EXPLAINING GROWTH DIVERGENCES IN THE EURO AREA

EXPLAINING GROWTH DIVERGENCES IN THE EURO AREA: THE ROLE OF RESIDENTIAL INVESTMENT
Klaus - Jürgen Gern and Carsten - Patrick Meier
IfW Kiel Institute for the World Economy




Over past years, there have been significant differences in cyclical developments in the euro area. The paper addresses the question to what extent these differences can be explained by the pronounced differences in residential construction activity. In our econometric analysis of housing investment in the euro area we, as a first step, distinguish between Germany and the rest of theeuro area. This distinction is motivated by the fact that German developmentshave been special in several respects over the past 20 years and, given the large size of the Germany as a proportion of the euro area economy, influence the developments on an aggregate euro area level significantly (as opposed to, e.g., Austria where housing investment—and population growth—was rather similar to German patterns). Since swings in housing investment in Germany over therecent two decades have been associated with pronounced changes in population growth, special emphasis is given to the importance of demographic developments in explaining diverging trends in housing investment. Population growth and demographic developments that affect the number of households, such as shifts in the share of population in household formation age and falls in the average size of households, all have potentially important implications for housing demand. We estimate functions for Germany and the rest of the euro area where residential investment depends on the existing level of housing stock, real income, the user cost of capital (proxied by the real interest rate) and population growth. In order to quantify the importance that demographic developments through the channel of residential investment have as an explanation of the growth differential between Germany and the rest of the euro area, we simulate how economic activity in the two regions had evolved under the assumption of identical demographic trends using these equations and a macroeconometric model for Germany and the rest of the euro area. In the literature, the impact of demographic developments on the housing market is usually discussed in the context of house prices. Several studies include demographic variables in their estimated house price equations (e.g. Meen 2002, Ahearne et al. 2005) , but they are omitted in recent VAR-studies (Sutton 2002, Tsatsaronis and Zhu 2004). Girouard and Blöndal (2001) discuss the influence of house prices on residential investment through the price-cost ratio, but do not discuss other determinants of residential investment.

Summary and Conclusions

Differences in growth dynamics within the euro area have been pronounced in recent years with German growth especially sluggish relative to the rest of the euro area. A substantial part of the growth differential between Germany and the rest of the euro area is due to the strong differences in residential investment growth which has been declining in Germany since the end of the 90s while expanding swiftly in the rest of the euro area. In Germany, changes in population growth have been pronounced in the past two decades and demographic developments have differed markedly from those in the rest of the euro area. Estimation of functions explaining housing investment for Germany and the euro are confirm a significant impact of population growth on residential construction in both cases. A simulation exercise based on these equations finds that if population growth in Germany had been the same as in the rest of the euro area the profile of housing investment in Germany would have been significantly altered and much less different from that in the rest of the euro area. However, while the effect of differences in population growth are not negligible, differences in demographic developments are found to account for only 10—20 percent of the growth differential between Germany and the rest of the euro area that has been observed in recent years. Therefore, in order to explain differences in intra-euro area growth dynamics other factors than demographics have to be taken into account.