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Home Price Expectations and Residential Investment

I have often wondered whether the very low level of Private Residential Investment (also known as building houses) in the USA is due to unusually low expectations of long term increases in home prices. Here, I add that I would guess that the change was and end of the belief that the relative prices of houses has a strong upward trend (so houses are good investments) which belief is not supported by Robert Shiller’s data in Irrational Exuberance.

Of course I knew that, to find out, I should google something like ( Shiller house price expectations ). I forget what I told google but google sent me to this pdf.

Which you must read, but from which I will steal data on expectated house price increases over the next 10 years and this graph

shiller

yes indeed, expected appreciation of house prices has dropped dramatically as one would expect given the bursting of the bubble. The question is does this explain the low level of residential investment ?

hinv

Note that Shiller thinks the relevant variable is the expected growth of home prices minus the mortgage interest rate. Unfortunately even he only has 10 observations of the expected growth of home prices over 10 years. It is easy to fit the ratio of private residential investment to GDP with this variable, but this may just be because it is easy to fit 10 observations.

shiller2

It is mildly interesting that the difference alone seems to explain the huge change in residential investment without any need to appeal to financial frictions.

The more interesting question would be whether the relationship between the variables in recent years is the same as it was before the great recession. Alternatively, it is possible that some factor other than low home price increases is needed to explain low US residential investment. The natural candidate would be unusually tight lending standards as an over-reaction to the disasters caused by the extraordinarly loose lending standards of the early 00s.

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The German euro is undervalued

I keep telling people that the German euro is undervalued, but some folks seem not to believe me. (See the comments section from this post last year for an example.) But this is a really big deal. The dominant narrative about the eurozone crisis is that fiscally irresponsible countries like Greece were bringing the once-proud currency to its knees, and weakening the European project to boot. Meanwhile, the virtuous Germans keep on cranking out trade surpluses and have to bail out Greece, Ireland, Portugal, and Spain. And it’s pretty clear that the Germans believe this version of events.

Never mind that Spain and Ireland, for two, had budget surpluses prior to the crisis, or that Spain’s economy is five times as large as Greece’s. What’s going on in Greece is supposedly the true explanation for the eurozone’s problems.

Let me challenge that narrative that with a simple thought experiment. Instead of one euro, let us reason as if each of the 18 eurozone members had its “own” “euro.” Let’s begin by thinking about what creates the value of the current 18-country euro. We might include interest rates, inflation rates, growth rates, and trade balance, among other things, and of course expectations for all these variables. What we need to remember is that the value of today’s euro represents the averaged effect of all these variables in all 18 countries, rather than reflecting the economic conditions of any one of them.

So the euro is currently worth about $1.25. It used to be higher; what is dragging it down? The simple answer is that conditions in Greece, Spain, Ireland, Portugal, and at time Italy have pulled its value down. As has often been noted, if Greece pulled out of the euro it would then devalue the drachma, becoming internationally competitive again without the need for the brutal austerity that has pushed its unemployment rate over 25%. The same is true for the other peripheral countries. By looking at what would happen to the drachma/punt/peseta/escudo, we can see that, for these countries, the euro is overvalued. Another way to say it is that the “Greek euro,” for example is overvalued.

So why isn’t the value of the euro lower than $1.25? The answer, of course, is that Germany, the Netherlands, Austria, Luxembourg, and so forth, are performing well and pushing the value of the euro upwards. These countries, by contrast, would see their currency values rise if the euro were suddenly abolished. For Germany, for instance, the euro is undervalued; an equivalent DM would rise in value.

U.S. officials constantly rail about the undervalued Chinese yuan and the huge bilateral trade deficit it creates for this country. But officials could (and to some extent do) say the same thing about Germany, which now has a larger trade surplus than the vastly larger Chinese economy. In fact, last year Morgan Stanley estimated that a stand-alone German euro would be worth $1.53, compared to the actual euro exchange rate then of $1.33.

With an undervalued currency, Germany gets a much larger trade surplus than it would have had otherwise, magnifying trade deficits in the United States and elsewhere. At the same time, it gets to pretend that this surplus is simply due to German thrift and virtue, rather than currency misalignment. It then points to its virtue as justification for doing nothing to increase domestic consumption, wages, or inflation, and for demanding austerity from the countries to which Paul Krugman rightly says Germany is exporting deflation.

Let me leave you with Krugman’s chart. You can see at a glance that Germany has throttled nominal wage growth and has inflation far below the European Central Bank’s announced target of just under 2%. When you combine its low inflation with an undervalued exchange rate (remember, low inflation should tend to raise the currency’s value), you come to realize that Germany is a huge part of the world economy’s problems today.

 

Credit OECD and IMF

Source: Paul Krugman

Cross-posted from Middle Class Political Economist.

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