Why we must not rely on the housing market to fuel the COVID-19 recovery

Photo by Tom Rumble on Unsplash

By Charles McIvor

This blog is a contribution from one of IIPP’s Master of Public Administration (MPA) students based on one of their assignments. To find out more about the course, click here.

A s COVID-19 continues to put pressure on economies around the world, governments and central banks are seeking new ways to encourage investment in the ‘real economy’ as part of the recovery efforts. However, unless investments are structured effectively, the support that they provide could be wasted on investments in real estate rather than tackling inequality, boosting innovation, or creating more sustainable economic recovery.

High house prices can limit investment in the rest of the economy. When house prices increase faster than wages do, mortgages can bridge the gap and help people buy a home. If people spend more on housing, they have less in their pockets to spend in the rest of the economy.

Less spending in other sectors means businesses earn less, and can’t increase their workers’ salaries. This in turn increases demand for bigger mortgages, which increases competition for houses. However, if the supply of housing cannot increase fast enough (or hits a limit because land is finite — especially in cities) house prices continue to rise. Banks can restrict the supply of mortgages to end this vicious cycle, but they see houses as profitable investments so they continue to lend.

To explore how this vicious cycle plays out in practice, I will look at the case study of Canada. The chart below shows that between 1990 and 2018 there was a 93% increase in the new home price index. At the same time, average real incomes only grew by 21%. This has resulted in household credit to household disposable income increasing from 87% in 1990 to 177% in 2018.

Index of house prices and real incomes (1990–2018)

Sources (author’s calculations): national house price index, average income

With an increasing percentage of income going towards mortgage credit, less money has been available to spend on goods and services in other sectors of the economy, so businesses have had less to invest. The chart below shows that business investment as a percentage of GDP rose along with mortgage debt as a percentage of GDP from 1995 to 2006, and then stagnated when mortgage debt skyrocketed following the financial crisis in 2008. Business expenditure on R&D also plummeted at this time because it follows a similar trend to investments in the real economy overall (except during the tech bubble in the late nineties).

Mortgages and business investment in Canada (1990–2018)

Sources (author’s calculations): mortgages — national balance sheet, gross fixed capital formation, business expenditure in R&D (BERD)

The real-estate sector is absorbing all of the savings households have made from not buying other things during the pandemic, leaving less to build back the ‘real economy’. While overall credit borrowing is down in Canada, demand for mortgages has continued to rise — almost completely cancelling out the decline in non-mortgage and consumer credit borrowing. Like in 2008, banks are continuing to lend for mortgages, because they are safe bets. While the construction industry is an important employer, the government must look to increase employment in other sectors and boost demand across the economy.

In recent months the Bank of Canada has started using quantitative easing for the first time, buying $5 billion of assets a week. This provides a huge opportunity for it to support a stronger economic recovery. While much of the talk around conditionality for government support has focused on government loans and investment, less focus has been placed on the conditionality of central banks.

As Canada begins using quantitative easing, it should learn from the United States’ experience in responding to the 2008 financial crisis. The US intended to increase private spending by buying assets, replacing them with central bank reserves, which increases the price of assets, increases the capital gains that can then be spent or loaned, and then this stimulates the economy. In 2008, the idea was that the financial sector was starved for cash and so buying its bonds and securities, while increasing its reserves, would increase the supply of loans for cash strapped firms and households.

But because there was no conditionality on this support, most of the financial sector played it safe and invested in existing assets, like property. In reality the problem wasn’t the supply of funding for loans per se but high unemployment, which meant that there was less consumption and lower demand for loans from both households and firms.

To boost consumption in areas beyond real-estate, the can UK use ‘financial guidance’ from central banks to support priority areas, like green infrastructure. This idea builds on a recent IIPP working paper which suggests central banks and state investment banks steer credit into “more desirable areas of the economy”.

For the Bank of Canada, this would mean using credit guidance to limit the supply of credit that banks extend to the real estate sector, encouraging lending at lower rates for investments in other sectors, or mandating a certain proportion of credit on banks’ balance sheets flows to sectors other than real-estate. It could also focus on buying assets in sectors that support a sustainable economic recovery.

Critics will tout the independence for the Bank of Canada. However, it provided credit guidance like this in the 1950s, but since then it has played a less activist role. Perhaps the time has come to revisit these tools to ensure that the recovery from the COVID-19 crisis is based on productive investment, rather than an unsustainable housing boom.

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