Blogs & Comment

Are housing bubbles inflated by foreign capital?: Erica Alini

Learning from America’s mistakes

(Photo: Dennis Novak/Getty)

(Photo: Dennis Novak/Getty)

Three economists, two of whom from the Federal Reserve, have a new paper out estimating that foreign capital inflows accounted for between one-fourth and one-third of the increase in U.S. house prices, and over a third in that of U.S. household debt in the run-up to the financial crisis.

The idea here is that massive purchases of U.S. Treasuries by countries like China and the Gulf oil-rich nations, coupled with European banks stocking up on U.S. AAA-rated asset-backed securities, provided some of the capital that fueled America’s borrowing binge and housing bubble. It isn’t a new idea. What’s interesting about this paper is that it tries to quantify the effects of foreign capital inflows and finds a sizeable impact. The economists offer this pretty striking chart:

Screen Shot 2013-11-27 at 11.56.38 AM

Source: The Effects of the Saving and Banking Glut on the U.S. Economy, by Alejandro Justiniano, Giorgio Primiceri and Andrea Tambalotti.

This is a cautionary tale for Canada. As Mark Carney noted when he was the governor of the Bank of Canada, “It is reasonable to expect that Canada will attract for the next decade or so sizeable foreign capital … and the question is what are we going to do with that capital.” Would we use the money toward promising enterprises and business initiatives or would we stash it into housing, the governor wondered. The latter option is, Carney warned, a “movie” we’d seen before: “It just played in a major cinema just south of here, over and over and over again, and it would be the height of folly to repeat those mistakes.”

There are some striking parallels between the U.S. and Canada in this respect. Before the crisis, foreign savers couldn’t get enough of lending to Uncle Sam because they perceived it to be a virtually risk-free investment. The inflow of foreign cash was a big reason why America started running bigger and bigger current account deficits in the 1990s and 2000s. Canada started running a current account deficit in the fourth-quarter of 2008, after the financial market meltdown. We’re still running one. In part this reflects the formidable hit that the U.S. downturn has dealt our export sector. In part, though it’s been money from abroad coming into Canada largely as a result of investors looking for a safe place to invest their savings. With its well-regulated financial system, solid banks and only mild economic contraction, the Great White North looked like a great place to store money away from the turmoil of Great Recession.

There’s nothing wrong, of course, with being popular with foreign investors. In principle, it is a very good thing. It is especially good in Canada, where the pool of domestic savings isn’t nearly big enough to feed a sustained demand for business investment, particularly in the resource sector.

Still, the problem is where the foreign money goes. If it doesn’t find its way to uses that will grow the productive capacity of the economy, it will help inflate bubbles — by as much as a third, apparently.

Erica Alini is a reporter based in Cambridge, Mass., and a regular contributor to, where she covers the U.S. economy.

Follow @ealini