On asset price bubbles

A while ago I had a lively Twitter discussion with Frances Coppola (read her blog) about inflation, where it hides and what to do about it.

Let’s face it: inflation levels in Europe and Germany are astonishingly low, given the enormous amounts of newly printed money that was released by the ECB. To my mind this has several reasons:

  1. The money is stuck in the banks. Which is good for Germany (little headline inflation) but bad for the periphery (credit crunch). We can see this on the charts of the money multipliers, e.g. the ratio of broad money to base money. The multipliers for both M2 and M3 have collapsed, despite the expansion of base money, meaning the banks have actually decreased lending.
    M3 to base money ratio (money multiplier) Source: ECB
    M3 to base money ratio (money multiplier)
    Source: ECB

    However, that may change rapidly and is no surefire backstop against monetary inflation. For now we are safe, but the ECB needs to collect all the excess money that is out there before it does harm. Unfortunately, it may have already done that, which I will explain in the second bullet.

  2. Second, and that is to me crucial, the measures such as HICP do not capture all price movements, especially in real estate and housing. This is troublesome for it feeds incorrect data into the decision making process of the ECB and because price increases in housing is bound to cause mayhem due to medium term “pork cycle”-like effects.
    Prices of residential property in Germany 1995-2011, Bundesbank, Financial Stability Review 2012
    Prices of residential property in Germany 1995-2011, Bundesbank, Financial Stability Review 2012

    Unfortunately, I didn’t find more recent data. Suggestions?
    The Bundesbank mentions basically three sources for these price increases: High demand, especially in the large(er) cities (due to good labour market prospects), low interest rates (hello, ECB) and uncertainty about inflation (Bundesbank, Financial Stability Review 2012). Whenever Germans are insecure about the economy (everything from stock markets to inflation), they buy flats, which is considered the safest investment of all – stocks and all the other fancy financial voodoo may loose value, but in a house one can at least live. Housing is a German`s primary defense against inflation. And we hate inflation. Really.
    So what to do with all the spare money issued by these reckless Southerners at the helm of the ECB? Right. Housing! This is likely optimal on the individual level, but has bad effects on the aggregate level: These are prime conditions for an asset price bubble.

Now Frances suggests to counter such asset price bubbles by taxing homeowners. Technically, she is right. Taxing homeownership (or at least new purchases) will at least slow the bubble down since it discourages people from pouring money into overvalued homes. However, taxing homeowners is only mechanically correct and deals only on the surface with rising living costs. People don’t care if they have to pay higher rents due to taxes or asset bubbles. They still will demand higher wages, kicking off the next round of the wage-price-spiral. Hence, taxing homeowners only shifts the problem but does not solve it.

Building more houses to increase supply and hence decrease upward pressure on prices is as stupid as an idea can be – except we want to end up like Spain with far too many empty houses.

There is only one sensible solution. Stop the expansionary monetary policy to stop people from worrying about inflation and pouring their money into housing. That is the problem of living in an non-optimal currency area. For Germany alone, the central bank would have sensibly raised the interest rates long ago. No cheap credit, no inflation worries, hence no bubble. But raising the rates in a mostly recessionary Euro area is likely worsening the whole mess.

So what to do? There is another “solution”, one that free-market-fans like me are very reluctant to embrace. The federal government discusses the idea of a “rent brake”, basically capping the amount of how much rents may rise. This is a deep intervention in markets and the price mechanism. However, it seems to me that the distortions caused by such a brake would be small compared to the effects of a bursted bubble. Moreover, policy makers should consider a rent brake that can deal with both regional differences and differences in distinct market segments (e.g. students` flats vs lofts).

On the other hand inflation in the Euro area is astonishingly high, given Europe’s recession. That is the problem of too heterogeneous a currency area. One size does not fit all. I will continue with some thoughts on the ECB`s mandate in another post.

What do you think? Can taxing homeowners help? I’m looking forward to your thoughts and comments!

Update (June 15th, 2013):

I found an interesting chart tool by The Economist: http://www.economist.com/blogs/dailychart/2011/11/global-house-prices

While it shows that Germany`s housing prices do rise, it also reveals some baffling (at least to me) results. Germany`s homes are undervalued compared to rents and income, and housing prices are in real term still far below their levels from 2000.

This in turn means that their is scope for more wealth for home owners, but also scope for more price increases for prospective home owners.

But the most baffling thing is Germany`s housing price development over the past three or four decades, when compared with, say, Britain.

That said, keep in mind that this chart offers again aggregated data, while the Bundesbank`s chart above makes regional and market segment-wise distinctions.

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I write about economics and politics. I take Ordnungspolitik seriously. While not blogging, I study monetary unions for my doctorate.