countries sources of funds are currently being invested that will result in future productivity? Not service sector productivity ie finance, real estate etc. but FUTURE productivity.

Before our access to capital runs out our country would be well served to determine where to invest in order to assure future productivity or we well may see a flock of black swans.

Posted by csodak | Report as abusive