Home Prices and Global Imbalances: Which Drives Which?

Abstract

Many of the countries which experienced sharply rising home prices (often later described as bubbles) over the 2000s decade also ran substantial trade deficits. Some early research on the topic suggested that countries such as the US, Ireland, Spain and others with bubbles in their housing markets had received capital from nations with trade surpluses such as China and Germany. These trade surplus countries sent capital abroad due to low returns or poor financial development domestically. This capital was thought to lower borrowing costs and boost housing values. In this scenario, the current account deficits and high home prices in bubble countries were driven in substantial part by capital flows from abroad. In contrast, some theoretical and empirical work suggests that domestic factors-rising home prices-stimulate borrowing, which leads to current account deficits. In this more recent telling, it is domestic changes in bubble countries-the increase in home values-that drive trade imbalances, rather than the reverse. There has been little empirical work on the topic, and what has been done is often crude and ignores other empirical work. In this study, we investigate the interaction of both the current account and home prices for six nations, including both capital receiving, bubble countries such as Australia, Ireland, Spain, the UK and US as well as capital exporting states like Germany. Unlike some previous research, we control for the impact of each variable on the other and for interest rates and income. We find strong evidence that the current account exerts a strong effect on home values, even controlling for reverse causality and the effects of other variables. The impact of home prices on the current account, on the other hand, is typically smaller. We also find, in the case of Ireland, that the interactions between the current account and home prices are even stronger since Ireland joined the euro zone. These findings of a strong effect of the current account on home prices suggest macroprudential policies regarding leverage and credit may need to be even stricter than would be the case if housing bubbles were simply “home grown”. Moreover, in the case of smaller nations, judicious capital controls may be useful.