References

The model has also implications for the relationship between the size of the bubble and the level of fnancial globalization. To see this more clearly, we can rearrange Eq. (4.12) and write the size of the bubble as

The frst term in Eq. (4.13) is the net demand of assets of the fnancially developed economy when R = 1, which, as we discussed, it is negative. The second term is the net demand of assets of one fnancially underdeveloped country at R = 1 multiplied by the fraction of fnancially underdeveloped economies participating in the international capital market (τ). As we have seen above, fnancially underdeveloped economies have a positive net demand of assets when R = 1 (i.e., AC (1) > DC (1)). That is, the frst term on the right-hand side of Eq. (4.13) is negative and the second term is positive. As fnancial globalization progresses (larger τ), the weight of the second term (the positive one) increases and, thus, the right-hand side of Eq. (4.13) rises. This means that, as fnancial globalization progresses, it becomes more likely that a bubble emerges (i.e., B(τ ) > 0) and, if the bubble already exists, it will raise its size.

Finally, as we have pointed out, the model cannot determine in which asset the bubble is going to be attached. However, if the bubble is attached to houses, the price of houses in the fnancially developed economy will be given by,

This equation is analogous to the price of houses in a fnancial underdeveloped economy derived in Eq. (3.10). B(τ) is the size of the bubble, which depends on the level of fnancial globalization (see Eq. 4.12) and σU(R) is the fundamental demand of housing. Note that for the case of the fnancially developed economy, this fundamental demand depends on the interest rate. This was not the case for the fnancially underdeveloped economy because the housing demand was determined by the borrowing constraint (Eq. R6). The choice of housing of agents in fnancially developed economies is not determined by this constraint. As we discussed, housing demand depends on the user cost of housing (the frst term into brackets in Eq. R5). It is easy to check (from Eq. R5) that if the interest rate falls, the user cost of housing falls and, thus, housing

B(τ) = AU (1) − DU (1) + τ AC (1) − DC (1) . (4.13)

p B(τ ) = B(τ) + σ U (R = 1)

1 1+ε

> σ U (R(τ ))

1 1+ε = p NB(τ ). (4.14)

demand increases. In other words, σU(R) is decreasing with the interest rate. Remember that if there is a bubble, the interest rate is equal to one, which is why we write σU(R = 1) on the left-hand side of Eq. (4.14).

4.3 An ApplicAtion: tHe us Housing BuBBle

We have seen that an increase in fnancial globalization raises both the probability that fnancially developed economies experience rational housing bubble episodes and its size. In the last part of this chapter, we want to apply the predictions of the model to the recent experience of the United States. Since we will be reviewing the US episode through the lenses of the model, we will exclude behavioral explanations. This does not mean that we think that there was no irrational behavior during this housing bubble episode. On the contrary, we believe that both explanations are relevant to fully understand the bubble episode. However, we focus on the rational component to see whether we can explain this episode without the behavioral dimension.

We start this chapter with the implications of the model on the current account of the United States between 1990 and 2015. The United States will be the fnancially developed country in the model. We will assume that the level of fnancial globalization rises over time. That is, τ = τ(t), where t is the year and τ′ > 0. That is, the fraction of fnancially underdeveloped economies that participate in international capital markets is increasing over time. To describe the evolution of the current account in the United States, we need to make an assumption on the evolution of bubbles over time. There is a general consensus that between the late 1990s and the late 2000s, the United States experienced two asset price bubble episodes: the Dot-Com Bubble and the Housing Bubble. We assume that the Dot-Com Bubble started in 1996 and it burst in 2000. The Housing Bubble started in 2002 and it crashed in 2006. As we have discussed in Chapter 2, there is no disagreement on the year in which the bubbles burst. There is however some discussion on the starting date of the episodes. In any event, the general consensus is these starting dates.

Given our simple model, the evolution of the current account defcit in the United States, as a function of the level of fnancial globalization is

CAUS (τ ) = AU (τ ) − DU (τ ) + B(τ ) . (4.15)