The resource mis-allocation problem during credit booms

FT chronicles the success of Jon Gray, the head of Blackstone's real estate business, which has made the private equity firm the largest real estate owner in the world,

Blackstone owns more offices in the US and India than anyone else. It is also the largest residential landlord in the US, with a portfolio of 50,000 rental homes that it would like to take public by next year... When Mr Gray joined Blackstone in 1992 straight from college, the young firm had only $1bn under management; today it has about $335bn. He is responsible for the greatest part of that pile of money, entrusted to find profitable opportunities for the $100bn he has received from investors. Mr Gray’s business has made as much money as all of KKR, a rival in private equity, in the past three years. And he can boast of 17 per cent annualised net gains over 25 years, according to public filings from Blackstone... (In India) has since (2011) invested a total of $1.2bn. Some of purchases came from developers who were forced to sell, either because of regulatory pressure or as a way to raise badly needed cash. Acquisitions included a partially completed Goldman Sachs project in Bangalore. Today Blackstone is the largest owner of office parks in the country, often bought at bargain prices, with a market value of $4.2bn.

Buoyed by cheap debt, PE firms in general have been very large investors in real estate,

Blackstone and the other alternative investment groups have been among the biggest beneficiaries of the US Federal Reserve’s quantitative easing policies. Low borrowing costs, combined with depressed asset prices, were a godsend for these companies, whose lifeblood is debt. The Fed’s policies may not have led to a robust economy, but they were the major reason asset prices in financial markets — including property — recovered so quickly.

This is a clear example of the resource misallocation towards low productivity growth and high pledgeability sectors (like construction and real estate) that happens when credit is plentiful. I have blogged about this earlier. In this context, Claudio Borio and the folks at BIS examined a sample of 21 countries over the period from 1969 and have these findings,

First, credit booms tend to undermine productivity growth as they occur. For a typical credit boom, a loss of just over a quarter of a percentage point per year is a kind of lower bound. Second, a large part of this, slightly less than two thirds, reflects the shift of labour to lower productivity growth sectors – this is the only statistically significant component. Think, for instance, of shifts into a temporarily bloated construction sector. The remainder is the impact on productivity that is common across sectors, such as the shared component of aggregate capital accumulation and of total factor productivity (TFP). Third, the subsequent impact of labour reallocations that occur during a boom is much larger if a crisis follows. The average loss per year in the five years after a crisis is more than twice that during a boom, around half a percentage point per year. Put differently, the reallocations cast a long shadow. Taking the 10-year episode as a whole, the cumulative impact amounts to a loss of some 4 percentage points. 

This is a clear market failure and one which requires regulatory action. It is also a strong reminder of the need to have robust macro-prudential norms and even some form of capital controls during credit booms that can prevent such resource misallocations.