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Ott, Hervé (2007): Three Empirical Essays on House Prices in the Euro Area. Dissertation, LMU München: Faculty of Economics
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Abstract

The real euro area house price has increased steadily since 1997 reaching more than 6.5% in 2004 and 2005. The rise on its own is not as striking as the long lasting effect of the phenomenon. Indeed, it is the longest lasting house price increase ever experience in the euro area since data are available. Due to a lack of data, I use panel econometrics. The estimated coefficients are then used to generate euro area fitted values in all three papers. In my first paper, I investigate the question whether we can explain past house price movements by the arbitrage theory. Since arbitrage is a static phenomenon, I use within FE and RE estimators. The pattern of the residuals proves that arbitrage is not the core mechanism in house price determination. This may be due to large transaction costs, but also housing is un-tradable by nature, and finally government regulations. Alternative explanations are, friendly tax schemes to promote home ownership against alternative assets, government regulations like tenants rights, and finally massive public investment to build social houses for small income households. Instead, in my second paper, I suggest to analyze directly the interaction of supply and demand together with the mortgage market. Due to endogeneity, Anderson & Hsiao (1981) and the GMM Arellano-Bond (1991) dynamic panel estimator (AB) are used. However, in macro-panel data, the time dimension is much larger than the cross-sectional dimension. A trade-off arises between efficiency and consistency. Thus, the results are checked by means of LSDV (Least Square Dummy Variables) estimates, which are indeed close to the AB estimates. In the third paper, a general equilibrium model underpins the choice of macro-variables. To disentangle long-term from short-term dynamics, the PMG (Pooled Mean Group) estimator developed by Pesaran, Shin & Smith (1997) is used. The PMG assumes homogeneity of long-run coefficients (or a sub-set) but without making implausible assumption of common short-term coefficients. In the short-term coefficients are allowed to vary across countries. Indeed, mortgage and house market in the euro area are characterized to be strongly heterogeneous. The conclusions on the short-term dynamics of the house prices are alike between the second and the third paper. As regards the factors: disposable income per capita and the autoregressive term mostly drive the house price dynamics. Moreover, the demographic variables and rents do not account in the short term house price dynamics. The conclusion on the long-term house price are mainly explained in the third paper. The empirical results of the Panel ECM suggest a strong long-term empirical relationship between house price and disposable income, interest rate, stock of dwelling, population, but also mortgage loan. However, long-term house price equilibrium is mainly driven by disposable incomes and interest rates. How can we explain the long lasting house price increase in the euro area? First, in the wake of the monetary union process, household’s in the euro area experienced a positive shift in their borrowing capacity which had a positive impact on house price dynamics. Second, the euro area business cycle since 1999 has been stabilized by means of an optimal leaning against the wind policy which has no pedigree in the euro area. The slowdown of the economy since 2001 has been offset by an accommodative policy. Monetary policy stance indicators like interest rate and mortgage loan development prove a leaning against the wind policy which sustained strong housing demand. Excess demand factor indicates that sticky supply did not react quickly enough, the overshooting of demand kept soaring house prices. Current house price cycle is above 2% since 1998, i.e. already 8 years (10 years with our adjustment process), the longest lasting cycle ever experienced. Thus, two effects explain this fact. The low interest rate in level due to the gained credibility and variation in interest rate (opticmal monetary policy). In contrast, the previous cycle duration was much shorter, i.e. from the mid-80s to the mid-90s. As inflation was already rising in the end of the 80s, the Bundesbank raised its discount rate in 1988, and kept tightening it until 1992 due to the German monetary reunification. The one to one exchange with the East-mark obliged the Bundesbank to lead an even harsher policy. The other member countries of the ERM (European Ex-change Rate Mechanism) had to follow at odds with an optimal monetary policy. Consequently, the “euro area” interest rates increased dramatically. Beyond the cyclical component, the overall interest rate level was excessively high. The financial liberalization in the mid-80s caused sharp real estate increases. Thereafter, high interest rates coupled with a weak business cycle dampened relatively quickly soaring house prices. Currently, the ECB reputation allowed a structural real and nominal real interest rate fall, as well as an optimal monetary policy in view of the business cycle fluctuations. This explains why current house price cycle already lasts twice as long as the previous one. As regards the mortgage market (second paper), collateral (house price) is the only core factor. Consequently, house market and mortgage market strongly interact via the collateral. Banks relax their lending standards by favourable house price prospects due to asymmetric information. Households can capture more mortgage loans which fuels demand. Higher house price impinges positively on household’s wealth. This self-perpetuating process is then reversed by a trigger event like monetary policy tightening. An interest rate increase of 1% causes a 1% house price inflation drop and a 0.4% decline in mortgage loan growth rate in the long term, according to the estimates. The interest rate shock has only a temporary effect on the mortgage market on its own but the collateral (house price) drop leads to a long lasting fall in mortgage loan volume. To conclude, interest rate increase impinges negatively on real house price growth, proving that demand outweighs supply. As a result, monetary can influence house price growth. The estimates of the euro area house price equilibrium (third paper) prove three positive misalignments with respect to actual house prices. The first started during the second oil price shock until the mid 80’s. The second began in the late 80’s and ended in the mid90’s. Finally, current house prices has overshot equilibrium price since 2001 and has not shown mean reversion yet. This history is in line with the literature on housing. However, the gap between house price equilibrium and current price cannot be assimilated to a bubble as defined by Stiglitz (1990). The misalignment of current prices to long-term equilibrium price characterizes a natural feature of the functioning of the house market. Supposing the tide starts to turn in 2006, current house prices would smoothly catch up equilibrium price in 5 to 6 years according to the Panel ECM. In the simulation of current house prices adjustment to equilibrium level, I suppose that all explanatory variables equal simultaneously their steady value in 2006 and onwards. The adjustment depicts a 4% growth rate in 2006 and thereafter 2% and then a tiny negative rate of approximately 2 years until 0% (in real terms). This is a smooth and soft landing in opposite to the “biggest bubble in history” documented by the Economist for instance. This empirical study might prove that no recession will occur and even less a deflation. First, most of the huge house price increase in the euro area is explained by the fundamentals and second, the bank risk exposure is relatively moderate, they have mostly already implemented Basel II, which will be officially implemented in 2008.