New Economist

House prices: fundamentals do matter

Across North America and much of Europe, countries have experienced record highs in house price to income ratios. To what extent have common factors driven this trend? A new paper by Kieran McQuinn and Gerard O'Reilly at the Central Bank of Ireland proposes A Model of Cross-Country House Prices. The authors find that despite substantial national differences, capacity to borrow - as reflected by income and interest rates - has been a common driver of house price increases:

In this paper we propose that a cross-country house price demand schedule can be adequately represented by a price suggested by the average amount that can be borrowed in each country with the latter being determined by current disposable income levels and interest rates.

Rising incomes and low interest rates have fuelled the housing boom:

The model is applied to a panel of 16 OECD countries from 1980 to 2005 using both single country-by-country and panel econometric approaches. Our results support the existence of a long-run relationship between actual house prices and the amount individuals can borrow and we find plausible and statistically significant adjustment, across countries, to this long run equilibrium.

A nice piece of work, on which others can build.

Of babies and currencies

It's a connection I confess I never made when working in the City, but a recent MAS Staff Paper by Andrew K. Rose and Saktiandi Supaat, Fertility and the real exchange rate, claims that countries with falling fertility rates are likely to experience a depreciation in their currency:

We use a quinquennial data set covering 87 countries between 1975 and 2005 to investigate the relationship between fertility and the real effective exchange rate. Theoretically a country experiencing a decline in its fertility rate can be expected to have higher savings, lower investment, a current account surplus, and accordingly a real depreciation. We test and confirm this hypothesis, controlling for a host of potential determinants such as PPP deviations and the Balassa-Samuelson effect. We find a statistically significant and robust link between fertility and the exchange rate.  Our point-estimate is that a decline in the fertility rate of one child per woman is associated with a depreciation of approximately .15% in the real effective exchange rate.

So that's bearish for the yen, bullish for Africa?

Who are the behavioral economists and what do they say?

That's the title of a new Tinbergen Institute paper by Floris Heukelom (Universiteit van Amsterdam). She identifies a divide within this economic school between those who see uncertainty as exogenous, and those who consider it endogenous:

The most important financial source for behavioral economics is the Russell Sage Foundation (RSF). The most prominent behavioral economists among the RSF’s twenty-six member Behavioral Economics Roundtable (BER) are Kahneman, Tversky, Thaler, Camerer, Loewenstein, Rabin, and Laibson. The theoretical core of behavioral economics made up of the work of these seven researchers is positioned in opposition to Adam Smith/Hayek type of economics, as exemplified by experimental economists Vernon Smith and Plott; and what is referred to as ‘mainstream’ or ‘traditional’ economics, meaning the neoclassical economics that roughly builds on Samuelson.

On the basis of an overview of the work of these seven behavioral economists, a theoretical division can be observed within behavioral economics. The first branch considers human decision-making to be a problem of exogenous uncertainty, which can be analyzed with decision theory. It employs traditional economics as a normative benchmark and favors a normative-descriptive (prescriptive) distinction for economics. The second branch considers human decision-making to be a problem of strategic interaction, in which the uncertainty is endogenous. Its main tool is game theory. It rejects traditional economics both positively and normatively.

Opening up the IMF?

The long-standing deal between the great powers was that the US Government would appoint the head of the World Bank, and the Europeans would get the head of the IMF. Hopes that this cosy arrangement might unravel with the departure of World Bank President Paul Wolfowitz came to naught, with the recent uncontested appointment of former US Trade Representative, Robert B. Zoellick.

However the surprise resignation of IMF Managing Director Rodrigo Rato has re-opened the issue. While the UK government backed Zoellick, they seem to have doubts about another European heading up the IMF, according to this evening's Financial Times story: UK calls to open up IMF chief selection

Britain added its voice to calls from developing countries against the French-led drive to position Dominique Strauss-Kahn as the sole candidate to succeed Rodrigo Rato as managing director of the International Monetary Fund.

Alistair Darling, the UK chancellor of the exchequer, will on Tuesday urge European colleagues to apply the brakes to the selection of a new IMF chief and not to be bounced into making a quick decision.

“The UK believes there should be an open and transparent process for selecting the next managing director of the IMF,” a British Treasury spokesman said, adding that the successful candidate could well be a non-European. “The UK will be pressing the fund’s board to set out publicly criteria and a timetable for the appointment process.”

At a board meeting on Monday afternoon in Washington, directors from the Middle East and Latin America were set to lead calls for an open global competition for the job. The post has traditionally been held by a European under an unwritten convention by which the US in turn chooses one of its citizens to be president of the World Bank. Some were clearly infuriated by what they saw as a move by the Europeans to pre-empt discussion about the succession by rallying around a single candidate.

Strauss-Kahn is by no means an unworthy candidate. But an open competition would give other suitable candidates a chance, especially those from developing countries. They might just know a thing or two about development that a senior European politician doesn't.

How to make guest-worker programmes work

A number of Western countries have implemented guest-worker programs in recent decades, with mixed results. The main problem is overstaying - a share of the guest-workers failed to return to their home
country when their contract period elapsed. Is there a future for temporary migration schemes? A new IZA discussion paper by Maurice Schiff argues that:

..temporary migration programs that are suitably reformed in order to make them more attractive to host countries can play an important role as part of a sustainable migration strategy in the future, particularly ..in the case of Mode IV where migrant overstaying is less likely to take place than under the guest-worker program.

'Mode IV' migration is temporary cross-border movement of service suppliers under Mode IV of the GATS.

Schiff's paper, Optimal Immigration Policy: Permanent, Guest-Worker, or Mode IV?, examines several reforms designed to reduce overstaying, and concludes:

This paper contributes to the debate by examining these migration regimes in a model in which the host country maximizes an objective function with respect to i) the size of the migration program, and – in the case of temporary migration – ii) the value of a bond employers must buy and iii) the share of migrants’ income whose payment is deferred. The maximization also takes into account the impact of the policy on source country cooperation on illegal immigration, migrants’ incentives and their preference for overstaying. The model solves for the policy measures, the overstaying probability, and the level of illegal migration. The paper concludes that the optimal policy is a combination of Mode IV-type and permanent migration.