Academics and central bankers across the world are again engaged in an intensive debate about how central banks should react to substantial rises in asset prices in the wake of recent booms and busts in housing markets in many countries. Until recently, there seems to have been a consensus that monetary policy should not be aggressively tightened in an attempt to prick a house price bubble. This so-called “Greenspan doctrine” (Greenspan 1999) argues that policymakers should instead “focus on policies to mitigate the fallout when it occurs” – a view that is supported by the research (Ahearne et al 2005).
Housing bubbles in a monetary union are different
Whatever the outcome of the debate, the prevailing hands-off approach to house prices may not be appropriate for individual euro area member states. These countries do not control their own interest rates and monetary policy is therefore not in a position to clean up the mess after a local house price bubble bursts. If there is a need to find a way to counteract bubbles more effectively in euro area countries, that responsibility will lie with national policymakers, not with the ECB.
There are already lessons to be learned on this score from the first decade of the euro. Over the past decade, house price increases in the euro area as a whole have been relatively moderate and therefore not a major factor for the ECB. However, there have been local housing bubbles that have burst and now threaten growth prospects and financial stability in some member states, most notably Ireland and Spain. It is important that we recognise what features and policies may have facilitated the overheating of housing markets in these countries and identify measures that would make national economies less vulnerable to destabilising housing booms and busts.
Housing bubbles under the euro: Ireland and Spain
Ireland and Spain have been two of the euro area’s best performing economies to date. The rapid growth in Ireland’s economy was initially driven by a positive shock to productivity in the traded sector. The Spanish expansion, in contrast, reflected a positive shock to domestic demand. In both cases, the shocks put upward pressure on the relative price of non-traded goods and services, including housing.
As we document in our Bruegel Policy Brief “A Tail of Two Countries” (Ahearne et al 2008), the associated boom in residential investment has led to a doubling of its share in GDP (Figure 1), directly contributing to annual growth of half a percentage point in Spain and a full percentage point in Ireland over the 1996-2006 period. The surge in investment was accompanied by soaring house prices (Figure 2). Other factors also contributed to the housing booms, notably sustained fast growth in disposable income; population dynamics including increased immigration flows; favourable tax treatment of home ownership; and demand by foreigners for retirement homes in Spain.
Figure 1. Residential investment (% of GNP/GDP)*
Source: Eurostat and CSO. *We use GNP instead of GDP for Ireland to exclude the supernormal value added recorded in some sectors that are dominated by foreign multinational companies.
Figure 2. Real house prices
Source: ECB, ESRI, Eurostat and Ministerio de Vivienda.
However, as in other housing cycles, the housing booms in Ireland and Spain turned into disruptive bubbles, as irrational exuberance caused price increases to feed upon themselves and housing valuations became unhinged from fundamentals. The drops in real interest rates (Figure 3) to inappropriately low levels after Eurozone entry created difficulties for both countries. These difficulties reflect the well-known “Walters’ critique” of one-size-fits-all monetary policy: real interest rates have moved in ways that have been partly destabilising (see Miller and Sutherland 1991, and Kirsanova, Vines, and Wren-Lewis 2006).
Figure 3. Real interest rates*
Source: Eurostat and Ameco. *Short-term nominal interest rates deflated by Harmonised Index of Consumer Prices.
Generous tax provisions for owner-occupied housing also appear to have been conducive to housing bubbles in both countries (van den Noord 2005). Both countries have generous interest deductibility systems for owner-occupied housing and tax breaks for profits made from the sale of primary residences.
Significant migration flows may also have played a role. Labour mobility is rightly regarded as a key channel by which a large currency area can cope with asymmetric shocks (Mundell 1961). However, the matter is somewhat more complicated when a local economic boom is accompanied, and to some extent fuelled, by a rapid increase in housing prices. The additional demand for housing due to immigrants is typically larger than the additional supply due to migrant construction workers so that immigration tends to push up house prices. What’s more, immigration can add an important dimension of speculative expectations. Specifically, there may have been a tendency to rationalise excessively high house prices by long-term linear extrapolation of current migratory trends, underestimating the pro-cyclical and therefore mean-reverting component of immigration.
Against a backdrop of rising interest rates in 2006 and 2007, house prices and residential investment began to fall. The contraction in home-building is expected to directly subtract about four percentage points from GDP growth in Ireland and Spain this year. This drag on growth will almost certainly push both economies into recession.
Developments in housing markets in Ireland and Spain raise questions about the functioning of the euro area and how national policy frameworks should be adapted to allow member countries to respond more appropriately to asymmetric shocks. These lessons may be particularly relevant for new catching-up countries in the euro area. Based on the experience so far, we recommend the following:
- Euro area governments should prick housing bubbles using countercyclical taxation of housing. Whenever ECB interest rates become inappropriately low for a member state, for example, aggressive reductions in tax breaks on housing should aim to reduce the stimulus coming from ECB policy. For example, mortgage interest relief could be conditional on the real rather than the nominal interest rate. At the same time, tax incentives that favour fixed- over flexible-rate mortgages might be called for, as well as changes to the property tax and capital gains tax regime so that they act automatically as countercyclical stabilisers. In some cases, additional temporary tax measures to contain an emerging bubble will be required.
- Housing booms associated with credit booms are particularly damaging (Mishkin, 2008). In Ireland and Spain, financial liberalisation and increasing banking competition have contributed to lower mortgage interest rates and facilitated households’ access to credit. The process of liberalisation and further competition has also induced the creation of new mortgage instruments such as 100 percent (or even higher) mortgage products, interest-only mortgages and mortgages with longer repayment periods. This has resulted in a rapid expansion of credit. These experiences suggest that banking regulations should be used more forcefully to dampen bubbles. In particular, regulations should address banking practices that contribute to credit-driven bubbles and perhaps should allow bank supervisors to play a counter-cyclical role.
- There is little political incentive for national governments to lean against the wind of housing bubbles within the euro area system. There should be, since housing markets are so large and housing busts are always very disruptive. A country with a housing boom easily meets SGP rules on fiscal targets since booms boost government revenues. As recommended in the recent European Commission report on the lessons from the first ten years of the euro, more effective surveillance of macroeconomic developments is needed at the euro area level. This surveillance should not be concerned by budgetary developments alone but recognise that housing market bubbles and their consequences can severely hamper the smooth functioning of the Economic and Monetary Union. For this reason, they are a matter of common concern.
Ahearne, Alan, John Ammer, Brian Doyle, Linda Kole, and Robert Martin, 2005, “Monetary Policy and House Prices: A Cross-Country Study”, International Finance Discussion Papers 841. Washington: Board of Governors of the Federal Reserve System (September).
Ahearne, Alan, Juan Delgado and Jakob von Weizsacker, 2008, “A Tail of Two Countries,” Bruegel Policy Brief 2008/04.
European Commission, 2008, [email protected]: successes and challenges after 10 years of Economic and Monetary Union’, DG ECFIN, May.
Greenspan, Alan, speech to Committee on Banking and Financial Services, U.S. House of Representatives, July 22, 1999.
Kirsanova, Tatiana, Davidand Simon Wren-Lewis, 2006. "Fiscal Policy and Macroeconomic Stability Within a Currency Union," CEPR Discussion Paper 5584.
Miller, Marcus & Sutherland, Alan, 1991. "The "Walters Critique" of the EMS--A Case of Inconsistent Expectations?," The Manchester School of Economic & Social Studies, Blackwell Publishing, vol. 59(0), pages 23-37.
Frederic S. Mishkin, 2008, How Should We Respond to Asset Price Bubbles? Speech at the Wharton Financial Institutions Center and Oliver Wyman Institute's Annual Financial Risk Roundtable, Philadelphia, Pennsylvania, May 15.
Mundell, Robert A., 1961, “A theory of optimum currency areas”, American Economic Review 51, 657–664.
Van den Noord, P. (2005), “Tax Incentives and House Price Volatility in the Euro Area: Theory and Evidence”, Economie Internationale, No. 101. Centre d’études prospectives et d’informations internationals, Paris.