When is a housing market overheated enough to threaten stability?

Sep 2012 | 623

Authors: John Muellbauer

In many countries, house prices are subject to boom/bust cycles and in some these are linked to severe economic and financial instability.  Overheating can have both a price and a quantity dimension, but it is likely that they are linked by common drivers.  However, much depends on the land-use planning regime which profoundly affects the supply response.  It is helpful to make the distinction between overshooting of house prices due to extrapolative expectations and 'frenzy', given fundamentals, and shifts in possibly fragile fundamentals.  The contribution of careful econometric modelling to estimating the effects of the former is demonstrated: central banks or other policy makers should institute quarterly surveys of house price expectations of potential housing market participants to help assess the first type of overshooting.  Assessing the fragility or otherwise of the economic fundamentals is more complex.  Credit supply conditions in the mortgage market are the 'elephant in the room'.  Without taking a credit conditions measure into account, one simply cannot understand the behaviour of house prices, housing debt and consumption in countries such as Australia, the UK, the US, South Africa or France or understand vulnerability of some economies to high levels of household debt.  Other financial and economic indicators of vulnerability are discussed, including high bank leverage ratios, high ratios of loans to deposits, debt, deficit and current account of ratios.  Models of early warning of financial and economic crises estimated on large country panels need to be quite complex, for example, including some important interaction effects since shock transmission is very institution dependent.

JEL Codes: R21, R31, G18, G21, E21, E51, C51, C52

Keywords: Financial crisis, Financial accelerator, House price determination, Credit boom, Credit standards, Subprime mortgages, User cost, Risk premia, Construction boom

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