I’m curious why governments around the world are fond of pursuing higher house prices as economic policy. Not that I have anything in principle against higher house prices. I understand why governments want to do it, housing is an important concern for many people and a significant contributor to an economy. But all of that is wasted if the policies stimulate a housing bubble that eventually bursts leaving people poorer because their main asset drastically falls in value. But I’m concerned that governments introduce significant economic risk to the whole economy by promoting housing bubbles. We saw this with the recent Great Recession that consumed the US and much of the world in 2008-09. Yet governments continue to inflate housing bubbles. In the end, we are worse off when a housing bubble pops. I’m no ‘economic girly man‘ when it comes to risk, but surely as stakeholders in the global economy (and voters, depending on where you are) shouldn’t we be cognisant of the risks that our governments introduce? That way if we know about it, we can demand our governments to manage or even prevent these risks. This post will attempt to identify the key ways that governments have introduced risks into our economies in order to stimulate housing bubble.
The most obvious way that governments have created housing bubbles is by adopting ‘loose’ monetary policy – i.e. hold interest rates for a prolonged period. The Federal Reserve has been criticised by the Nobel Prize winner, Joseph Stiglitz, for maintaining an ‘easy’ monetary stance in the period before the 2008 Great Recession. The then Federal Reserve Governor, Ben Bernanke, and his predecessor, Alan Greenspan, vigorously rejected this claim. They argued that ‘exotic’ loan products (e.g. adjustable rate mortgages or ARMs) dampened the effectiveness of monetary policy in deflating housing bubbles. In other words, if the Fed raised rates, the increase in rates may not be transmitted to borrowers and lenders. This may be the case in the US that has a bewildering array of financial products. But in economies with less sophisticated or more regulated financial sectors, the link between monetary policy and mortgage rates is still strong (e.g. Australia). Besides, the use of monetary policy to target one asset class may be a blunt instrument; while it may deflate a housing bubble it may also drive the rest of the economy into recession.
A more direct way that governments can create a housing bubble is by subsidising mortgage interest payments. In the US they are called interest deductions and negative gearing in Australia. By subsidising interest payments, governments are effectively making borrowing (or gearing in financial jargon) cheaper which would obviously encourage people to take on more debt to purchase houses. By encouraging gearing, this also increases demand which in turn leads to higher house prices. In that sense, it is a very effective policy instrument to increase people’s wealth. However, it does have a few negative consequences. First, it encourages borrowers to take on more debt which in turn increases the borrowers’ risk in the event of an unplanned economic event such as unemployment or higher interest rates. Second, the subsidy, while not an explicit cash transfer is still considered an expenditure. In the US, mortgage interest deductions cost the US government $US80 billion in 2008. Third, subsidising mortgage interest has regressive impacts on economic inequality by transferring tax savings to high wealth individuals who are able to benefit from interest deductions or negative gearing. Higher wealth individuals are able to obtain larger loans and therefore gain the greatest tax benefits from the interest deductions.
Similarly, tax exemptions for capital gains reinforce the demand-stimulating and risk-increasing impacts of interest subsidies. For example, in Australia, a house considered a ‘main residence’ is capital gains tax free. For investment property, if it is held for more than one year, the capital gains is reduced by 50%. Similar exemptions apply in the US. Capital gains exemptions not only increase demand and prices, but also distort investment decision-making from other asset classes to property. In the extreme, subsidising debt could deprive capital from productive sectors of the economy towards speculation in established housing stock. There seems to be some evidence of that occurring in Australia.
Attempts to improve housing affordability have perverse impacts on prices and risk. The Community Reinvestment Act (CRA) has been criticised for being a main cause of the Great Recession. The CRA mandated that financial institutions ensured a specific proportion of their mortgage portfolio was allocated to marginalised communities (e.g. low income individuals). This had the perverse effect of increasing the risk profile of mortgage lenders or the loans they securitised and sold to institutional investors. Furthermore, the government sponsored mortgage lenders Fannie Mae and Freddie Mac became dominant lenders in this segment which drove commercial lenders to lower their lending standards to the extent they provided no-doc and no cash down loans. Lowering lending standards resulted in increasing the risk of bank’s mortgage portfolios and, as it turned out, wider economic risks.
Until now, we have discussed ways that governments can increase demand for housing. Governments can also affect the supply of housing by restricting the supply of land or imposing delays on development through an intensive approval process. Usually, these restrictions are imposed at the local government level who have responsibility for land use planning. These land use restrictions are often introduce to protect the property value of current owners at the expense of new residents and developers.
This post is by no means comprehensive. We haven’t even touched on lax enforcement of financial sector regulation, short-term incentives in banks or the preferential treatment of mortgages under Basel rules. Nevertheless, I hope this post has given you a better understanding on how governments may be contributing to the next housing bubble. By understanding the dynamics of a housing bubble, maybe you can act to protect your family from a crash. To be forewarned is to be forearmed.