Property Bubbles and the Driving Forces in the PIGS Countries

Abstract

The PIGS countries stand in the spotlight of the current financial crisis in Europe. The boom and bust of the real estate sector was one of the major sources putting these countries into an economic downturn. This paper determines the extent to which these countries experienced property bubbles and sheds light on the role of monetary policy in the formation of bubbles. We draw from Stiglitz’s (1990) theory on asset bubbles and apply the direct capitalization approach through weighted average cost of capital (WACC) to identify real estate bubbles in the period from 1999 to 2012. In the next step we apply VAR and VECM models to investigate short- and long-run dynamics between the monetary policy of the ECB and property bubbles in the PIGS countries. Our findings indicate that Spain and Ireland experienced the largest positive bubble formation, followed by Portugal with a small bubble. In contrast to that, Greece experienced a strong negative bubble. While we find only a very weak short-run relationship between monetary policy and bubble formation in Portugal, we find both, evidence for a long- and short run relationship in the case of Ireland, Greece and Spain. The varying extent of the bubble formation and the differing impact of the monetary policy on the bubble across the PIGS countries can be mainly attributed to characteristics in the domestic financial-, fiscal- and macroprudential-system. This paper provides strong evidence that countries with very low interest rates and low to moderate tax rate as well as high loan-to-value ratios have the potential to experience large property bubbles. Central bank’s policies are crucial to trigger the boom and burst of property bubbles by manipulating the interest rate and availability of lending for house purchase. As this research only covers aggregate data for entire countries, diverging developments within each country are not captured. Future research could contribute to the literature by focusing on property market developments in specific cities or regions.