Image credit: Sérgio Garcia (CC Licence)

For the European Central Bank’s Forum conference in Sintra, Portugal, John Muellbauer was invited to present a paper on booms and busts in real estate markets and examine implications for monetary transmission and financial stability in euro area countries.

In advanced countries, financial crises often begin with overvalued asset prices, especially of housing and commercial real estate, preceded by poor quality of lending and excessive credit growth funded by often highly leveraged lenders. The paper examines empirical evidence on the complex and heterogeneous channels of transmission of monetary policy and loan standards to mortgage interest rates, house prices, residential investment, debt, wealth, consumption and non-performing loans (NPLs). Though relevant both for monetary and macroprudential policy, most current central bank policy models have an inadequate coverage of these channels.

Using a case study for France, Muellbauer was able to quantify the role of lending standards in the credit cycle: a period of easy credit conditions, resulting in lax lending standards, tends to create financial vulnerability among borrowers and potentially among lenders, particularly if followed by an economic downturn. Then, rising NPLs and other credit risk measures result in a reduced ability and willingness of banks to extend credit, resulting in tighter credit conditions that amplify the downturn in the economy.

The paper also proposes new methods for measuring changing lending standards and of judging over-valuation of house prices to improve macroprudential policy making. It argues that the effectiveness of monetary policy in stimulating aggregate demand via real estate channels has been overstated and comes with serious negative side effects for stability and inequality.

Prof Muellbauer noted:

“The Global Financial Crisis triggered what has been little short of a revolution in macroeconomic thinking away from the dynamic stochastic general equilibrium (DSGE) approaches with representative agents and towards heterogeneous agent models in an incomplete market setting (Appendix 1 gives a bird’s eye summary). Heterogeneity, trading and search costs, asymmetric information, and credit constraints are ubiquitous in housing markets, see Glaeser and Nathanson (2015), yet were neglected in DSGE model approaches. There is now a greater understanding of how real estate markets, the financial sector and the real economy interacted in the financial accelerator that operated during the GFC. This has helped change the conventional wisdom about monetary transmission. One result is a new focus on household balance sheets and the related distributional effects that have aggregate consequences. Another is that new attention is being given to bank balance sheets, the role of banks in generating credit and which factors drive the variation in lending standards, all important for financial stability and macroprudential policy.”

Read the paper in full here.

Find a copy of the presentation slides here.