Location, Location, Location: Long-run Trends in Housing Markets and Regional Economic Development

Abstract

This thesis tries to make some progress in understanding long-run trends in the spatial behavior of housing markets and economic development. To achieve this, it introduces and analyses new regional long-run data to uncover new stylized facts and combines state-of the art econometric techniques with parsimonious, target-oriented economic theory. The questions this thesis wants to advance on are: How do returns on housing investments vary across space (Chapter 1)? Does the nationwide fall in the risk-free rate have the potential to explain the increasing dispersion in housing prices relative to rents within developed countries (Chapter 2)? Can institutional innovations and an increase in market size help to explain why some regions in Europe industrialized quickly and are developed today whereas others stayed behind (Chapter 3)? <br /> Chapter 1 - "Superstar Returns: The Geography of Housing Market Risk", which is joint work with Francisco Amaral, Sebastian Kohl, and Moritz Schularick, documents, for the first time, substantial spatial variation in housing market return premia. For this purpose, the chapter introduces a novel international data set covering 27 large cities from 15 developed countries spanning a period of nearly 150 years. Next to city-level housing price and rent series, it contains annual total housing return series as the sum of capital gains and rent returns. The data set uncovers large variation in total housing returns across locations. Total returns in large "superstar" cities are close to 100 basis points lower per year than in the rest of the country. As shown in previous studies, house prices tend to grow faster in large cities. Rent returns, however, are substantially smaller within large cities, resulting in lower long-run total returns. <br /> This key finding can be rationalized in a standard asset-pricing framework where excess returns are a compensation for housing investment risk. Suppose that everything that makes a large "superstar" city – its diversified economy, its large and liquid housing market, its productivity, its amenities – also makes it a safer place as an investment. A consequence would be that buyers are willing to pay a higher price and accept a lower return for housing investments in these cities. The rest of the chapter provides empirical support for this interpretation of the (negative) large city premium. On the one hand, we present evidence that the co-variance between housing returns and income growth is lower in large cities. On the other hand, we show that idiosyncratic housing risk is larger outside the large cities, which seems to be related to the fact that housing markets in large cities are considerably more liquid. <br /> Chapter 2 - "The Fall in the Risk-Free Rate and Rising House Price Dispersion", also written jointly with Francisco Amaral, Sebastian Kohl, and Moritz Schularick, offers a new explanation for the increasing dispersion of regional housing prices over the last decades. Existing explanations mainly from the urban economics try to explain the rising spatial heterogeneity in housing prices with local housing market fundamentals. A combination of rising local demand and inelastic housing supply implies an increase in the value of housing services in supply-constrained cities. As housing prices, in equilibrium, equal the discounted future value of housing services, this translates into growing housing prices in these cities. Recent empirical literature and our new data, however, show that rent dispersion has increased considerably less than housing price dispersion. This limits the potential of local fundamentals to explain the rising dispersion in housing prices. <br /> The chapter develops a new spatial Gordon growth model that shows that a nationwide fall in the risk-free rate combined with initial regional differences in rent-price ratios increases housing price dispersion without affecting rent dispersion. The initial difference in rent-price ratios is evident in our new data. In accordance with Chapter 1, we argue that it is probably due to lower local housing risk-premia in larger cities. We calibrate our model to the 1985 values assuming a difference in risk-premia that coincides with the return differences uncovered in Chapter 1. Under these assumptions, a uniform fall in discount rates of only 1.3 percentage points is able to generate the increase in levels as well as dispersion in housing prices observed in the data in 2018. <br /> Chapter 3 - "Freedom of Enterprise and Economic Development in the German Industrial Take-Off" turns away from housing markets and instead analyzes differences in long-run trends of economic development. It contributes to the literature on the fundamental causes of economic growth by examining the interaction between institutional innovations and increasing market size as drivers of the industrial revolution. In the literature, institutions are debated as a fundamental cause of economic development, because inclusive institutions might be necessary to create the incentives required to invest in and industrialize production processes. On the other hand, demand needs to be sufficiently high and markets sufficiently large to enable increasing returns to scale technologies to break even, such that a sector industrializes. In the Chapter, I use the division of the Kingdom of Westphalia as a natural experiment to show that only reforms in both dimensions combined stimulated economic growth during the German industrial take-off. Homogeneous counties were allocated quasi-randomly to Prussia or the Electorate of Hesse as part of a package deal at the Congress of Vienna. In Prussian counties, the Gewerbefreiheit (freedom of enterprise) and the abolition of guilds increased incentives to industrialize manufacturing production, yet these counties and those under the guild system developed similarly. Only the establishment of the German Zollverein (customs union), which increased market size considerably, enabled counties featuring the Gewerbefreiheit to experience significantly higher growth.