2014): “Betting the House

Is there a link between loose monetary conditions, credit growth, house price booms, and financial instability? This paper analyzes the role of interest rates and credit in driving house price booms and busts with data spanning 140 years of modern economic history in the advanced economies. We exploit the implications of the macroeconomic policy trilemma to identify exogenous variation in monetary conditions: countries with fixed exchange regimes often see fluctuations in short-term interest rates unrelated to home economic conditions. We use novel instrumental variable local projection methods to demonstrate that loose monetary conditions lead to booms in real estate lending and house prices bubbles; these, in turn, materially heighten the risk of financial crises. Both effects have become stronger in the postwar era. ∗The views expressed herein are solely the responsibility of the authors and should not be interpreted as reflecting the views of the Federal Reserve Bank of San Francisco or the Board of Governors of the Federal Reserve System. This work is part of a larger project kindly supported by a research grant from the Institute for New Economic Thinking (INET) administered by UC Davis. Schularick is thankful for generous financial support from the Volkswagen Foundation. We are indebted to Katharina Knoll who permitted us to use her cross-country database of historical housing prices. We are particularly grateful to Early Elias and Niklas Flamang for outstanding research assistance. All errors are ours