Real estate, growth’s parasite

The meager European economic growth – often described as anemic – stems from a savings glut. Economic stagnation becomes secular from the moment the money stops flowing, that is, once the investor keeps his precious cash in his bank account and that bank is no longer able to recycle it towards productive sectors of the economy. From this point of view, banks are the armed soldiers of growth and they are essential in channeling private savings toward that growth in the form of lending to private business. When you have a severe balance sheet financial crisis, credit stops flowing and economic growth drops abruptly. And, not only is it important that banks resume lending but it is also crucial that they lend to the right borrowers and for the right reasons!

Let us have no illusions though. Even excluding times of crisis, banks have hardly increased lending to businesses. The 1970s witnessed a major change in the original function of Western banks. They gradually raised their loans to real estate transactions to 60% of total lending at the expense of businesses and trade. Today, our banks can be compared to giant real estate investment funds that finance their transactions through deposits from savers. And the growth of the real estate market has thus become vital to a financial system that has not anyone to blame but itself. This aberrant growth in mortgage lending (in Europe and the US) evidently leads to housing bubbles. Financial instability, that permanent concern of all regulators and central banks, derives mainly from the phenomenal volume of real estate loans.

The corollary is that it is now relatively easy to predict a financial crisis by measuring the increase in mortgage lending. In addition, multiple studies and research have unequivocally shown that recessions caused by episodes of excessive real estate debt last longer and have less spectacular recoveries. The 2008 U.S. subprime crisis and the giant Spanish property bubble are supreme evidence. Ironically, governments did everything to promote bank mortgage lending.  Lax and generous mortgage lending practices created an incentive for citizens to further indebt themselves. Mortgage tax deductions for taxpayers also stimulate speculative real estate investment. It is the changes in banking regulations in the 1970s, especially 1988 (Basel I), which literally threw banks into a mortgage abyss. A significant easing of capital-ratio requirements for all bank real estate transactions made it less risky to make a mortgage loan than to lend to businesses.

Therefore, it was obvious that the Western banking system would channel the bulk of its loans to real estate, to the detriment of other sectors monopolizing more capital reserves and generating lower profits. Bank exposure to the real estate sector has reached potentially devastating levels, even among German and Swiss institutions, in countries where traditionally the number of homeowners is the lowest in the West. In the U.S., thanks to a gradual economic recovery the statistics show a spectacular recovery in mortgage lending (and thus in the U.S. housing market) at the expense of loans to small and medium-sized companies.

While large companies in both the U.S. and Europe traditionally finance themselves in the bond markets, small and medium-sized firms are extremely dependent on bank loans for working capital. This phenomenon has regrettable consequences for economic growth and productivity given that small and medium enterprises are traditionally the engines of progress and innovation within our integrated economies. In summary, mortgage lending and the clear preference given by our governments to this activity make real estate a…parasite, which even now is about to suffocate our recovering economic growth.