Australian banks’ reliance on foreign funding has lead to the alarming situation whereby we (as a nation of households) have borrowed from the rest of the world to buy existing houses from each other at inflated prices. As I once said it makes me quite frustrated to even suggest that a fair portion of foreign debt incurred in the past decade was used to pay each other higher prices for existing houses. Delusional Economics has explored this idea in more detail here.
Admittedly I made that claim without evidence – it was an intuitive interpretation of the data in the balance of payments and in particular, the interest payments heading abroad in the primary income account. But, in the interests of an informed debate, I have digested some of the literature on this matter and found that the intuitive principle is well supported.
In February this year, Andrea Ferrero, of the Federal Reserve Bank of New York, published this paper arguing that a progressive relaxation of borrowing constraints can generate a strong negative correlation between house prices and the current account. Households increase their leverage borrowing from the rest of the world so that the current account turns negative. The following plot is from the paper (p2).
Out of interest, here is a list of countries according to their current account balance. Eyeballing this list it is pretty easy to find the prominent housing bubble markets near the bottom.
To be clear, access to credit is the key (and this may provide the explaination of the Japanese experience in the 1980s). Tighter standards on loan-to-value ratios force domestic saving and limit the need for foreign borrowing, meaning asset prices can reflect the economic reality of that country alone, and not the savings decisions of other nations.
One example of where the relationship between house prices and the current account appears to fail is Japan in the 1980s. A housing bubble coupled with a growing current account surplus (at 2.1% of GDP on average over the decade) is not what these models predict. One might argue that Japanese saving was high enough that the current account was simply lower than it would have otherwise been, but not negative.
I will present one final conclusion from here, with my emphasis.
We find robust and strong positive association between current account deficits and the appreciation of the real estate prices/(GDP deflator).
Our results are consistent with the notion that for all countries, current account deficits are associated with sizeable appreciation of the real estate. This effect holds controlling for the real interest rate, GDP growth, inflation, and other conditioning variables. We also find evidence consistent with the growing globalization of national real estate markets. These findings are consistent with various scenarios explaining patterns of capital flows across countries, including differential productivity trends and varying saving patterns. In the absence of pre-existing distortions, financial inflows are unambiguously welfare improving. Yet, in a second-best environment, public finance considerations imply that inflows of capital may magnify distorted activities, increasing thereby the ultimate costs of these distortions.
Arguably, the experience of emerging markets in the aftermath of financial liberalization during the 1990s illustrated these concerns. Needless to say, this second-best assertion is not as argument against financial integration, but a cautionary tale – greater financial globalization implies the need to be more asserting in dealing with moral hazard and other pre-existing domestic conditions.
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