Question

In the run-up to the financial crisis, the United States experienced what appears to have been a bubble in house prices. U.S. households borrowed heavily in order to finance the purchase of houses, some of which were the result of new construction. Treat new housing construction as an increase in private Investment, and increased household borrowing as a decrease in Saving, and use the national income accounting framework discussed in class to illustrate the consequences of the housing bubble for the U.S. current account. (Assume that government spending and taxes are held fixed, for the purposes of this exercise.) What is implied about international capital flows during this episode?     

Answer 1

The underlying causes of the housing bubbles are complex. Factors include tax policy, historically low interest rates, tax lending standards, failure of regulators to intervene, and speculative fever. This bubble may be related the stock market or dot - com bubble of the 1990s.

Hedge funds, banks, and insurance companies caused the subprime mortgage crisis. Hedge funds and banks created mortgage - backed securities. The insurance companies covered them with credit default swaps. Demand for mortgages led to an asset bubble in housing. When the Federal Reserve raised the federal funds rate, it sent adjustable mortgage interest rates skyrocketing. As a result, home prices plummeted, and borrowers defaulted. Derivatives spread the risk into every corner of the globe. That caused the 2007 banking crisis, the 2008 financial crisis, and the Great Recession. It created the worst recession since the Great Depression.

The bursting of the US housing bubble will change expected returns to housing assets and will lead to a reallocation of capital within the United States as well as between countries. This reallocation of capital will have knock - on effects for the world economy, exchange rates and international capital flows. These financial effects need to be assessed alongside the effects on the real economy from lower investment in housing and lower spending from the negative wealth effect. These are all analysed with the economy wide framework used in this issue.

The increase in the US house prices and also in other parts of the world since 2000 has been described as the biggest bubble in history. It has estimated that the value of residential property in developed countries increased by more than $30 trillion.

The boom in house prices was driven by low interest rates and a lack of perceived returns on stock markets following the bust of the Stockmarket boom in 2000.

The fall in wealth from the sharp fall in the value of housing causes a larger drop in consumption. The initial decline a year after the bursting of the bubble is ten percent below baseline. the effect persists for several years.

The large drop in consumption weighs heavily on the economy and real GDP falls by 4.1 percent below base line.

With the bursting of the housing bubble, investors now switch to alternative assets where expected returns are high.

The large drop in consumer spending and the real GDP in the United States means that a substantial part of the asset reallocation would go offshore rather than staying within US assets. The capital outflow this generates causes the US current account to improve by 1.2 percent of GDP in 2006 and by 1.6 percent of GDP consequently.

Most of the improvement in the US current account from baseline is made up by an improvement in the trade balance . Contributing to the improvement in the trade balance from base line is an increase in US exports to the rest of the world and a reduction in imports shows a favourable trend on current account.

One of the worries of a housing bubble starting in the United States and an initial slowdown is the negative impact on the rest of the world.