Both Morgan Stanley (at least Eric Chaney) and JP Morgan (in their latest global outlook) now recognize that Europe has emerged as an important engine of global demand growth. Indeed, the 2005 surge in European demand seems to be reasonably well correlated with the surge in US pessimism about Europe. Europe, the story went, couldn’t generate the political consensus to make the necessary labor and product market reforms, so it wouldn’t be able to support global demand.
What did that story leave out? Low European interest rates and the housing market. I have often argued that Europe (France included) looks a lot more like the US than most folks realize. Job growth hasn’t been all that impressive on either side of the Atlantic. Indeed, by some measures, it has been better in old Europe. Real compensation growth hasn’t been all that impressive on either side of the Atlantic.
And in both regions, frothy housing prices have supported consumption growth.
Today, I am turning the blog over to Charles Gottlieb of the European Capital Market Institute and the Center for European Policy Studies. He is writing in his own personal capacity – the usual disclaimers apply with force.His topic: the European housing boom (or bubble) – a topic he also wrote about in the Spring for the ECMI. There is a lot of interesting material -- and a few nice graphs -- below the fold. Enjoy.
The US housing bubble is about to burst, which is likely to curb US growth. For the first time since 1994, the median selling price for US homes is not increasing (see The Economist August 24, 2006).
It seems though (see Setser,) that the EU has taken over from the US as the key driver of global demand growth. Interestingly one of the determinants of current EU dynamism —the evolution of European housing prices —should be familiar to Americans. Daniel Gros rightly points out that EU House price cycle lags the US by one or two years (see Daniel Gros paper, February 2006). The EU therefore may support global growth over the next two years, before it gets into a similar situation to that of the US.
In fact, European house prices seem to be far removed from their fundamental value. Indeed housing prices are highly persistent (upward and stable trend) and revert to mean less strongly than other asset markets (due to inelastic supply), yet, according to OECD data, since 1996 some housing markets have taken off at a rapid path and are currently reaching unprecedented levels. The heterogeneity of patterns in housing prices evolution is striking, and four countries have taken more than expansionary paths…
According to the data, the French housing market looks a lot like the American housing market. In both France and the US, home prices have undergone similar evolution and are currently both well above long-term trends. Spain, UK and Ireland have experienced an even more robust increase in housing prices. Since 1997 the Spanish and UK house prices indices have more than doubled, and Irish prices have more than tripled. Spanish and British housing prices are about twice their 20-year average.
Chart1: The EU housing market on the take off
Source : OECD
In the housing market, demand – not supply – determines price dynamics, at least in the short-run. The supply of housing is fixed in the short-run, only adjusting over the medium to long run.
On the demand side, housing is closely tied to the evolution of household income, financial markets and population growth. Countries that greatly benefited from the European integration (Spain and Ireland) and whose household income grew at a rapid pace, have experienced surging house prices (see Chart1).
Secondly, credit markets in Europe are increasingly competitive, and credit standards have been continuously eased over the past years (see ECB report). Declining mortgage rates have supported housing demand over the recent period of house price dynamism. Finally, recent lenient lending policies in France and Spain rendered mortgage funding attractive further fuelling housing demand. Despite high house ownership ratios, households still have strong financial incentives to further invest in housing, particularly after an equity bust (look at house price growth after 2000…).
Thirdly, migration flows contribute greatly to housing demand. In countries such as Spain, France, United Kingdom and Ireland, immigration has rejuvenated the domestic age structure. This implies a higher mortgage demand, and a rational decision (according to the life-cycle hypothesis) to take up more debt.
Supply-side limits have further supported the price surges. Particularly in Europe buildings restrictions are particularly strong (The Economist). The Impact of zoning on housing affordability further inhibits supply-side adjustments, and drives prices up.
Yet supply constraints haven’t been the determining factor in many markets. Residential investment is probably the best indicator to foresee supply-side adjustments on the housing markets. The surge in Spanish and Irish housing prices does not reflect a lack of new supply – far from it. Residential investment has increased dramatically as a share of Spanish and Irish GDP.
Chart2: Housing investment in Europe
In France and the United Kingdom, by contrast, housing supply seems to be stuck. Such rigidities are probably due to labour market inflexibility (in France, which may need more Polish brick-layers) or to the above mentioned zoning rules, which hinders the ability of the housing sector to satisfy expanding demand.
Germany may be experiencing a hang-over from a post reunification surge in residential investment – hardly a comforting signal. However, it now seems that the German market is starting to wake up.
The house-ownership ratio can be considered as a good proxy for the sustainability of house price evolution and the growth potential of the market. Given that every household strives for a dwelling, low house-ownership ratio would justify a great potential demand for housing and thus strong mortgage-funded housing demand.
Share of ownership dwellings
The above evidence supports the house price surge in France, and to a slighter extent for the UK. On the contrary, the strong share of ownership dwellings in Spain and Ireland emphasizes the irrational exuberance in those housing markets.
The above exposition of the demand and supply factors crystallizes a so-called centre-periphery dilemma in Europe. On the one hand, the converging periphery, namely Spain and Ireland, exhibit booming housing markets in which supply is adjusting. And on the other hand, in Europe’s core, France, the UK, and Italy to a certain extent, a demand-led boom hasn’t triggered supply adjustments. In France, UK and to a lesser extent Italy (again) strive to offer a dwelling for each household, but face bottlenecks on the supply-side and most probably very stark regional disparities.
Spain and Ireland have the highest share of ownership dwellings ratio and strongest supply-side adjustments. Their housing boom can not be explained by a housing shortage. But it could potentially be due to some sort of Balassa-Samuelson effect on the housing markets. Houses are non-tradables; their prices increase more rapidly than those of tradable products. Thus, the current explosion of house prices in Spain could have a “Balassa-Samuelson component” —something that I hope to examine at a later date.
How does this relate to recent European demand growth? Simple. Surges in housing prices foster consumer optimism, and stimulate consumption. And rising housing prices rising residential investment and buoyant consumption demand push up overall investment by firms. High domestic demand in turn triggers an import boom. As chart 3 underlines, the correlation between house prices and domestic demand is strong in most European countries (high R2). European households are spending "à l'américaine" – spending not just some of their current capital gains, but some of their expected future gains (anticipated wealth effect).
Chart 3: Housing prices and Domestic demand
Simultaneously, Spain has experienced a worrying deterioration of its current account since 2003. Indeed, (see FT) Spain’s current account deficit reached a whopping 7.6% of GDP (Q1 2006), topping that of the US. While absolute values at stake are not the same, both the US and the Spanish imbalances stem from similar economic distortions/misallocations are at their root, and they both need to be addressed. Yet Spain’s situation is rather worrying as export dynamism (as a share of GDP) has dampened out and imports have surged. At least the US’ exports share in GDP reignited with growth in 2004.
The UK’s current account is also negative, but export dynamism remains contrarily to Spain where the share of exports in GDP has continuously plunged since 2000. In France, the situation is less cumbersome too. The current account deterioration is considerably weaker, as exports are growing at a reasonable pace. Nevertheless, the current account turned negative for the first time since 1991, suggesting that the house price surge and the abundance of consumer-friendly mortgage programmes has fuelled internal demand.
Overall housing prices have arguably strongly revived the European consumer’s wealth perception, and strengthened their confidence. Internal demand revamped European growth which was revised upwards by the bureaucracy in Brussels: Euro Area growth is to be the best since 2000, achieving 2.5% yoy.
The bottom line: Europe has taken the housing relay baton from the US, but in this race, the baton is perhaps better described as a bubble.