In mid-June the International Monetary Fund’s Global Housing Watch warned that we might be seeing the development of another unsustainable global housing bubble. Reflecting a new sense of awareness on the part of economists that asset price bubbles are real and can cause major damage to the economies in which they inflate, the IMF published four key charts on its website (see slide show below) clearly indicating that home prices were substantially above trend in at least nine countries. Do we have reason to be alarmed?
The IMF says the bubble economies are Sweden, the Netherlands, Norway, the United Kingdom, France, New Zealand, Australia, Canada and Belgium (and possibly Austria). All these countries have house-price-to-income ratios and house-price-to-rent ratios that are well above trend. These indicators suggest that people’s purchasing power is not catching up with house price and rent increases — both signs that property price valuations might be out of line with fundamentals.
What does this mean for the global economy? While high house prices might redistribute income from first-time buyers to people who already own property, which would be unfair, the most important aspect of any housing bubble is the threat that it poses to economic growth if it pops. How housing bubbles stimulate economic activity is quite straightforward, working through two channels.
Rising house prices make people who own houses feel wealthier. Because they see the value of their property go up, they assume that they have more money, and this leads them to spend more on consumer purchases. In really crazy property bubbles, people may even remortgage their homes and spend the money on consumer goods, effectively using their properties like ATMs. Economists call this channel the wealth effect.
The other channel through which housing bubbles lead to economic growth is far more direct. When house prices are rising, investors build more houses because they think it will be profitable to do so. This relationship is known in economics as Tobin’s Q for new dwelling investment. Building more houses leads to people being employed to build the houses and generates revenue for suppliers of construction materials. This is the key channel through which house price bubbles generate economic growth and employment. It is also the key way that a sharp decline in property prices can lead to a recession.
The bursting of the U.S. housing bubble in 2006 and ’07 led to a financial crisis and a worldwide recession. The financial crisis began when many of the mortgages that the banks had extended went sour as people found themselves unable to make repayments. The Great Recession, on the other hand, was more directly caused by the fall in property investment. If the IMF is correct that the countries it highlights are bubble economies, then we need to understand what sort of impact might be felt on the world economy if the bubbles pop.
According to World Bank figures, together the nine bubble economies made up just under 15.5 percent of world GDP in 2012. By contrast, the United States accounted for a little less than 22.4 percent of global GDP that year. We should add Ireland and Spain to the latter figure because those countries also had substantial housing bubbles that burst in 2006 and ’07 and may have contributed to the worldwide downturn; so the bubble economies that crashed the world economy in 2006 and ’07 accounted for almost a quarter of world GDP.
Clearly the countries that the IMF thinks might be bubble economies are not as important to the global economy as are the U.S., Ireland and Spain. That said, the IMF’s bubble economies still account for a substantial slice of world GDP, and if they take as big a hit as the three countries that did in 2006 and ’07, this could spell bad news for the global economy. This is especially true if we consider the weakness of the current global recovery. A simultaneous bursting of housing bubbles in countries that account for over 15 percent of world GDP could have ripple effects and knock the global economy off balance.
The IMF’s bubble economies are not as reliant on property investment as the economies that blew up in 2006 and ’07. At the height of the bubble then, property investment in those economies accounted for just over 7 percent of their GDP. By contrast, today property investment accounts for 4.0 to 4.5 percent of the GDP of the IMF bubble economies. This means that, should the bottom fall out of these markets and property investment take a hit, the effects on economic activity are unlikely to be as bad as those seen in the wake of the financial crisis.
The graph below shows the growth rate of investment in property in the bubble economies and the post-bubble economies. Investment due to the housing bubble of the 2000s began to fall off in 2005 and then went firmly negative before recovering somewhat in 2012. Property investment in the IMF’s bubble economies declined sharply after 2006, recovered briefly and seems to be falling once again.
The chart suggests that there was never really a second investment boom in property in the IMF’s bubble economies. This means that although prices have continued to rise in these countries, they have not been accumulating large supplies of property in their property markets. While a substantial decline in house prices in these economies will probably hurt property investment, it seems unlikely that this would be as severe as that experienced by the U.S., Ireland and Spain beginning in 2006 and ’07. A stone hits the ground harder the higher you throw it, and property investment does not have as far to fall in the IMF’s bubble economies now as it did in the bubbles of 2006 and ’07.
Compared with the economies whose property markets crashed then, the IMF’s bubble economies account for less of the world’s GDP, are less reliant on property investment for their economic growth and have been experiencing less of a surge in property investment than the U.S., Ireland and Spain did before their crash. This implies that should house prices fall in the bubble countries, the impact on the global economy will be substantially less than the earthquake felt after the 2006 and ’07 collapse. Nevertheless, there will still likely be significant effects for the world economy and even more so for the bubble economies. Given the weak state of the present global economic recovery, such a collapse may be enough to tip the world back into recession.
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