House prices and the world economy Homing in on the risks
Jun 3rd 2004 From The Economist print edition
Inflated house prices pose an even bigger risk to the world economy than oil
OVER the past 12 months the world economy has grown at an annual rate more than 5%, possibly its fastest pace for two decades. How long can the party last? Most economists have identified three potential threats to this healthy rate of growth: higher oil prices, higher American interest rates and a sharp slowdown in China's economy. All three certainly need watching. Yet there is another risk that is just as great?the overvalued prices of houses in many countries. A slide in house prices, either by itself or combined with any of the other threats, could cause serious economic damage.
Economists generally devote much less attention to global house prices than to share prices. That is a pity, because studies have shown that swings in real house prices can have much bigger effects on economies than swings in share prices. Households in rich countries have, on average, twice as much of their wealth tied up in housing as in equities. Most people also find it much easier to borrow against their home than against shares. Over the past few years this has allowed consumers from America to Australia to turn capital gains on their homes into cash, helping to prop up spending.
In many countries real house prices, after adjusting for inflation, have been rising at their fastest pace ever. Property markets look frothy not just in America, Britain and Australia, but in China, South Africa and Dubai as well. The housing-price bubble has been partly fuelled by easy money: the average short-term interest rate in the G7 economies is at its lowest in recorded history. But not for much longer: America's Federal Reserve is expected to start raising rates this month.
Our calculations suggest that in many countries, including America, Britain, Australia and Spain, average house prices stand at record levels in relation to wages and rents (see article). In other words, they look more overvalued than at previous peaks from which prices fell sharply in real terms. Today inflation is much lower than in earlier downturns, so more of the adjustment may need to come from a fall in nominal prices. If so, there is a risk that for the first time ever, house prices could simultaneously fall in several countries.
Suppose house prices fell by 10% over a period of four years, implying a real decline of 20%. According to calculations by the OECD, that might reduce consumer spending (which accounts for two-thirds of GDP) by more than 2% in Britain and 1% in America. To return to their long-term average, house prices need to fall by more than this. If so, this is likely to do more harm than the recent surge in oil prices.
This is not because oil no longer matters. It does. And after last weekend's attack in Saudi Arabia, oil prices rose to $42 a barrel, 50% above their average level in 2002-03. This is bad, but not nearly as bad as in previous oil shocks, when prices roughly tripled. If oil prices remain at around their current level, past experience suggests that this will knock about 0.4% off GDP in the developed world. That is not insignificant, but it suggests that falling house prices have the potential to make a bigger dent in some countries' growth. A sharp spike in oil prices because of a disruption to Saudi supplies would, admittedly, be very bad news, but worst of all would be if oil prices rise further at the same time as house prices fall.
Whether growth is halted by rising oil prices or falling house prices, policymakers can cushion the blow by cutting interest rates or taxes. The snag is that America already has a huge budget deficit and rock-bottom interest rates. Britain and Australia would have more room to manoeuvre. Less wonder down under
Most analysts maintain that house prices will not fall. A fall in house prices is unlikely, they argue, unless there is a sharp rise in interest rates or a jump in unemployment; prices are more likely to flatten off. It is true that interest rates are unlikely to return to the double-digit levels that triggered previous housing downturns. However, recent experience in Australia tentatively suggests that house prices can drop without a big rise in interest rates or unemployment. In the first quarter of this year both Sydney and Melbourne saw falls in house prices despite low unemployment and a mere half-point rise in Australia's interest rates last year. The argument that prices would happily flatten off always seemed implausible. For one thing, surging house values have priced out first-time buyers; it will require a sizeable drop in real house prices to lure them back. Second, while it is true that most homeowners stay put rather than sell in a weak market, the growing ranks of buy-to-let investors will be more likely to sell if prices stop rising and their rents do not cover their costs.
Housing optimists dismiss these fears by pointing out that doomsters such as The Economist began wringing their hands about a property bubble a year ago, and yet prices have continued to climb. But this has made the housing market not safer, but more vulnerable. The first law of bubbles is that they inflate for a lot longer than anybody expects. The second law is that they eventually burst.