The relationship between GDP and Interest Rate : The case of U.S. housing market
Category : Economics
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The Mortgage Crisis
The U.S. experienced the first wave of mortgage collapse in 2006. This caused the different economic actors to point-finger to one another. Generally, the house price bubble is caused by behaviors of virtually all economic actors leading to market failure. The vicious cycle started with the eager buyers of homes due to unprecedented rise in value. This is followed by lenders that saw opportunities of gaining significant market. Since home purchases are largely financed through credit, the buyers use their newly-bought homes as collateral to acquire more homes as investment while lenders accepted credit applications without minimal to liquidity of clients.
The destination of lenders when they felt lack of liquidity is the stock exchanges. The latter provided temporary liquidity to the lenders by serving as a bridge between foreign financers and domestic lenders. The problem started here as foreign financers did not get their expected return. When lenders have no option and they continued to experience lack liquidity in their operations, this resulted in increasing the interest rate (e.g. the rate of the borrowers). With weak government intervention to solve liquidity problems, numerous home buyers that have a pending obligation to the lenders started to fell the burden. Actually, this feeling is triggered by the fact that the interest they pay to own their homes is now greater than potential returns of those formerly high-valued homes.
The credit crunch is the term to describe the abrupt increase in the interest rate which re-positioned purchasers and lenders from a profit stance to losing stance. House price bubble is a term to describe the weak relationship that links the value of home to the condition of economic fundamentals. For example, it is possible to have a highly-priced asset even if economic activities are in contraction. When there is a misallocation of resources (i.e. paying much with less means), the amount of money in the economy (i.e. liquidity) is depleted. Using this framework, it is a good starting point to introduce the role of the gross domestic product (GDP) in preventing the misallocation of resources as well as maintaining a dependable level of money supply in circulation.
Economic Analysis of House Prices
The components of GDP are consumption, private investment, government spending and net exports. With a direct positive relationship between all the variables, GDP is expected to rise if one of the variables has increased. On the other hand, interest rates are determined by factors such as opportunity cost, inflation, default, deferred consumption (e.g. premium in excess of achieving the same level of purchasing power) and length of time. Obviously, although not commonly written as formula or equation, these variables have positive relationship with the interest rate. Finally, the price of houses is achieved in various ways; namely, similar properties can be compared, a capital rate can be attached with reference to income generating-capacity and financial valuation through discounting the current value of future cash flows. With preference over the median housing estimate, the house price index for the U.S. is announced.
At this point, it is clearer if the analysis starts from linking GDP to house prices and interest rates to house prices. In Figure 1, the diagram of the demand and supply curves for house prices are shown. The four quadrants are identified as being the stock of house in the economy, the cost of owning the house or an equivalent rent, the market price of houses and the newly-constructed houses that contribute to annual stock of house. The basic tool of analysis of the diagram is to ensure that the equilibrium is achieved in every cyclical impacts that each of the elements may apply to the framework. As illustration, when year-end figures showed that the remaining house stock is depleted from its beginning level, the inability of each element to respond to the situation eminent in the short-run will result to economic issues worthy of attention.
Figure 1: Asset and Property Market for Housing Industry
GDP and House Prices
As stock of house in the short-run is fixed, a rise in housing demand will result to simultaneous increase in price (See Figure 2). The positive demand shock is shows that an increase in consumption (e.g. rise in GDP) is a determinant of house price increase. The interesting issue is that house is both a consumption and investment commodity where pricing preferences are generally extreme. In efficient markets, the former objective is the primary concern of purchasers which in case they prefer lower price. However, the mortgage crisis which initially started with skyrocketing house prices motivated purchasers to invest rather consumes houses. Therefore, high prices is not a cause of alarm rather opportunity to profit.
Figure 2: The Market with Increased Demand of Houses
As positive demand shock pushed house prices upwards, real estate and construction companies also saw profit opportunity the same as the buyers. Another implication of GDP is observed in the adjustment made by the second and third quadrant. Construction of new houses required additional investment from these companies which contributed to increase GDP. It is to note that the corporate investment particularly investment to build new houses are direct investments different from soft investments of buyers. The latter is more inclined on speculative behavior where there is less additional value contributed to GDP. As the succeeding discussion will show, speculative investment has significant contribution to the housing price bubble.
The adjustment in quadrant 4 completes the required reaction from the economic actors where the initial inability of beginning-year house supply to obtain equilibrium is solved at year-end. Thus, the earlier house price increased is pulled back to normal levels by the start of the second year. But speculative investment continued and positive demand shock again resulted to increase in price. It is apparent that what follows is a series of adjustments to each quadrant. The relationship between GDP and house prices is evidenced in the economic scenarios of modern economies such as U.S. where prediction of economic transactions and results is reliably possible. For example, it is found that historical fall in house prices are followed by decreases in consumption and GDP of the economy.
Interest Rate and House Prices
The role of interest rate in house price is indicated in Figure 3. As mentioned earlier, one of the realities of home purchase is that majority of funds used to acquire are based on borrowed money. When interest rate is increased from an independent cause such as new tax regimes, the P-curve in the second quadrant will rotate clockwise. This phenomenon will have impacts on other quadrants and the effect is the reverse of positive demand shock. When interest rate increases, as shown in the case of U.S. homebuyers and lenders, it is harder to finance projects. In the case of real estate companies and homebuilders, this is a reason of cutting construction project.
Figure 3: The Market with Increased Interest Rates
The movement of the P-curve specifically shows how the demand for new homes can decline. This is due to the higher cost of owning/ renting a home particularly via borrowed money. The effects on construction companies are not limited to their own sourcing of funds but more importantly to the aggravation brought about by negative demand shock. Such result to lower house prices will necessarily reduce the motivation of constructors to build more homes and increase industry spending and investments. With minimal yearly addition to the stock of houses, the current house stock will also offer few supply. The first quadrant, where the terminal adjustment is made, clearly shows that the cost of living both purchase of new houses and rental fee will increase to coupe with the trend. As people do not have access to cheap lending, the rise in cost of living can impose financial problems.
Like GDP, the mortgage crisis is able to be explained by interest rates and house price relationships. As interest rate is increased, house price is also increased due to intense competition from lack of new housing stock. This is where liquidity problems are observed as minimal money can support the needs of the buyers and homebuilders. Initially, the role of the latter is not emphasized in the U.S. experience simply because they are only getting the signal from house prices which are determined by the interest rate. When the interest rate is low, it is a sign of building opportunity and homebuilders are encourage to produce more thus resulting to lower prices. However, the mortgage crisis exemplified the reverse, that is, high interest rates and high house prices. The question now is how to relate GDP and interest rates to explain the crisis.
How GDP and Interest Rates are Related?
Due to the strength of relationship between GDP and U.S. house prices, the increased consumption of buyers and investment from additional house construction of homebuilders contributed to an increase in GDP. The earlier signs of increasing value of house prices would not lead to house price bubble or collapse of the housing industry as the yearly increase in housing demand is automatically reacted by the other quadrants and/ or economic actors as shown in Figure 3. However, the negative side of all bubble is the speculation which diminishes the positive effect of GDP to house prices. As speculation snowballs, the quality of consumption in relation to GDP contribution is eradicated. That is, the liquidity of the economy is financing an industry which is characterized by very high risks. Two of the risks are the inability of homebuyers to pay their obligation and devaluation of home prices in the future.
At this point, it is clear that lenders to both homebuyers and homebuilders became doubtful as the continued increase in house prices never resulted to increase in their ability to pay for their obligation. Instead, especially on the part of homebuyers, lenders are receiving home collaterals and frequent default on interest payments. This phenomenon sent an alarm to lenders that the value of the industry may not be as lucrative as house prices suggest. In effect, some became conservative and careful in selecting clients while others became aggressive in preventing default such as imposing foreclosure to the homebuyer’s collaterals. This started the credit crunch in the housing industry. The credit crunch pressured interest rates to go up, and applying Figure 3, house prices began to plunge. This resulted to debtors who use collateral and investment on houses (e.g. homebuyers) to be insolvent while domino effect on lack of liquidity, default and non-performing loans bugged the lenders.
With high GDP, interest rates tend to lower at least in the short-run that highly depends to the growth targets of the government. High GDP and high interest rates are basically contradictory to one another because the former is about economic expansion while the latter is for the purpose of economic contraction. Therefore, their relationship is negative where an increase (decrease) in one will necessarily result to decrease (increase on the latter). The mortgage crisis is a unique case. One is that the high GDP is based on speculation and the borrowed capital that is provided by for economic expansion is misallocated. Another, and perhaps the more destructive, is that the shift of the P-curve (i.e. increase of interest rate) happened just when people are awaiting the profits of their house investments and are on the verge of negotiating a loan to buy a new one to finance the current house payment.
Andrews, E. (2007). US Congress split on solution to sub-prime crisis. New York Times.
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Dupuis, F. (2007). Impacts of the US Mortgage Crisis. Available in www.desjardins.com/economics
Garcia-Herrero, Alicia and Tuuli Koivu, 2007, “Can the Chinese Trade Surplus Be Reduced through Exchange Rate Policy?” BOFIT Discussion Papers No. 2007-6 (Helsinki: Bank of Finland, March).
Stockman, A. (2000). Exchange rate systems in perspective. Cato Journal, vol. 20, no. 1.
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