Paul Krugman has a nice post on the housing bubble in Canada. Needless to say, I strongly agree. It is painful how so many people refer to this downturn as the result of a financial crisis.

I have often posed the simple question of what would be different right now if we had not had the crisis but house prices were exactly where they are today. Would firms be investing more, would people be consuming more, would we see more building in spite of near record vacancy rates? It's hard to see the answer to any of these questions as being yes.

The failure to recognize the last housing bubble and its risks was an act of astounding incompetence by people in policy positions and really the economics profession as a whole. The failure to see the continuing risks posed by renewed bubbles should be enough to sentence these people to the sort of hardcore unemployment experienced by people with no marketable skills.

One item that Krugman misses in comparing household debt in the U.S., U.K., Canada, and the euro zone is that the overwhelming majority of the debt in the U.S. is 30-year fixed rate mortgages. The interest rate on these mortgages will not change if long-term rates rise by 2-3 percentage points as folks like CBO predict.

On the other hand, the standard mortgage in the UK is an adjustable rate mortgage. In Canada it's typically a 5-year mortgage that has to be paid off or refinanced at the end of the period. It's easy to see what happens in these cases when interest rates rise and it's not pretty.



Since I've been asked in e-mails and twitter comments I'll present again the patented Dean Baker Bubble Bursting Formula for Central Bankers:

1) Talk

2) Regulatory Powers

3) Higher Interest Rates

By "talk" I don't mean mumbling "irrational exuberance." The point would be for the central bank to use its research capacities to document the existence of a bubble in every possible way. The Fed employs hundreds of economists. There is nothing more important that they could have been doing in the years 2002-2006 than documenting the existence of the housing bubble. (Instead many were doing the opposite. For example, a vice-president of the NY Fed co-authored a paper arguing that there was no run-up in prices, the problem was just a faulty price index.)

Then the central bank could use its enormous megaphone to highlight this research in every possible forum. This means that Greenspan and other governors should have been talking about the housing bubble in every congressional testimony and public speaking engagement.

This would get the facts on the table where the financial industry could not possibly ignore them. I know that many economists are dismissive of the idea that this sort of talk could have an impact on the financial markets or homebuyers but what is the downside?

Talk is cheap; the worst case scenario is that it has no impact. I've been told that this would hurt the credibility of the Fed. Who gives a flying f***? Tens of millions of people are suffering because the Fed let a housing bubble grow unchecked, by comparison the Fed's credibility is not worth wasting a moment's thought.

The use of regulatory powers will differ by the type of central bank. Many central banks have little under their authority other than the narrow pursuit of monetary policy. However the Fed has direct regulatory responsibilities for a large portion of the financial system. Some of this could be simple. For example the Fed was supposed to produce guidelines for mortgage issuance ever since the mid-1990s. (It eventually did, in 2008.) Other regulatory steps might involve more heavy-handed assessments of loan quality.

Greenspan pooh-poohed the importance of this authority by noting that only a third of mortgages were issued by banks under the Fed's direct supervision. His comments ignored that both one-third is still a lot of mortgages and that the Fed sets the gold standard. If the Fed laid out guidelines that other issuers clearly were not following would they still be able to sell their mortgages all over the world in the secondary market? And if they couldn't sell them, they wouldn't issue them.

Perhaps the Fed's regulatory efforts would have no effect, but again what is the downside, more concerns about lost credibility?

Finally the Fed could raise interest rates. Higher interest rates will burst a bubble, but of course they will also slow the economy. This makes it a last choice. (Let me repeat this for all the folks who say that I want the Fed to raise interest rates to combat bubbles --- raising interest rates should be a last choice.)

Let me also suggest that if the Fed or any central bank is raising interest rates to counter a bubble then it should say this explicitly, as in "we are raising interest rates by 0.5 percentage points today. We will continue to raise interest rates until house prices are back below their level of two years ago." My guess is that this sort of explicit targeting of house prices would have a sobering effect on the housing market. (Would you buy a home at today's prices if the central bank announced a commitment to lower them by 15-20 percent?) 

I know this might sound strange among the cult of central bankers who worship at the alter of inflation targeting. This is a radically different course that would mean temporarily losing sight of the inflation target. Even the idea of targetting house prices probably sounds strange, after all they could be wrong.

My response is the same as with the other two: weigh the relative risks. If central bankers can't talk about targeting house prices because it sounds strange then they should look for another line of work. In fact, whoever does the hiring of a central banker should require any candidate for central bank head to say they are targeting house prices 4 or 5 times during an interview just to make sure that they are capable of doing it.

In terms of abandoning the inflation target, this should be a joke. Should the ECB be boasting to the population of the euro zone countries that they have met their targets for price stability? I'm sure that is very consoling to the folks in Spain: "sure we have 27 percent unemployment, but at least the inflation rate is under 2.0 percent."

As far as the risk of being wrong, well life is uncertain. Any decision by central banks could be wrong. Is it that big a concern that house prices might be temporarily depressed below their correct market level? Presumably the central bank will not have shut down their research department. If it turns out that higher house prices really are justified by the fundamentals of the market the central bank should be able to figure this fact out without going through a decade of wrong-headed anti-bubble policies.

So there it is, the anti-bubble recipe. There is no excuse for a central bank allowing a bubble to grow large enough that its collapse will wreck the economy. The central bankers who fail this test should be at the front of the unemployment lines.