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Dealing with Real Estate Booms and Busts

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Abstract

The global financial crisis changed the way we view macroeconomic policy, especially in the context of housing and mortgage markets. The main policy tenet in dealing with a real estate boom used to be 'benign neglect' (Bernanke (2002)): better to wait for the bust and pick up the pieces than to attempt to prevent the boom. Two assumptions underlie this advice: the belief that it is extremely difficult to identify unsustainable booms, or 'bubbles', in real time and the notion that the distortions associated with preventing a boom outweigh the costs of cleaning up after a bust. But the crisis has shown that post-bust policy intervention can be of limited effectiveness, and thus the costs associated with a bust can be daunting. While early intervention may engender its own distortions, it may be best to undertake policy action on the basis of a judgment call if there is a real risk that inaction could result in catastrophe. Yet a call for a more preventive policy action raises more questions than it provides answers to. What kind of indicators should trigger policy intervention to stop a real estate boom? If policymakers were fairly certain that intervention was warranted, what would be the policy tools at their disposal? What is their impact? What are their negative side effects and limitations? What practical issues would limit their use? This short paper explores these questions. It should be recognized at the outset that there is no silver bullet. A more proactive policy stance can help reduce the risks associated with real estate booms, but will inevitably entail costs and distortions, and its effectiveness will be limited by loopholes and implementation problems. With this in mind, we reach the following conclusions. Policy efforts should focus on booms that are financed through credit, and when leveraged institutions are directly involved, as the following busts tend to be more costly. In that context, monetary policy is too blunt and costly a tool to deal with the vulnerabilities associated with increased leverage, unless the boom occurs as a result of or at the same time as broader economic overheating. Fiscal tools may be, in principle, effective. But in practice they would likely create distortions and are difficult to use in a cyclical fashion. Macroprudential tools (such as limits on loan-to-value ratios) are the best candidates to deal with the dangers associated with real estate booms as they can be aimed directly at curbing leverage and strengthening the financial sector. But their careful design is crucial to minimize circumvention and regulatory arbitrage. Further, they will entail a cost to the extent that some agents find themselves rationed out of credit markets. In what follows, we first give a summary of how real estate boom-bust cycles may threaten financial and macroeconomic stability. Then we discuss different policy options to reduce the risks associated with real estate booms, drawing upon several country experiences (a more detailed analysis of country cases is in Crowe et al (2011). We conclude with a brief discussion of guiding principles in dealing with real estate booms.

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