Dealing with Housing Booms and Busts Deniz Igan, IMF-Research LIME Workshop Brussels - December 8, 2012 Disclaimer: Views expressed in the presentation and during the talk are those of the presenter and should not be ascribed to the IMF.

Before the crisis… Monetary policy to focus on inflation and output gap (exclusively in AE, more flexible in EMs) Asset prices a concern only through their impact on GDP and inflation Benign neglect approach to boom/busts: Bubbles difficult to identify Costs of clean up limited and policy effective Better clean up than prevent

Then came the crisis… Bust had enormous consequences Standard policies rapidly hit their limits Limited effectiveness of less traditional policies Large fiscal and output costs

Need to Reconsider Consensus Benign neglect approach may be dead But, problems and trade offs with more interventionist strategy remain: Bubbles difficult to detect in real time Risks associated with pricking bubbles Traditional policies may be ineffective And have large costs

Booms in housing markets are particularly dangerous Not all asset-price booms should be target of policy But how to choose? Some consensus emerging that culprit is leverage (Nasdaq crash was fine) Housing markets are special: Leverage (link to crises) Large storage of wealth Major supply-side effects Network externalities

Boom, Leverage, and Defaults

Real Effects of House Busts

Leverage and Link to Crises: Current Episode Booms, Financial Instability, Macroeconomic Performance Followed by … Boomsystemic banking crisis significant drop in real GDP growth eitherboth Real estate53%77%87%43% Credit67%78%93%52% Real estate but not credit 29%71% 29% Credit but not real estate 100%75%100%75% Both61%78%91%48% Neither27%18%45%0%

Bottom line Strong association between real estate boom-busts and financial crises/recessions Leverage is key What to do? Monetary policy Fiscal tools Macro-prudential measures

General Points When to take action Deviation from yardsticks (price-income, price-rent, leverage, credit growth) Bubbles difficult to spot but many policy decisions are taken under such uncertainty Objectives Prevent unsustainable booms and leverage buildup Increase resilience to busts No silver bullet Broader measures: hard to circumvent but more costly Targeted tools: limited costs but challenged by loopholes

Monetary Policy Make borrowing more expensive and may limit leverage and risk taking But: Too blunt: costly for the entire economy (unless in context of general overheating) Issues for small open economies Effect on speculative component may be limited Panel VAR suggests impact on house prices at considerable cost to GDP growth 100 basis points reduce house price appreciation by 1 but also lead to a decline of 0.3 in GDP growth

Fiscal Tools Debt-financed ownership favored: allow deductibility of mortgage interest (DMI) do not tax imputed rents and capital gains fully But: No link between favorable treatment and the crisis Cyclical use is difficult and violates tax smoothing Evidence: Structurally, removal of DMI may help reduce leverage Cyclically, transaction taxes may help during busts less so during booms with impact falling on transaction volumes rather than prices

Macro-Prudential Tools Most ‘experiments’ in emerging markets, particularly Asia Common tools: Maximum LTV/DTI limits Differentiated risk weights on high-LTV loans Dynamic provisioning Discretion rather than rule-based Mixed evidence on effectiveness

Could macro-prudential tools have prevented crisis in EuroZone? Greece and (to lesser extent) Portugal classic fiscally driven crises: Large fiscal deficits Relatively low growth (and very low productivity growth) Large current account deficits But Spain, Ireland, Latvia different Prudent fiscal (at time of crisis, plenty of fiscal room) But buoyant private sector Asset price bubbles and credit booms Large current account deficits (especially Spain/Latvia) Common currency a constraint for all

Spain: Cannot stop a herd, but… Dynamic provisioning in place since July 2000 Housing demand shock (immigration and foreign investors): Rapid growth in prices and credit Construction boom Lack of monetary/ER instruments Bubble burst in 2007: Dynamic provisions accounting on average for 10% of net operating income of banks Total accumulated provisions cover 1.3% of consolidated assets while capital and reserves stand at 5.8%, providing some buffer

Tentative Lessons Ensuring financial resilience and avoiding boom-bust cycles are not mutually exclusive Macro-prudential policy still in its infancy Pragmatic and discretionary, mobilized within existing institutional frameworks, targeted at specific markets Some evidence of temporary cooling effect on markets and building enough buffers for bad times Too early to judge impact on aggregate cycles and interaction with other policies

Tentative Policy Taxonomy Macro-prudential tools first line of defense Target leverage Strengthen balance sheets Monetary policy definitely to be involved when there are other signs of overheating Fiscal tools hard to use cyclically But removing distortions may help at the structural level

Important Open Questions Who does what? Where should macro-prudential authority reside? Relationship among policies To what extent are these independent tools? Rules versus discretion Far away from IT standards Risks associated with excessively interventionist policy Challenges from political economy perspective Preventing circumvention and risk shifting

Hong Kong: Limited effectiveness of LTV limits

Korea: Effective LTV limits, but difficult calibration?