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Of Housing Bubbles and Trade Deficits
Jesse Richman, 9/4/2012

Yesterday's blog post highlighted the fact that quite a few countries experienced housing bubbles at roughly the same time.  The countries included on the graph were all of the countries from the Economist's dataset that had housing bubbles in which real housing prices increased to levels higher than the United States' housing bubble during the period from 1998 to the present. 

Yesterday I speculated that there might be a connection between trade deficits and housing bubbles.  My theory was that housing bubbles are associated with the influx of capital (current account deficit) that finances massive run-ups in property values. 

To test the proposition that countries with large current account deficits had large housing bubbles (i.e. bigger than the U.S.) but countries without current account deficits did not, I collected data on current account deficits from tradingeconomics.com for each of the countries for which housing price data is available on the Economist website.  I then compared the current account deficit for countries with a large housing bubble with the current account deficit for countries without.

The average 2007 current account balance for countries with a large housing bubble was -2.84 percent of GDP, while the average current account balance for countries without a large housing bubble was 7.19 percent of GDP.  Thus, on average for these twenty countries those with a housing bubble had a current account balance that was 10 percent of GDP worse. 

To be clear, it is possible that the housing bubble (by attracting foreign capital) might be causing the current account deficit.  It is also possible that the influx of capital (driven by other factors) led to low interest rates and lax lending standards and thereby created the bubble.

Even more complex causal stories might be true.  For instance, perhaps countries with trade deficits kept interest rates low in order to compensate for the drain on the economy associated with running a trade deficit.  In turn these low interest rates might have contributed to higher housing prices.

In addition, it is possible that a domestically generated housing bubble could generate a current account deficit by creating large amounts of paper wealth that consumers subsequently spent.  

Obviously untangling causality is extremely difficult here.  Though the graph shows that there is a strong relationship (and it is statistically significant p<0.01) we cannot say for sure that the trade deficit caused the housing bubbles, nor can we say for sure that the housing bubble caused the trade deficit. 

One way to get at least some sense of the time-order is to look at the current account deficits before the housing bubbles were really rolling.  In 2000 (before much of the appreciation in housing prices had occurred) there was already a large difference (4.65 percent of GDP) between the current account of countries that later had a large housing bubble and the current account of countries that didn't.  This difference is statistically significant at p=0.016.  This suggests that substantial current account deficits preceded and presaged the housing bubble, although it is by no means definitive.