Is there a house price bubble in the Euro Area?

Long-Term Real House Prices, 1971-2006: US vs Euro Area. Source: CEPS

Some of the big questions facing the US at the moment is the extent of the housing recession, and the implication for the wider economy. Another issue is whether the US housing recession will spill over into the euro area. In the past, housing shocks were transmitted across the Atlantic. Will it happen again?
The first thing to note is that there is a high correlation between house prices in the US and in Europe, and especially with France and Spain. In a recent analysis, Deutsche Bank producing a scoring model to identify the sensitivity of European house prices to change in US house prices, and concluded that Ireland and Spain are most vulnerable to a slowdown in US housing. They conclude that any bad news from the world economy will not be compensated by housing, as happened in 2001, when the housing market arguably went to the rescue of the US economy. “If anything else is going awry in the world economy, don’t call for the housing markets to save the economies again. They are not waiting in the wings this time,” Deutsche Bank concludes.
In a comparison between the US and the euro area housing markets, Daniel Gros from the Centre for European Policy Studies in Brussels notes that there are strong similarities between the two:

Two important characteristics of the housing market are actually quite similar on both sides of the Atlantic: Home ownership rates are similar in the euro area (64%), Nordic countries (62%) and in the US (68%). Another similarity between the eurozone and the US is that, as a rule of thumb, families invest often 6-7 times their annual income in housing. This implies that a movement of housing prices of 10 % can have a very strong impact on actual or perceived wealth. For the cash-constrained part of the population, a fall in housing prices, of say, 10%, could thus be equivalent to a loss of more than one- half of one’s annual income, with a correspondingly strong impact on consumption demand.
The key difference lies in the potential for extracting one’s equity investment in housing, which is much lower in most euro area countries than in the US. This difference is partially due to differences in the transaction costs associated with mortgage loans (and their re-negotiation), but also due to the different levels of indebtedness of euro area consumers. In the euro area, mortgage loans amount to around 30% of GDP, compared to over 60% of GDP for the US.

There is some debate over whether the we can talk about a Euro Area housing market in the first place, or whether housing is a purely regional phenomenon. There are some signs of overheating in Ireland, Spain and France. For example, there never has been a housing bubble in the US mid-West, nor has there been a bubble in Germany, for similar reasons. In both countries/regions supply has expanded and contracted with demand.
But Spain and Ireland are in a different category altogether. Since 1996, Spanish houses have appreciated by 150%, and Irish prices by 300%. The Irish boom was driven by the following factors: a dramatic fall in nominal and real interest rates after the adoption of the euro; financial deregulation and ready availability of mortgages; large and persistent demand for Spanish property from norther Europe, and a trend according to which young people are buying first homes. In another note on Spain (see below) Daniel Gros notes that construction constitutes 17% of GDP, compared to a normal level of around 8% in most industrial countries. Germany experienced a similar though not nearly as dramatic shift in the post-unification construction boom in the early 1990s. Gros argues that a normalization in Spain would lead to a long period of below-par growth. It may also be accompanied with a sharp decline in house prices.
The Bank of France in its quarterly selection of articles Autumn 2006 also published an analysis of real estate prices, on the basis of the three indicators, affordability, the rend-vs-buy trade-off from the demand side, and buy-to-let analysis on the supply side. The conclusion is that home prices in France and Spain are significantly overvalued on the basis of these criteria.
Taken together, the literature suggests that there is significant evidence of co-movement of property prices in the US and in the euro area, and that based on a number of different types of analysis, various European property markets seem strongly overvalued, with France, Spain and Ireland being mentioned most often.
Below are two relevant documents for downloading, the ECB monthly report Feb 2006, which contains an article relating to the measurement of euro area house prices, and the European Commission's Quarterly Report on the Euro Area (1/06), which contains an article on property price developments in the euro area. Further reference, including those used in the article are given below.