By Gu Bon-sung
Research fellow, Korea Institute of Finance
Four years have passed since the global financial crisis was triggered by the Lehman Brothers debacle. Even now the eurozone crisis is still in the middle of uncertainty without any ideas for a quick resolution. A financial expert harshly put it that the global economy will be faced with a severe recession which may linger for several years. And in the domestic economy, exports and imports started to contract sharply, casting a gloomy shadow over future economic growth.
Meanwhile, even if the stock market showed resilience with the high expectation for Ben Bernanke’s announcement of the third round of quantitative easing (QE3) there remains phobia against recession or economic downturn. Why is it that uncertainty about economic recession is repeatedly raised? And how should the global economy be adjusted to fully recover from the crisis? We need to re-examine the core problem of the cyclical effect from the real estate crisis in 2008.
Looking back, the global financial crisis can be said to be part of the real estate crisis. Real estate provided credit to the whole economy, and the price stability of it offered massive and complex securitization.
As a result, the rising price of the real estate boosted consumption in the economy. Thus, the adjustment in the real estate market should be re-examined for its impact on economic growth, production and, above all, consumption. Before the global financial crisis the real estate market exhibited the acceleration effect from rising property prices. However, once the crisis hit, the deceleration effect has become dominant, similar to what happened in Japan between the mid-1980s and early 1990s.
The deceleration effect from the real estate adjustment can be twofold. First, the value of the real estate which is normally considered as one of the best collaterals is usually related to the debt problem, or household debt. The high expectation on the future price of the real estate remains during the economic boom or the period of income growth.
In particular, when the real estate price rises sharply in a very short period, it will accelerate debt financing, which will lead to a price hike in the real estate market. It is a typical correlation between debt and the price in the asset market. Such a correlation could be detrimental to consumption and production if and only if the real estate price unexpectedly falls. The burden of debt repayment can cause a sharp fall in consumption without a corresponding rise of disposable income. The contraction of aggregate consumption will inevitably press down economic growth and increase the probability of recession.
Second, the falling real estate price will inevitably undermine the soundness of the financial system. When the asset price falls, the credit system based on the price of the collateral will restrict the credit availability by financial institutions.
Also the negative outlook on the future price of the real estate will reduce the new demand for real estates and decrease their transactions as well, which will limit the opportunity for liquefying them.
That is to say, the downward pressure on real estate prices will deepen the deadlock situation of the real estate market through the financial deceleration mechanism. In a nutshell, the nature of the real estate crisis is the cost of repayment and the risk-sharing of the financial system in such a procession.
During the past four years, the global financial market could partially recover by boosting consumption, facilitating trade, and creating liquidity instead of the recovery of the real estate market itself.
Meanwhile, policymakers around the world have endeavored to resuscitate the real estate market by trying to recover fiscal consolidation through the re-balancing of the real economy, by improving the profitability of financial institutions, and through improving the market confidence. Yet, the global economic situation seems to be still subject to uncertainty due to the persistent real estate crisis. The resolution of the current global crisis hinges on efforts to redress the unproductive nature of real estate prices to prevent a long-term slump in the real estate market or in the aggregate economy.
That is to say, the challenge that remains for the world economy is how to improve economic efficiency by reducing or minimizing inefficiencies in the real estate market. In macroeconomic terms the world economy needs to streamline excessive exposure to the real estate market as a whole, stabilize rents to a reasonable level, and improve overall productivity.
For example, the rise of real estate prices usually pushes up fixed costs such as rent, which will suppress the incentive for productive activities and services and even the opportunity of employment due to the high cost of business. Also the unnecessarily high housing price may dampen the opportunity of future consumption because of high living costs compared to disposable income. The resolution of the real estate crisis should be more focused on revitalizing the household sector without which the phobia about recession may not disappear.
In order to support the household sector it will require comprehensive reform of housing finance.
The housing policy for home ownership should be more focused on strengthening the public’s role in the housing market as in Germany or the Nordic countries. Those countries have tried to keep or expand public housing services for low or middle income families despite the trend of deregulation.
Moreover, the housing financing system should be more tightly regulated. The core principle of the housing finance system should not be directed to promote the housing investment but rather to facilitate affordable home ownership based on an expected lifetime of disposable income.