What should Central Banks do aboutReal Estate Prices?

Franklin Allen

and

Elena Carletti

Asset Prices, Credit and Macroeconomic Policies

March 25-26, 2011

Idep-Greqam, Marseille, France

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Real Estate Markets and Financial Stability

• Reinhart and Rogoff (2009) document that many financial crises are the result of a sharp drop in property prices

• In the current crisis Ireland, Spain and some regions of the U.S. had sharp run ups and then collapses in property prices that have had a severe effect on these countries’ banking systems and economies

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Figure 1Nominal housing Prices in Ireland, Spain and the U.S.

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1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 20090.00

50.00

100.00

150.00

200.00

250.00

300.00

350.00

Some other countries

FranceGermanyGreeceItalyPortugalSpainUKUSA

Hous

e Pr

ice In

dex

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What are the causes of these real estate bubbles?

• It is widely argued there are two important ones

1. Loose monetary policy – low interest rates

2. Global imbalances – easy availability of credit

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Total Reserves in Billions of US $ 1996-2009

1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 20090

1000

2000

3000

4000

5000

6000

7000

8000

9000

10000

Total

Asia

Oil producers

Latin America-oil producing

Central & Eastern Europe

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Residential Mortgages

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Figure 3Current Account Deficits as % of GDP

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009-12.00%

-10.00%

-8.00%

-6.00%

-4.00%

-2.00%

0.00%

2.00%

SpainIrelandUnited States

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• The debate needs to go beyond Taylor’s (2008) assertion that low interest rates cause property bubbles if preventive policies are to be designed

• We need to model how property bubbles arise

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Theories of bubbles

1. Infinite horizon (Tirole 1985, Caballero and Krishnamurthy 2006, Kocherlakota (2010), and Farhi and Tirole 2010)

2. Asymmetric information (Allen, Morris and Postlewaite 1993, Conlon 2004, and Dobles-Madrid 2010)

3. Agency problems (Allen and Gorton 1993, Allen and Gale 2000, 2003, Barlevy 2009)

4. Behavioral (De Long et al. 1990, Herring and Wachter 1999, Abreu and Brunnermeier 2003, and Scheinkman and Xiong 2003)

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What should a theory of bubbles explain?

• In “normal times” there are not property bubbles (e.g. Germany for last 20 years)

• In “bubble times” there is a sharp increase in leverage and run up in property prices, then a collapse

• This distinction suggests there is a threshold where speculators enter and start a bubble

• We use an agency approach to model this

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Normal timesWillingness to pay for housing services

Supply of housing services

S1’Pr. π

S1’’Pr. 1- π

P1’ = H(S1’)

P1’’ = H(S1’’)

N 1 10 0

C

P (1 )PP H

1

Risk neutral consumers determine prices

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Bubble times

• Risk neutral speculators use their own wealth W and loan with loan-to-value ratio λ to buy x units at price Pt

so • We focus on the case where there is no default when

the price is high but there is when it is low so speculators enter if

t tP x W P x

N0 S 1 0 0 SH (1 ) P (1 r ) P x W(1 ).

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• In this case speculators enter and the price is bid up so this condition is satisfied with equality and there is a bubble if

• In the special case ρS = ρC = r0 = r we can simplify the entry condition by substituting the borrowing constraint

B N0 S 1 S0 0

0

H (1 ) P W(1 ) /( x)P P

(1 r )

N10 0

P 'H P

1 (1 ) 1 r

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• In the special case λ = 1, W = 0 and ρS = ρC = r0 = r

• In this case bubbles always occur

B N1 1 10 0 0 0

P P (1 )PP H P H

(1 r) 1 r

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Policy considerations

• Objective of policy should be to prevent bubbles occurring in the first place and restoring normal times if speculators have entered

• Speculators’ entry condition more likely to be satisfied with low interest rates and easily available credit

• Monetary policy and credit availability can have a role to play in controlling bubbles in small homogeneous countries like Sweden but in large heterogeneous economies like China, the Eurozone and the U.S. macro-prudential policies need to be relied upon

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Macro-Prudential policies

Macro-prudential policies are designed to counter a whole range of systemic risks

• Countercyclical regulatory policy

• Control of contagion risk

• Discretionary policies

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Macro-Prudential policies for real estate

• Should eliminate speculators’ incentive to enter the real estate market and create a bubble

1. Mandatory reductions in loan-to-value ratios

2. Increases in annual real estate taxes

3. Increases in taxes on real estate transfers

4. Direct restrictions on real estate lending

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Implementation of macro-prudential

• Borio and Lowe (2002) and other papers from the BIS suggest difficult but not impossible to identify property bubbles

• Christensson et al. (2010) look at Financial Stability Reports of the Netherlands, Norway, Spain, Sweden, and the U.K. over the period preceding and during the crisis

• FSRs were successful in identifying risks and unsustainable trends but many were regarded as low probability events not worthy of action

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Chinese experience

• The Chinese have tried a number of these measures

– Lower loan-to-value ratios for second, third, and more houses

– Taxes on resales of certain types of housing– Restrictions on foreigners buying– Loan restrictions on commercial property

• They have not worked very well in the major cities

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50100150200250300350400

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i ncome

housi ng pri ce, RMB/ sqm

Bei j i ng Housi ng Pri ce vs Di sposabl e Annual IncomeNormal i zed, base year=2002adj usted by CPI, 2002=100

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50100150200250300350

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i ncome

housi ng pri ce, RMB/ sqm

Shanghai Housi ng Pri ce vs Di sposabl e Annual Incomeadj usted by CPI, 2002=100

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50100150200250300350400

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i ncome

housi ng pri ce, RMB/ sqm

Shenzhen Housi ng Pri ce vs Di sposabl e Annual IncomeNormal i zed, base year=2002adj usted by CPI, 2002=100

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Concluding remarks

• Objective of policy should be to prevent the property market becoming speculative

• Monetary policy and credit availability can have an important role in some economies like Sweden

• It is not clear that macro-prudential policies will prevent or eliminate bubbles but they may help

• Inefficiency of property markets is also important, i.e. positive serial correlation of returns (e.g. Englund, Quigley and Redfearn 1998), and needs to be incorporated in the analysis