Sunday, December 13, 2009

Relative Prices and the Real Estate Bubble

. Sunday, December 13, 2009

Megan McArdle asks, Why did investment in real goods and services suddenly become so much less attractive than housing?" I suggest the answer lies in four words: real exchange rate appreciation.

Why would real appreciation divert capital to real estate? Think of the economy as composed of two sectors, the traded sector and the non-traded sector. When the currency strengthens, traded sector activity suffers. It becomes more difficult to sell American products abroad, and foreign products sell cheaply in the US market. Hence, anyone who makes traded goods is going to struggle. Non-traded sector activities do not face international competition, and thus do not suffer such competitiveness problems under a strong currency. In fact, if you earn your income in non-traded activities and consume lots of traded goods and services, then a strong dollar actually works to your advantage because it reduces the price of the things you buy while having little impact on your nominal wage. All of which we can summarize by suggesting that the return to non-traded activity rises relative to traded activity as the currency strengthens.

Consequently, if you are looking to invest hundreds of millions in the American economy in 1998-2006, are you going to invest in auto production and other traded sector activities or are you going to invest in real estate and other non-traded sector activities? The figure at the top of the post suggests that the answer should be rather obvious. The dollar appreciated in real terms against a weighted basket of the US's most important trade partners by 20 percent or so between the late 1990s and the early naughts. Consequently, investment in non-traded activities was much more attractive than investment in traded sector activities (with the obvious exception of investment in financial services).

All of which makes one wonder why the dollar strengthened so sharply in this period. But that is a topic for another day.

*Real Effective Exchange Rate indicies from Economic Report of the President, Table B-110


Anonymous said...

How do restrictions and investor biases that favor domestic financial markets impact the relative attractiveness of non-tradable sectors? For example, pensions w/ overweight position in domestic assets tend to keep capital onshore. If instead, investors applied a global capital mindset, it seems that capital should also flock to those foreign producers that benefit from a strong dollar (and real estate would not be the only outlet for this capital).

Relative Prices and the Real Estate Bubble
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