Bubbles in Real Estate?

A Longer-Term Comparative Analysis of Housing Prices in Europe and the U.S.

The main point of my latest paper on housing in the US and Europe is to document a remarkably close correlation between US and average euro area housing prices over the long run. This has not been widely noted beforehand because most observers have emphasized intra-euro area divergences (boom in Spain, slump in Germany). But it appears that the ongoing decline of prices in Germany has been more than compensated for by the boom in other parts of the euro area.

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The stylized facts can be summarized 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 co-movement 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. The euro area data become available only much later. Hence it is not possible to determine whether housing prices have already turned on this side of the Atlantic as well. One key question for the ECB is now whether the usual pattern of (continental) Europe following the US will re-assert itself.

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Given the sluggishness of housing prices, it seems likely that it will take some time before they actually decline on this side of the Atlantic as well. But it is also possible that the financial market turbulences caused by the US sub-prime lending sector will accelerate the ongoing slowdown of the housing sector in Europe.

My paper concentrates on the price/rent ratio as an indicator of overvaluation of housing since any change in the demand for housing (e.g. immigration) 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 house prices does not simply reflect a higher demand for housing.

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Should policy-makers be concerned about the behaviour of house prices? There is little evidence in the euro area of large-scale ‘sub-prime’ lending. But the evidence shown in Figure 7 suggests that house prices seem to have an important impact on domestic demand, with wide variations among individual countries.

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In France and Italy, where house prices have increased almost as much as in the US, there is no evidence of a housing overhang. A downturn in housing prices might depress consumption somewhat, but not construction investment. By contrast, in Spain and Ireland, construction investment has increased to levels (18-20% of GDP) not seen in any other OECD country except Japan. In these two countries, 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 has now for some time been below average. 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.

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9 Responses to "Bubbles in Real Estate?"

  1. Guest   October 16, 2007 at 4:01 pm

    Real fascinating paper. So should we expect a bust of some housing markets in Europe of the same magnitude as in the US? And which housing markets?

  2. eparisi   October 16, 2007 at 4:32 pm

    The property market synchronization even before the recent bout of globalization and financial innovation on both sides of the Atlantic is amazing.. could we speak of global property cycles? What shapes them?

  3. Anonymous   October 16, 2007 at 8:45 pm

    If regulatory policy is different in the US and in Europe and in Australia and NZ, what explain the sharp rise in home prices in a wide range of countries across the globe? Low real interest rates? And could then the bubble now burst in many countries if there is a sharp repricing of risk?

  4. Guest   October 16, 2007 at 8:50 pm

    Interesting piece and interesting correlation between Eurozone and US property prices. How does the ECB incorporate these property price movements in its reaction function?

    Is it really negative real rates that fed property bubbles in Europe? There is no trace of reckless lending practices in the Spanish property market, for example.

  5. Detlef Guertler   October 17, 2007 at 6:56 am

    Before starting to think about the strange fact that european housing prices correlate highly positive to US prices long before Euro and eurozone entered the game (figure 2 begins in 1971, when e.g. Spain was not only no part of the EU, but ruled by dictator Franco), I’d like to know some more about the data used here. What kind of price-rent-ratio is used? What kind of adjustments are made? In figure 2, I may guess that 1990 (or 2001?) = 100, in table 3 best guess is 1970 = 100. In figure 7, some titles for the axes might help.
    And how could Mr. Gros find out the amount of housing overhang for some of the most important countries in the world (tables 4 and 5)? And what do his numbers say? 30.2 % of all houses actually constructed in Spain are over-supply? At which prices? At which time?
    If numbers fit too brilliantly to the author’s words, it needn’t mean they are wrong. But it does mean they should be thoroughly checked.

  6. eparisi   October 17, 2007 at 8:51 am

    Mr.Guertler, for a detailed description of data and methodology please refer to the paper:
    http://shop.ceps.be/downfree.php?item_id=1545

  7. Detlef Guertler   October 17, 2007 at 10:52 am

    eparisi: Thx a lot, the paper convinced me. Of course you can always argue about the quality of long data series (37 years and still going strong), but the data used is sound, as are the assumptions the author made, e.g. for calculating the housing overhang.
    So all that’s left for me is one little question mark: I would not dare to equate the depreciation rate of German and Spanish houses. A typical German house may last 50 years – a typical Spanish house is rotten after 25.

  8. christian   October 17, 2007 at 10:58 am

    For more good research and analysis on housing markets in Europe:
    European Housing Markets Cooling Down: Which Economies are at Risk?
    (http://www.rgemonitor.com/10009?cluster_id=4759)

  9. Guest   October 19, 2007 at 7:15 pm

    What are the common factors that led to housing booms and bubbles in so many different countries: not just the US and Western Europe but also the Baltics, Central Europe, Turkey, the Middle East, Singapore, Australia, New Zealand, China and more?