Discussion by Peter Englund Sveriges Riksbank, 12 November 2010 International developments in housing markets Philip Davis

The issue Should central banks care about (observe, react to) house prices? ”Key lesson…. avoid housing boom bust cycles” Housing price changes predict financial crises, but do they cause them? Panel logit model nicely identifies housing as one of four key indicators of a crisis. Based on 12 crises (systemic and non-systemic) in a 17-year panel of 14 OECD countries. Housing market may have helped predict but did not play a major role in the Nordic crisis of the 90s (commercial real estate did). The current crisis was triggered by specific features of the US housing finance system, but US house prices did not grow extremely fast relative to the rest of the world.

What would the causal mechanism be? Direct effect on banking stability depends on nature of housing finance Loans with no versus full recourse to borrower assets. Floating versus fixed interest rates Indirect effects via aggregate demand (consumption and investment) Marginal propensity to consume out of housing wealth versus financial wealth. MPC of financial wealth ≥ real interest rate MPC of housing wealth ≈ 0? (Housing wealth is not net wealth?) Econometric evidence MPC of financial wealth 1-5% (Poterba, JEP 2000) MPC of housing wealth In some studies higher than MPC of financial wealth (US data; Case, Quigley and Shiller, 2005) In other studies somewhat smaller but still positive (European panel data; Slacalek, 2009). This suggests that housing capital gains release credit constraints. Financial accelerator. Collateral cycles.

Basics about house prices Real house prices trend upwards Urbanization Land scarcity Land prices increasing fraction of house prices: from 32% in 1984 to 50% in 2004 (Davis and Palumbo, JUE 2008). Housing prices not anchored by production costs. Trend reverting (sluggish quantity adjustment). Correlated across countrie. Think in terms of two markets The market for housing services sets the price (implicit rent = user cost) as a function of fundamentals (income, demographics..) The market for housing assets sets the asset price as a PDV of future rents. Long-run asset price tied down by production cost (and land prices). Asset price effects feed back into user cost via capital gains expectations (Poterba, 1984). Monetary policy and credit market institutions (like LTV limits) primarily work via the asset market (the discount rate).

Real price development per year (BIS data) Since peak New Zealand + 4.4%( )+ 12.3% Spain + 2.6% ( )+ 11.4% Denmark + 3.0% ( )+ 9.1 % UK +2.2% ( )+8.8% Canada +1.1% ( )+8.5% Australia + 3.4% ( )+ 8.5% USA + 0.9% ( )+ 8.5% Belgium + 6.2% ( )+ 8.4% Ireland + 6.0% ( )+ 7.7% Sweden + 2.5% ( )+ 7.2 % Italy + 0.9% ( )+ 6.3% Finland - 0.7% ( )+ 5.8% Norway + 1.7% ( )+ 5.5 % Netherlands + 4.6% ( )+ 2.5% Switzerland - 1.2% ( )+ 2.2 % Japan - 3.2% ( )- 4.2%

House prices and downpayment constraints PDV of housing services (R), growing exponentially at rate g and disconted at rate ρ PDV of costs of buying a house at price P, putting a fraction θ down and borrowing the remainder at the after-tax rate r(1-t) and paying a fraction m of house value for maintenance Equating costs and benefits yields

The ratio of Rent to Price as a function of the cost of equity and the downpayment rate θ ρ Parameter values assumed: r = 0.06, g = 0.03, m = 0.035, and t = 0.30.

Impact of changing LTV For unconstrained households cost of equity ≈ cost of borrowing. R/P independent of LTV. In general, the cost of equity ρ increases with θ, thereby amplifying the impact of a change in LTV. For severely constrained households available equity puts a cap on demand. LTV also impacts on tenure choice, assuming landlords’ capital costs to be unaffected. Duca, Muellbauer and Murphy (2010) estimate US house prices as a function of fundamentals and LTV for first-time homebuyers and find economically and statistically significant effects.

Conclusions There may be good reasons for central banks to want to affect housing prices to avoid collateral cycles. For given fundamentals, house prices are determined by Financial market institutions and regulations Real after-tax long-term interest rates. Cost of equity. Can monetary policy control the real interest rate and the cost of equity?