House prices, financial cycles and business cycles

Abstract

In Chapter 5 Byrialsen, Raza and Pierros discuss the issue of financial imbalances. It is often argued that house prices are an important driver of the financial cycles in most countries, since there exists a strong relationship between house prices, the business cycles and financial cycles. Focusing on the Danish data since 1950, changes in house prices and the business cycles seems to be leading the financial cycles. In this chapter, the authors use an empirical SFC-model for the Danish economy to investigate the different channels through which housing prices affect both the business cycles and the credit cycles, with specific focus on the period leading up to the latest crisis. They perform counterfactual analysis and attempt to understand the effects of a lower accepted debt-to-income ratio in the economy. While the effects in the short run seem as expected, the medium-run effects provide interesting insights. The empirical findings indicate that changes in the housing prices not only explain financial and business cycles but that the reduction of their impact on economic activity, via regulation of the housing market, renders the economy more prone to recover in the presence of a negative shock. Regulation can further stabilize the macrofinancial system by making households less risky in taking up more debt, or banks less willing to lend.