Deflating Housing Bubble Risks Recession

Seen in isolation,  Finance Minister Flaherty probably did the right thing yesterday in seeking to safely deflate the housing bubble and lower the dangerous growth of household credit to a record level as a share of household income.

But he did it very late in the game, and risks tipping an already very fragile economy into recession if he and the provincial governments do not ease up on fiscal austerity .

The government is dropping the maximum amortization period for CMHC insured mortgages from 30 years to 25 years, lowering the percentage of household income which is taken up to service an insured mortgage, lowering the maximum amount of insured mortgages to below $1 Million, and limiting the amount of home equity that can be withdrawn when refinancing.  The major impact is expected to be to lower demand for new mortgages for first-time buyers, which will take some steam out of an already slowing housing market, especially the condo market.

Clearly, Finance Minister Flaherty and Bank of Canada Governor Mark Carney are concerned about the steady growth of total household debt – now 151% of personal  income – and about the dangers of a further inflation of house prices.

I argued  back in February 2010 that Canada was clearly  experiencing a housing bubble, and David Macdonald issued a major report for the CCPA in August, 2010. At the time, bank economists and many others were pretty dismissive, even though our situation was little different than in the US before the collapse of their housing bubble back in 2007.

Mr. Flaherty should have tightened the rules much earlier before things got out of control. Recall that it was he who increased the amortization period for insured mortgages to an astonishing 40 years back in 2006, notwithstanding warnings from then Bank of Canada Governor David Dodge.

Yesterday’s very late move could be dangerous. If housing prices have already more or less peaked – as seems to be the case – then shutting out a significant number of new first-time buyers could lower prices significantly. If that happens, those who have recently bought in the run up to the peak will find themselves in a negative equity position, and they will be even more exposed if unemployment begins to rise. The end of the housing bubble will depress residential construction and sales, and also depress consumer spending due to negative wealth effects.

The macro economic impacts of a slowing housing market are the larger danger.  Over the past year, (Q1 2011 to Q1 2012) residential construction investment accounted for 23% of real GDP growth, with much of the remainder coming from growth in household consumption. The economy grew by a soft 1.8% over the past year, led by a 1.9% increase in consumer spending. The growth of net exports over the year was just 0.7%, while government spending was a drag on growth.

As residential construction slows and house prices fall, what will take up the slack? Business investment in the resource sector has been strong of late, but is not enough to carry the entire economy. Net exports are hardly likely to increase much given the global economic slowdown and the still very high Canadian dollar.

Over the past year, real government investment fell by 13.4% and government current spending fell by 0.1%. The IMF projects that the total Canadian government cyclically adjusted budget balance will contract by 0.7% of GDP this year, enough to depress growth by some 0.4% of GDP.

Mr. Flaherty was right to be alarmed about the housing bubble and the excessive growth of household debt. But, he must realize that removing one major source of growth and job creation is dangerous if he does not act to increase other sources of growth. Easing up on fiscal austerity – especially by boosting productive public investment – is the most obvious solution to hand.


  • I am certainly not opposed to productive public investment, but we need our economists to be promoting long term solutions. A vision of how we deleverage both public and private sectors so that the right amount and type of demand can be supplied. As per Steve Keen; what are the various ways to reverse the explosive levels of asset inflation that don’t take the system down altogether?

  • the timing of this policy is just another sign of how poorly the tories are in managing an economy. We could have waited a while more to see how much the economy slows due to the current instability of the world economy unraveling, which has a very strong likelihood of slowing our housing market . Now we will have two major forces acting on the housing sector and that is not how one carefully deflates the situation. I agree very much with your assessment Andrew- this expertise in this process is knowing the timing and right now is about the riskiest period I could have imagined to do all that he did. I could see maybe tweaking one item in the mortgage rules, and marrying that announcement with reductions in some of the austerity policies previously announced or how about a massive training initiative.

    Yikes. bad decisions here, too far and the wrong time. of course that is heaped on top of a whole pile of other bad decisions on the economy.

    Does anybody on the Hill actually read? Gees how can they get stuff this wrong?

  • The housing bubble has distorted the Canadian economy, and thus it was inevitable that whatever policy prescription was offered, homeowners would suffer, as would the economy itself. The time to act was in 2008-09, when it was already clear that we were in an bubble situation. Flaherty’s moves–and those of last year–were probably intended to provoke a “soft landing” for house prices, but it’s not clear that an asset bubble of the size being experienced by Canada lends itself to this kind of correction. If the IMF is to be believed, housing bubbles rarely lead to gentle correction; they deflate, usually quickly and brutally.

    Thus, I fail to understand why Andrew thinks it’s “dangerous” that the government’s move could “lower prices significantly.” This has to happen–and will happen eventually–no matter the prescription. Inflated housing values are dangerous: they encourage overbuilding, speculation, and overspending based on the housing wealth effect, all of which will disappear with a burst bubble. Yes, this will leave a massive demand hole in the economy, which only government stimulus–in the order of hundreds of billions of dollars–can fill. But the process of price deflation has to begin somewhere, and there is no way to reasonably protect homeowners as the process unfolds.

    It will be painful–but the danger now is not price decreases, but a mentality that housing can be “stabilized,” with all the concomitant bubble-generated overspending maintained.

  • The cost of living has increased this entire recession. Housing prices should never have increased. Now as with the US; Anthony many will claim buyers waiting for housing prices to fall will create dreaded deflation, maintaining the mentality of ever-increasing prices even when wages do not follow & match.

    In my opinion the sediment to further prevent prices from falling will result in the type of inflation that grows faster then wages, which will cause massive rates of unemployment, coincide with increasing costs from healthcare, maintenance, education, food & energy, which again wages, salaries, income will not cover unless your the top1%.

  • I see no risk of deflation–the bursting bubbles in the eurozone and the US did not lead to any. Housing prices generally rise in lockstep with inflation, but in the last few years diverged from that trend, and are now somewhere in the range of 50% to 75% overvalued (and keep in mind that that’s an average; some regions, such as Toronto, have seen greater bubble-generated price increases).

  • Inflation does not increase equally, otherwise the price of labor would be increasing faster then prices for goods in lockstep.

    My grandfather paid 8k (8000), for house with 5 acres, end of world war 2 with wages when they increased faster then prices made sense.

    Progressive often make the case were headed for Japan, or 1930 America. Problem they don’t, or attempt to explain Wiemar Germany, or Zimbabwe where increasing prices destroyed the fabri.

    The cost of living, is not the CPI which understates inflation, for example when housing increased it was not reflected, when housing falls, the CPI will reflect deflation. I dont have money saved to spend, others do not, yet prices this recession keep going up. I am getting slaughtered. Wage led inflation will not occur. no deflation in the US is wrong. Deflation is occurring at hyper rate in areas where Americans with debt such as a mortgage. Inflation as occured mainly elsewhere food, energy. Sure it creates a low inflation as an average but people dyin!

  • Progressive often make the case were headed for Japan, or 1930 America. Problem they don’t, or attempt to explain, to calm the fears of Wiemar Germany, or Zimbabwe where increasing prices destroyed the fabric of society. In those coutries inflation, distorted prices for labor, assets, goods, and services.

    Today the price of labor is weirdly low, the price of assets is weirdly high, the price of goods is weirdly high, the price of services is weirdly high. Maybe you’re a winner, you dont have these problems but you’re becoming the exception, look no further the income inequality.

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