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Home Publications Blogs Beat the Press The Reason God Created Central Banks

The Reason God Created Central Banks

Friday, 20 July 2012 16:25

Matt Yglesias notes the housing bubble in Canada and then asks what the Canadian government could do about the bubble. His point is that it would be enormously unpopular if the government deliberately took steps to burst the bubble.

This is of course true and it is one reason why the government should have acted years earlier to prevent the bubble from getting as large as it did. However there is another actor that doesn't appear in Matt's story, the Bank of Canada. The official story on central banks is that they are supposed to be independent so that they can do what is best for the economy without fear of the immediate political repercussions.

As a practical matter, central banks tend not to be independent of political influence, especially from the financial sector. However it is reasonable to ask why the central bank is not doing what it is supposed to do. Suppose the Bank of Canada announced a 1 percentage point increase in the overnight money rate and that it would continue to increase interest rates until house prices fell by 30 percent, or whatever amount it considered appropriate.

It is difficult to believe that this policy would not quickly deflate the bubble. This may not be pretty (if the bank had been awake it would have done this 5 years ago), but it would be better than letting the bubble just continue to grow. And what is the Bank doing that is more important, targeting 2.0 percent inflation?

Comments (9)Add Comment
written by Brito, July 20, 2012 4:45
Maybe there is a bubble, but it sure as hell doesn't look like one in that graph, maybe because it only goes back to 2000. But bubbles are normally exponential looking, this just looks like a linear trend.
written by anthrosciguy, July 20, 2012 6:48
Here's some further charts showing prices from longer ago. There's a bubble.

written by Dave, July 20, 2012 6:54
From a Canadian, a few things to consider:
- the graph obscures the fact that the major rise in Canadian r.e. has occurred in BC and Ontario: the former reflects a growing cohort of affluent immigrants, the latter of their children attending university. A lot of this is Chinese, but not exclusively.
- we live up to the stereotype in that our central bank has a great deal of credibility to us. The tradition here, and embodied by Mr. Carney, is that they really do tend to be the 'smartest people in the room'. A month and a half ago they eliminated CMHC (gov't) insurance of mortgages of 1mil+ and shortened the amort. rate. Coincidentally, we had a meaningful drop in activity by the next round of numbers - of course the market does not react instantly, but like I said, we do take what Mr. Carney says about debt levels and ltv seriously, as corny as that sounds nowadays.
- we are a stable currency union bordering a vary large stable currency union, like Hong Kong or thr UK. We're not talking apples to apples here.

Love the blog, you, Krugman, DeLong, and Alphaville are royalty of the menschocracy!
written by JSeydl, July 20, 2012 7:24
I wish Scott Sumner and all those strange MMers would get this point. Oh wait, I forgot that they don't believe in asset bubbles because they believe in efficient markets. This is like believing in the rise of Jesus after his body was dug up near Jerusalem; it's a false belief.
The Fed is primariy interested in the Short Term Health of Banks
written by Doc at the Radar Station, July 21, 2012 6:35
The Fed is primarily interested in the Short Term Health of Banks. So, when (yet another) asset bubble inflates it's profitable for banks in the short term to dole out the loans, whether they are wise in the long term or not. I think that persistently low rates are bad (there has got to be other ways to improve aggregate demand, employment, and raise inflation). Also, shadow banks can provide low rates in the market despite what the Fed wants. In essence, we are borrowing the "forced" savings of CA surplus countries to sustain AD. I think the solution is capital controls, import/export certificates (or similar) to get the trade deficit down, and reflation of the economy to get interest rates higher at full employment. Then the asset price instability and bubbles should stop.

I think JW Mason has a very interesting post here about interest rates:
Interest Rates and (In)elastic Expectations

"...But the conclusion, then, is not to accept a depressed real economy as the price of stable interest rates and asset prices, but rather to "tune" aggregate demand to a higher level of nominal interest rates. One way to do this, of course, is higher inflation; the other is a higher level of autonomous demand, either for business investment (the actual difference between the pre-1980 period and today, I think), or government spending..."
What's a country supposed to do about a house price boom?
written by LSTB, July 21, 2012 8:14
Dean has a good short-term answer, as does Miles Kimball (http://blog.supplysideliberal.com/post/27673561271).

What surprises me is that Yglesias recently extolled the wonders of land value taxation but doesn't apply it here. Henry George pointed out, beyond Ricardo, that taxing zero-sum economic activities such as land speculation was highly beneficial because it forces capital to move towards activities that produce real value. Given that housing bubbles aren't caused by the physical houses themselves appreciating in value but by the land they sit on, taxing away the speculative benefit would appear the appropriate solution. Then again, oddly, Yglesias has shown no knowledge of Henry George or the single tax movement.
written by liberal, July 21, 2012 11:48
LSTB wrote,
Given that housing bubbles aren't caused by the physical houses themselves appreciating in value but by the land they sit on, taxing away the speculative benefit would appear the appropriate solution.

Damn straight!

Then again, oddly, Yglesias has shown no knowledge of Henry George or the single tax movement.

I used to read his blog before it moved. It was never clear to me whether he knows about HG; certainly he never seemed to mention him.
written by skeptonomist, July 21, 2012 3:03
The Fed raised federal funds rate from 1% in June 2004 to 5 1/4% in July 2006 - did this safely deflate the US housing bubble?

If God created central banks He did not endow them with supernatural powers. And would Alan Greenspan with supernatural powers be a good idea?
written by skeptonomist, July 21, 2012 6:18
What to do about a house price boom? Regulate finance so that irresponsible mortgage lending does not build up in the first place. Lenders were allowed to offer impossible-to-pay mortgages on the absurd assumption that prices would always rise. Derivatives gave the illusion that the bundled mortgages were safe. There will always be local land bubbles, but last time was the result of very serious systemic flaws. Very little has been done about the things which led to the world-wide bubble.

The answer is not for impossibly unselfish and objective Maestros to step in and blow some sort of magical whistle - the system must be set up to be stable under the administration of human beings.

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About Beat the Press

Dean Baker is co-director of the Center for Economic and Policy Research in Washington, D.C. He is the author of several books, his latest being The End of Loser Liberalism: Making Markets Progressive. Read more about Dean.