Real estate booms and busts can have far-reaching consequences. These booms are generally accompanied by fast credit growth and sharp increases in leverage, and when the bust comes, debt overhang and deleveraging spirals can threaten financial and macroeconomic stability. These dangers notwithstanding, the traditional policy approach to real estate booms has been one of “benign neglect”. This was based on two main premises. First, the belief that, as for other asset prices, it is extremely difficult to identify unsustainable real estate booms, or “bubbles” (sharp price increases not justified by fundamentals), in a timely manner. Second, the notion that the distortions associated with preventing a boom outweigh the costs of cleaning up after a bust. The recent crisis has challenged (at least the second of) these assumptions.
The bursting of the real estate bubble in the U.S. led to the deepest recession since the Great Depression, and quickly spread to other countries; in particular those with their own home grown bubbles. Traditional macroeconomic policy rapidly reached its limits, as monetary policy rates approached the zero bound and sustainability concerns emerged on the fiscal front. Despite the recourse to less standard policy tools (ranging from bank recapitalization to asset purchase programs and quantitative easing), the aftermath of the crisis has been characterized by a weak recovery, as debt overhang and financial sector weakness continue to hamper economic growth.
It remains true that bubbles are difficult to identify with certainty. But this task can be made easier by narrowing the focus to episodes involving sharp increases in credit and leverage, which are, after all, the true source of vulnerabilities. While early intervention may engender its own distortions, it may be best to undertake policy actions on the basis of a judgment call (as with inflation) if there is a real risk that inaction could result in catastrophe.
CONTENTS
I. Introduction
II. The Case for Policy Action on Real Estate Booms
III. Policy Options
A. Monetary Policy
B. Fiscal Tools
- Transaction taxes
Property taxes
Mortgage interest tax deductibility
C. Macroprudential Regulation
- Higher capital requirements/risk weights
Dynamic provisioning
Limits on loan-to-value and debt-to-income ratios (LTV and DTI)
IV. Model-Based Evaluation of Policy Options
- Effectiveness of monetary policy
Effectiveness of fiscal policy
Effectiveness of macroprudential policy
V. Conclusion
References
Appendix
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How to Deal with Real Estate Booms: Lessons from Country Experiences
