More on China, Currency Crises, and Real Estate

Me in March:

I often hear anecdotal arguments, especially from executives and know-nothing business types, that the building boom in China is evidence that it will overtake the US. This analysis appears intuitive, but it is incorrect.

One of the main features of planned economies is that they can mobilize resources more quickly than market economies. Yes, China has moved towards a more capitalist model, but the government still holds a disproportionate control of economic resources. Governments are very good at getting stuff built. They condemn old buildings. Knock them down. New construction starts.

This type of thing is great for planned economies for three reasons. First, it is relatively easy to build a building. One does not need to make any new discoveries. Second, the finished product is a tangible example of the progress of the country. People see skyscrapers go up, and think, "Wow, our country is really growing!" Third, it provides a lot of medium and low skilled work. This is important for a communist government. Better to have the population working than protesting.

Me in October:

Oh, and [the Chinese] are building skyscrapers and ports and roads. That's what everybody finds so impressive. Those delightful, futuristic buildings. They're tangible and beautiful. But remember property booms are fantastic for making everybody think the economy is gangbusters. The Asian financial crisis started in the Thai real estate market. The current global financial meltdown started in the US housing market.

Yesterday on Economist Free Exchange:

Why then is China slowing so sharply? Simple, real estate investment has hit a wall. After growing at 20% y/y for a long time, real estate investment stalled – with a y/y growth rate of around 0% (Figure 5). That means that China is in turn producing more steel and cement than it needs, and producers of steel and cement are cutting back. That in turns hurts iron ore exporters …

Remember this:
Real estate can lead to real growth, but when it goes bad it goes really, really bad for a few reasons. First, real estate is illiquid, which is to say that a house takes longer to sell than almost anything else. This means that stability takes time to reemerge. Second, it offers the most leverage of any investment open to the public. People don't typically borrow multiple times their yearly income to buy stocks on margin. Lastly, I theorize that people have a psychological bias to think that real estate investments are safer than stocks because it is more tangible, and also an emotional attachment to the value of your house. You live in your house everyday. Most people don't even see their stock certificates, and if they do they're just pieces of paper. People seem to think their house price reflects as some sort of judgement on how they live their life. Price goes up, society approves. Prices down, can't be because the way I live my life is fine. This bias in favor of real estate as more real leads to a false sense of security in the gains, and the emotional attachment leads to denial of price falls. Add to this the leverage, and some people are going to stick with high prices until the cows come home. Thus, the market remains in disequilibrium.

For these reasons, real estate booms lead to financial crises such as the Asian crisis ten years ago and our current problems.