Stop the housing bubble before it’s too late

Here is the problem and these are the solutions.

Larry MacDonald 0

(Photo: Dennis Novak/Getty)

A friend of a friend recently drove to an empty lot with a trailer on it. Half an hour later, he put a down payment on a couple of condos that won’t be built for two to three years. I was told he wanted to sell them whenever he could get a higher price.

While anecdotal, such personal stories tend to bring home the fact that rank speculation seems to be in full bloom in the housing market. People are now signing agreements to purchase like they’re trading futures and options.

Just after hearing about the condo-flipper, I came across an article reporting on bidding wars in Toronto. One house listed at $650,000 attracted over a dozen bids and finally sold at a price of nearly $1 million.   

The Ottawa Citizen‘s Garry Marr offers a less anecdotal view that the housing bubble is indeed still alive and growing. His article finds evidence in surveys and statements from the Bank of Canada Governor that there is “a sense of desperation to buy now out of fear you won’t be able to buy later.”

I had been hopeful we weren’t headed toward a U.S.-style collapse in Canadian house prices, even taking housing bears such as Garth Turner and Ben Rabidoux to task in an April column, “Are house prices going to tumble?” Moreover, a buying binge was expected ahead of Finance Minister Jim Flaherty’s last round of mortgage restrictions back in March. So was a cooling off in the housing market afterward. But the latter doesn’t seem to be happening very much. If the housing bubble keeps inflating—and especially if the commodity boom were to come off the boil—the bears may well be proven right.

In a June 20 Toronto speech, Flaherty has said he has no further plans to tighten mortgage credit. He might want to reconsider that decision because past rounds of tightening don’t seem to have taken enough of a bite out of demand.

The Bank of Canada should also reconsider its stance on interest rates. Its policy of maintaining extremely low interest rates has been, in large part, responsible for fueling the current mania for housing. 

BoC Governor Mark Carney feels he doesn’t have to raise rates because inflation, as measured by the core Consumer Price Index (CPI) is still within target. But this is how the Federal Reserve in the U.S. was misled into maintaining an overly expansionary monetary policy that resulted in the U.S. housing bubble of the 2000s.

The U.S. core CPI was well behaved and lulled the Fed into thinking inflation was under control. But the measure did not include house prices. If it had, the core CPI would have been much higher and rung some alarm bells.

The Canadian core CPI similarly is not influenced by house prices. This suggests there is a risk the Bank of Canada may find it has gone down the same road as the Fed. The central banker thinks Canada enjoys price stability but house prices are beginning to look bubble-like.

At the very least, it might be prudent for the BoC to separately take into account asset prices when it sets monetary policies (as I’ve argued in past columns stretching back to 2007). We don’t want to fan debt-financed appreciation in the price of a major asset because when the escalation reverses, it can trigger a self-feeding spiral of debt defaults.

The second reason Carney is holding off on raising interest rates is fear they would increase foreign capital inflows, which would further drive up the Canadian dollar and correspondingly dampen manufacturing exports. But this fear may be misplaced.

A higher loonie comes with some perks, for one thing. For example, it lowers the price of capital equipment from foreign suppliers and allows Canadian businesses to increase productivity. But even if the loonie does fly higher, it will be self limiting: should the economy decline, history tells us the loonie will follow suit and reverse the dampening effect.

Alternatively, if the Department of Finance were to continue tightening mortgage credit, and to also withdraw some of the government’s past measures boosting the housing sector, it may not be necessary for the Bank of Canada to rein in a housing boom with higher interest rates. That would seem to be the best solution and would be least disruptive to the export sector.

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