Canada's Housing Bubble

May 11, 2010 financialexpress.com

In America policymakers are too busy coping with the aftermath of the last housing bubble to worry about preventing the next one. But elsewhere in the world, things are different. In China’s cities, house prices rose by 11.7% in the year to March, according to official estimates, and by much more, according to unofficial ones. That is one reason why the central bank raised reserve requirements (the share of deposits banks must keep in their vaults) on May 2nd for the third time this year. In Canada, the Canadian Real Estate Association calculates that homes were worth 17.6% more in March than a year earlier, taking them well above their pre-crisis peak. And down under home values only seem to go up, rising by 20% in Australia’s eight state capitals in the first three months of this year, compared with a year earlier.

How should policymakers respond? In a December speech, Adam Posen, an economist who sits on the Bank of England’s rate-setting committee, complained that policymakers need a bigger toolkit. Before the crisis many central bankers believed that all they needed was a “hammer” (interest rates) to strike a “monetary nail” (consumer-price inflation). But not every problem is a nail. Policymakers also need a full set of “macroprudential” tools, from wrenches to duct tape.

To fix housing bubbles, Posen suggests, policymakers should consider a tax on real estate that varies over the cycle, rising in property booms and falling in busts. His suggestion echoes an idea proposed a year earlier by Olivier Jeanne of Johns Hopkins University. According to Mr Jeanne, debt, including mortgage debt, is like pollution. It imposes costs on others that the borrower fails to take into account. The right response to an externality of this kind is to tax it—to make the polluter pay.

In a preliminary paper*, he and Anton Korinek of the University of Maryland spell out the logic further. When people borrow to buy houses (or any other asset), they push up the price. This raises the value of the collateral against which borrowing is secured. It then becomes easier to borrow to buy homes, which pushes prices even higher. This “financial accelerator” (a term coined by Ben Bernanke, now chairman of the Federal Reserve, and Mark Gertler of New York University and Simon Gilchrist of Boston University) operates in reverse during a downturn. Falling prices erode the value of collateral, tightening credit and depressing...