Housing bubbles worldwide will test a big lesson from the financial crisis

Can you slow housing prices without raising interest rates?

(Mike Cassese/Reuters)

Bank of England Governor Mark Carney is concerned about the “prospective evolution of the housing market.” That’s the rhetorical flourish central bankers use to say that they think they’re sitting on something that’s starting to resemble a bubble. You might recall such a figure of speech being deployed by Carney in mid-2012—one of many examples— when the governor announced measures intended to ensure the “sustainable evolution” of the housing market. Only, back then he was the governor of the Bank of Canada, a position he left in June after being poached for the top job at Old Lady of Threadneedle Street.

The new gig must feel a lot like the old one. Property prices in central London are now well over 10 times average earnings, and just around 10 times are great as prices in the suburbs. Prices in the rest of the country haven’t reached their pre-crisis peak, but, as Alen Mattich of the Wall Street Journal notes, the greater London area is home to fully one-fifth of the British population. Across the country, households with debt five times their income make up 20 per cent of the mortgage market. The governor, then, is back to his old task of trying to let the air out of the bubble gradually (he likes to call it a “constructive evolution”), without triggering a pop and without raising interest rates. But this isn’t only Mark Carney’s curse. Central bankers and finance ministers in Norway, Israel, Switzerland and New Zealand, to cite a few, are trying to pull off the same trick. Their efforts are testing one of the big lessons the West thought it had learned from the financial crisis: That you can use regulations alone to tame bubbles.

That lesson came from Asia. Well before the financial crisis, Hong Kong, South Korea and others had started regulating and supervising the financial system as a whole, rather than focusing on single banks and financial institutions. After the collapse of Lehman Brothers, cold-sweating Western eggheads started to pay attention. Low interest rates had helped fuel the disastrous U.S. housing bubble, but the midst of the worst recession in half a century was no time to raise them. How to keep monetary policy loose without fuelling new bubbles and borrowing binges? By using regulations to toughen financial conditions in certain trouble areas even as low interest rates kept propping up the rest of the economy.

Countries that, like Canada, emerged relatively quickly and unscathed from the Great Recession seem set to be the testing ground for this new kind of thinking. We weathered the storm well because of our tightly-regulated banks and soon returned to growth. Our interest rates, though, have been very low for years. A number of foreign investors have lent us their prized savings because we seemed a safe place to put their money. And a number of our local residents have been borrowing merrily, feeding various housing booms. Norway, Israel and other have similar stories. Great Britain had a much rougher ride in the aftermath of the financial crisis, but London is still one of the favourite hangouts for the world’s super-rich, so property prices there have been skyrocketing anyway.

With growth still sluggish, though, no one is eager to hike up interest rates, which would raise borrowing costs for everyone, not just homebuyers, and hurt exporters by tilting up the exchange rate. So we’re all trying the alternate approach. Here in Canada, Jim Flaherty has tightened mortgage rules on government-insured mortgages four times since 2008. The Office of the Superintendent of Financial Institutions, Canada’s financial watchdog, has toughened underwriting standards and is contemplating a few more targeting uninsured mortgages. So far, though, this seems to have simply slowed the pace of housing prices and household debt growth. Both are still rising. Around the world, similar maneuvers have produced similarly iffy results.

Maybe the key is to be a lot bolder. Maybe Canada should do more to limit the use of CMHC insurance, as the IMF suggested this week. CMHC was meant to provide government backing for risky mortgages made to Canadians who wouldn’t have qualified for one otherwise. In recent years, though, banks have been using CMHC insurance to cover portfolios of low-risk mortgages, which are then repackaged as bonds often sold to foreign investors. In general, the IMF said, extensive access to CMHC insurance provides an incentive for banks to pump too much capital into the housing market and lend to little to, say, businesses that want to expand and upgrade.

For now, the jury on whether tighter rules are really a substitute for tighter monetary policy is still out. Managing a prolonged period of low interest rates without creating dangerous asset bubbles would be the equivalent of the proverbial having your cake and eating it too. As we all know, it doesn’t work in the world of physics. Whether it will in the world of finance remains to be seen.

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