As go home values, so goes the economy. But why?

Many agree with Bank of Canada governor Stephen Poloz when he says big-city house prices are too high. Even so, there are two different schools of thought—with wildly different outcomes—on how to handle the issue
By Ian McGugan

High anxiety: The more house prices rise, the scarier the prospects if they ultimately fall

Across the street from my family’s modest Toronto house, workers are building a condo tower. From Monday through Friday, the rumble of dump trucks and clank of bulldozers punctuates our breakfast. Mind you, we’re not unusual: the creaky clatter of industrial-scale building has become the theme music for our entire neighbourhood. Within a few blocks of where we live, at least seven massive condo projects are under construction.

What’s behind the building boom? I would like to say it reflects the exotic beauty of our little patch of Hogtown and its stunning economic growth, but neither is true. Our neighbourhood is unhip, unbeautiful and—until recently—un-rich as well. It’s been that way for decades. The outburst of construction appears to be fueled simply by buyers’ conviction that real estate prices will keep soaring higher.

As everyone knows, Canadian home prices have shot to the moon over the past two decades. In terms of the ratios of home prices to rents, or home prices to incomes, we’re far above historical norms. Optimists argue that growing incomes and low interest rates support the housing frenzy. I’m not so sure and Stephen Poloz, the Bank of Canada governor, shares my concern. He warned in early June that recent gains in Toronto and Vancouver home prices are unsustainable. For a central banker that’s an astonishingly frank warning.

The implications are scary. A look around the world suggests that household spending—and thus the economy—tracks the trajectory of home prices. You can point to many examples of countries, like Japan, the United States, Spain and Ireland, where consumers spent lavishly as home prices ascended, then clamped their wallets shut as home prices fell, leading to deep, long-lasting recessions.

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Surprisingly, economists still aren’t sure exactly why this pattern holds true. There are at least two schools of thought. One says the problem is too much debt; the other says it’s a matter of how housing affects our perception of personal wealth. Right now, the outlook for interest rates and the Canadian economy hinges on which theory our top policy makers choose to favour.

The first theory argues that real estate manias end badly because people borrow large amounts to buy homes. When prices inevitably weaken at some point, families have to slash spending until their personal balance sheets get back in order. That process can take years. So debt kills growth.

Richard Koo, a Nomura economist, has invented the term “balance-sheet recession” to describe what he believes happens in such downturns. His theory helps to explain why some calamities, like the collapse of the dotcom bubble, destroy huge amounts of wealth but have relatively mild effects on overall prosperity, while other mishaps, like the popping of the U.S. real estate bubble, devastate an economy for years. The difference is that few people borrowed heavily to buy Internet stocks. In contrast, lots of them went into hock to purchase homes.

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But maybe debt is not the entire story. Maybe it’s not even the main plot line. Dean Baker, the founder of the Washington-based Center for Economic and Policy Research, has long argued for the second school of thought noted above. He says the most important link between home values and economic growth is the so-called wealth effect.

When homes are growing in value, middle-class people feel rich. They spend freely as a result. When real estate values fall, the process goes into reverse. Baker says the key distinction between the end of the dotcom bubble and the end of the U.S. real estate bubble was how differently the two events affected the wealth of average households. The Internet slump didn’t inflict much damage on Mr. and Mrs. Middle America, or on the broad economy, because regular folks never bet big on the stock market euphoria. In contrast, the collapse of home values in 2006 clobbered the net worth of most working Americans. Their losses compelled them to slash their spending and that led to a broad, prolonged downturn. Or so the wealth story goes.

This debate about whether big recessions are caused primarily by debt overhangs or wealth effects may seem like an academic squabble to most people. However, the controversy has major implications for how Poloz and other Canadian regulators conduct themselves.

If the issue is too much debt, Ottawa should lean on banks to reduce lending. Policy makers should demand higher down payments on mortgages and impose stricter criteria for personal loans. Tighter lending rules—as well as an early rise in interest rates— would encourage consumers to throttle back on borrowing.

Here’s the catch, though: if Baker is right about the wealth effect, any measures designed to reduce debt could spark disaster. That’s because lower levels of borrowing would depress the real estate market, hurt the net worth of average people and lead to a steep fall in consumer spending. By trying to discourage debt, regulators could encourage recession.

If it’s the wealth effect that matters most, the Bank of Canada should do all it can to sustain asset values. It should keep interest rates low and encourage more borrowing to keep the economy chugging ahead. In short, it should do just the opposite of what it would do if too much debt is the problem.

In a recent survey of the academic evidence, Noah Smith of Bloomberg concluded that the bulk of the data appear to be lining up behind the wealth-effect theory of big recessions. Perhaps he’s right, but I’m glad I’m not in Poloz’s shoes. Pretty soon, he and other policy makers will be called upon to make some huge decisions. I hope they get it right—even it means more banging and hammering across the street.

Photo: Julie Gordon/Reuters

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