House price bubbles made in Europe

That house prices can have a profound effect on the economy is by now widely known. In the US, Professor Rober Shiller has for some time already argued that US houses were overvalued. By contrast, the OECD (2005) came to the conclusion that there was no clear-cut evidence of a bubble, at least on the basis of the prices observed then (i.e. 2003/4). However, this discussion seems moot now. In the US, house prices are now clearly heading downwards.

The downturn in the US housing market has attracted a lot of attention as it sparked the global subprime financial crisis. But what about Europe?

As the chart below illustrates, there are two strong reasons to be concerned about housing prices on this side of the Atlantic as well.

1. The euro area average index of real housing prices has risen almost as much as that of the US and is now (as that of the US) about 40% above its 30-year average. This is similar to the overvaluation of Japanese real estate at the height of the Japanese bubble, which was then followed by over a decade of continuous decline.
2. Over the last 30 years, the euro area index for real housing prices has tended to follow that of the US quite closely. The lag is now much shorter than in the 1970s or 1980s. The euro area market is thus likely to turn soon as well.

How high is high?

What measure should one use to judge house prices? The level of real house prices might be the best indicator if one wants to judge the extent to which households feel richer because of high house prices. However, there might be valid reasons for real house prices to increase permanently; e.g. if the demand for housing increases because of higher immigration or population growth. It might thus be best to concentrate on the price/rent ratio as an indicator of overvaluation of housing since any change in demand factors should be reflected in both prices and rents. However, over the last decade, the price/rent ratio has increased in parallel with the price of housing, as rents have in general not increased by more than the overall consumer price index. This suggests that the current level of the house prices does not just reflect a higher demand for housing, but is likely to constitute an overvaluation (a bubble?) that is likely to be corrected soon.

The table below shows the averages by decade for price-to-rent ratios in the US, Japan, the Eurozone and the OECD average. It is apparent that for all the major areas considered – the US, the Eurozone and the OECD average – the average value for all three decades up to 1999 was close to 1. The only exception is Japan, where the price/rent ratio went up to 1.2, only to fall back down to below its long-term average, as is shown in the last column below. The numbers for the overall OECD average show clearly that the first years of this century have been an exception. Until 1999, the price/rent ratio was never more than 2 percentage points from its long-term average, but it has now, as of the end of 2006, risen to 1.22. However, the overvaluation is most pronounced with the US standing at 36%, and the euro area at 24%, above the longer-term average.

Table . Housing price-to-rent ratios by decade (average levels)

	Average 1970-1980	Average 1981-1990	Average 1991-1998	End 2006/30-year average
US	1.06	0.98	0.94	1.36
Japan	1.02	1.20	1.22	0.69
Eurozone	1.06	1.07	1.00	1.24
OECD average	1.01	1.02	0.99	1.22

Source: Own calculations based on OECD data. Eurozone and global average are based on GDP weights.

The stylised facts on housing prices can thus be summarised as follows:

• There has been a tight correlation between US and euro area housing prices, with the latter following the former initially with a lag of about one to two years. More recently, the correlation has become close to contemporaneous.
• On both sides of the Atlantic, prices (in real terms) have reached historical peaks, and on both sides the upward movement had, until recently, accelerated.
• Since late 2006, prices seem to be declining in the US. It is thus likely that in Europe prices will soon start to fall as well.

Should European policy-makers worry?

Should European policy-makers be concerned about the behaviour of house prices? There is little evidence in the euro area of large-scale ‘subprime’ lending. But the evidence shown above suggests that house prices seem to have an important impact on domestic demand, with wide variations among individual countries. Within the euro area average emphasised so far, there are large divergences – cases of ‘froth’ (Spain, for example) co-exist alongside cases of declining prices (Germany). These divergences have persisted for over a decade, and have led to important macroeconomic disequilibria.

Spain and Ireland constitute special cases. Here, construction investment has increased to levels (18-20 % of GDP) never seen before in any other OECD country except Japan. In Spain and Ireland, lower housing prices are likely to be associated with a sharp and prolonged drop in domestic demand. Germany provides the mirror image to these two cases in that construction activity in Germany shot up to very high levels during the post-unification boom, was then depressed for a decade and might now be poised for a rebound. All in all one can thus conclude that the coming downturn in housing prices should not have a strong impact on the Eurozone average, but it is likely to lead to serious tensions within the area.

One important feature of housing price cycles tends to be forgotten – their extraordinary length. Many last for more than ten years. This persistence means that the downswing, which now seems to have started, is likely to last into the next decade – on both sides of the Atlantic. The US is thus likely to enter a prolonged period of weaker consumption growth and the star performers in Europe, like Spain and Ireland, are likely to face their proverbial 7 years of meagre cows.

References

Shiller, Robert (2005), Irrational Exuberance, Princeton, NJ: Princeton University Press, second edition.

OECD (2005), Economic Outlook No. 78, Chapter III, “Recent House Price Developments: The Role of Fundamentals”, pp. 193-234.

Daniel Gros (2006). “Bubbles in Real Estate, A Longer-Term Comparative Analysis of Housing Prices in Europe and the US.” CEPS Working Document, No. 239.