Monday, May 17, 2010

Structural Rigidities and Financial Crisis

Sometimes it is hard to understand the connection between structural rigidities and financial crises. The connection between excessive regulation and government deficits is not exactly direct. Financial crises tend to be due to problems with banks or with government borrowing. But this article in the NYTimes on Portugal does a good job of clarifying the point.

The specific example is rent control. This is quite severe in Portugal:
José Gago da Graça owns a Portuguese real estate company and has two identical apartments in the same building in the heart of Lisbon. One rents for €2,750 a month, the other for almost 40 times less, €75.

The discrepancy is a result of 100-year-old tenancy rules, which have frozen the rent of hundreds of thousands of tenants and protected them against eviction in Portugal.
What is the connection to the financial crisis? Well, these rules limit production of rental housing, and thus force people to purchase rather than rent housing.
The post-revolution rules helped protect tenants, but also led to a chronic shortage of rental housing. This, in turn, persuaded a new generation of Portuguese to tap recently into low interest rates and buy instead — often in new suburbs — thereby exacerbating the country’s mortgage debt and leaving Portugal with one of Europe’s lowest savings rates, of 7.5 percent.
When the opportunities to borrow at low rates -- due to the euro -- presented themselves, Portuguese households took advantage. Rather than rent and save, households were pushed, by rent control, to borrow and purchase. That would not be so bad if the price of housing was not experiencing a bubble. But the borrowing took place precisely when housing prices departed from rents.

Of course we know that rent control is bad. We just now see how it is bad in other unintended ways.

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