When real estate threatens growth
It’s not a coincidence if real estate prices – relatively stable up until now – suffered unhealthy volatility at the dawn of the 1990s. This phenomenon was the direct consequence of integrating the banking and financial systems together because deregulation and innovations such as securitisation intensified the flow of cross-border and transcontinental capital, thus inducing unhealthy volatility in real estate. In reality, it’s the nature of this (real estate) market itself which is now undergoing a structural change in its interactions with the economy, resulting in an increase in real shocks proportional to the integration and to the sophistication of the financial system. It is therefore not by chance if our modern episodes of speculative booms are very often preceded (or at the very least accompanied by) periods of real estate euphoria, nor if, on the other hand, episodes of economic depression are very often triggered by the implosion of real estate bubbles.
In fact, the cause-effect relationship has been established between real estate prices and consumption, the latter increasing with property prices, and vice versa. The property market’s multiplier effect on activity and growth is intuitively understandable thanks to drivers of property owners’ sense of wealth. Studies conducted by the University of Virginia even indicate that every rise of 1% in property prices equals at least a 0.25% improvement in the economy of a country like the United States. In reality, the current structure of our highly integrated Western economies suggests an even greater impact of the property market on the rest of the economy. This has occurred through the intervention of a whole series of collateral effects which have meant that the fall in real estate prices are landing the economy with even more serious consequences than a debacle of the stock markets. This is why, after the subprime implosion, the US authorities so ardently threw themselves into the quasi-nationalisation of their real estate market by according unlimited support to Fannie Mae and Freddie Mac, two institutions which guaranteed only themselves with more than half of the country’s mortgages. By buying back toxic debts secured by property assets, the Federal Reserve was obviously trying to plug the haemorrhaging of its whole economy.
As a household is in a position to increase its loan when property appreciates, the financial establishment also has a tendency to intensify its credit when secured assets gain in value. Consequently, any ascent in the property market is amplified by a set of drivers (acting exactly like dominoes once they fall) which induce a virtuous (and then vicious) cycle of easing of loan criteria, increased consumption, and extra investments coming from companies who have to respond to improvements in growth. Harmful to all economic actors, the sudden rises in real estate prices are nearly always accompanied by drops in credit distributed by banks to companies that are penalised by higher interest rates, a recurrent theme during real estate gains.
We therefore often find ourselves in a disdainful scenario where a specific sector of the economy (property) is inflating a bubble under the weight of liquidities which are lavishly handed out, all the while productive sectors of the economy are desperately in search of capital. Studies conducted between 1988 and 2006 in the States have come to the delightful conclusion that the most dynamic regions of the US were also those where the property market had progressed the least! Companies finding themselves caught up in a flamboyant property market have been reduced to borrowing less – at higher rates – and have therefore invested considerably less than their counterparts located in zones where the property market was behaving in a more neutral fashion, and who therefore have been able to benefit from the robustness of the financial system in larger quantities and at better prices. As has been noted, public policies actively supporting the property market are always systematically implemented to the detriment of the rest of the production unit. In the long run, banks thus reduce their credit to businesses like a well-oiled machine in order to better focus themselves on their real estate loans.
Today, the impact of the property market on all fundamentals is substantial, including in countries as massive and as diverse as the US. As real estate property remains the main source of wealth for US and French households, the effects of price depreciation lead logically to harmful consequences for all economic actors, and not just property owners. On the other hand, it is the rapid rise of real estate which partially cushioned the blow of 2001’s explosion in the prices of internet shares which helped the American economy to avoid a deep recession. The implosion of the tech bubble was thus in this regard very revealing, destroying from 2000 onwards a few 6.2 trillion dollars, in comparison with that of the subprimes which was to cost around 6 trillion from 2007 onwards. Why were the consequences of the former almost insignificant while we are still feeling the effects of the latter 9 years on?
In reality, the adjustment variable was consumption which – against all expectations – was to progress by 5% in the US between 2000 and 2002, whereas it declined by 8% in 2007 and 2009. The property market collapse of 2007 was therefore to very harshly affect the poor and the middle class, that is to say those who were the least capable of dealing with such shocks, and who were logically the first to reel back on their consumption. From 2007, property market experts in countries like the US (or Spain and Ireland) were therefore to decimate growth by killing consumption. In fact, it is the distribution of losses engendered by this real estate collapse which worsened the crisis and its repercussions on the economy, much more than the distribution of losses affecting the victims of the internet crisis. This last crisis – on the stock market – was of concern only for those who had the means to speculate on the stock market and who most likely weren’t in debt. Consequently, the results for economic activity in the crisis of 2000/2001 were altogether limited, in comparison with the subprime crisis which poor and middle-earning households felt the full brunt of, and who were forced to slam the brakes on their consumption, having no other riches than their property.
While real estate only really makes up a small portion of the rich’s heritage, it may represent between 80 and 100% of the least affluent household’s holdings, which therefore become extremely vulnerable to any property crash. Worse still, since almost all of these impoverished households can acquire their property only by means of credit, contrary to the rich who don’t have to get into debt. These inequalities therefore weaken the economy which is vacillating even more quickly and fatally than a part of its actors and players is lacking protection in the face of a system which inflates speculative bubbles everywhere where they are likely to make money from it. Because, there too, it’s always the impoverished who take the heat: it goes without saying that Warren Buffet or Mark Zuckerberg would not reduce their consumption if they were to make an investment at a loss of $50,000, while a precarious or middle class family would be severely damaged by it. Real estate therefore creates false, negative and fictitious growth.