The run-up to the recent global financial crisis was characterised by an environment of low interest rates and a rapid increase in housing market activity across OECD countries. Some scholars argue that expansionary monetary policy was responsible for the low level of interest rates and the subsequent house price boom.2 Others contend that the low degree of financial development in emerging market economies led to capital inflows to developed countries, depressing long-term interest rates and stimulating an increase in the demand for housing.3 Figure 1 provides support for this hypothesis, showing that in the period from 1999 to 2006, house prices rose by more in countries with larger current account deficits. This negative correlation suggests the presence of an important link between the current account balance and the housing sector, but the direction of causality is unclear.

The effects of the shocks are greater in countries with a higher degree of mortgage market development. This suggests that excessive financial innovation may act as a propagation mechanism. The existence of mortgage-backed securities has a much larger effect on the transmission of capital inflows shocks. Legislation permitting the issuance of mortgage backed securities increases the impact of capital inflows shocks on real house prices, real residential investment and real credit to the private sector by a factor of two, three and five, respectively.