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Deflating housing bubble risks recession

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Seen in isolation, Finance Minister Flaherty probably did the right thing in seeking to safely deflate the housing bubble and lower the dangerous growth of household credit to a record level as a share of household income.

But he did it very late in the game, and risks tipping an already very fragile economy into recession if he and the provincial governments do not ease up on fiscal austerity.

The government is dropping the maximum amortization period for CMHC insured mortgages from 30 years to 25 years, lowering the percentage of household income which is taken up to service an insured mortgage, lowering the maximum amount of insured mortgages to below $1 million, and limiting the amount of home equity that can be withdrawn when refinancing. The major impact is expected to be to lower demand for new mortgages for first-time buyers, which will take some steam out of an already slowing housing market, especially the condo market.

Clearly, Finance Minister Flaherty and Bank of Canada Governor Mark Carney are concerned about the steady growth of total household debt -- now 151 per cent of personal income -- and about the dangers of a further inflation of house prices.

I argued back in February 2010 that Canada was clearly experiencing a housing bubble, and David Macdonald issued a major report for the CCPA in August 2010. At the time, bank economists and many others were pretty dismissive, even though our situation was little different than in the U.S. before the collapse of their housing bubble back in 2007.

Mr. Flaherty should have tightened the rules much earlier before things got out of control. Recall that it was he who increased the amortization period for insured mortgages to an astonishing 40 years back in 2006, notwithstanding warnings from then Bank of Canada Governor David Dodge.

Last week's very late move could be dangerous. If housing prices have already more or less peaked -- as seems to be the case -- then shutting out a significant number of new first-time buyers could lower prices significantly. If that happens, those who have recently bought in the run-up to the peak will find themselves in a negative equity position, and they will be even more exposed if unemployment begins to rise. The end of the housing bubble will depress residential construction and sales, and also depress consumer spending due to negative wealth effects.

The macro economic impacts of a slowing housing market are the larger danger. Over the past year, (Q1 2011 to Q1 2012) residential construction investment accounted for 23 per cent of real GDP growth, with much of the remainder coming from growth in household consumption. The economy grew by a soft 1.8 per cent over the past year, led by a 1.9 per cent increase in consumer spending. The growth of net exports over the year was just 0.7 per cent, while government spending was a drag on growth.

As residential construction slows and house prices fall, what will take up the slack? Business investment in the resource sector has been strong of late, but is not enough to carry the entire economy. Net exports are hardly likely to increase much given the global economic slowdown and the still very high Canadian dollar.

Over the past year, real government investment fell by 13.4 per cent and government current spending fell by 0.1 per cent. The IMF projects that the total Canadian government cyclically adjusted budget balance will contract by 0.7 per cent of GDP this year, enough to depress growth by some 0.4 per cent of GDP.

Mr. Flaherty was right to be alarmed about the housing bubble and the excessive growth of household debt. But, he must realize that removing one major source of growth and job creation is dangerous if he does not act to increase other sources of growth. Easing up on fiscal austerity -- especially by boosting productive public investment -- is the most obvious solution to hand.

This article was first posted on The Progressive Economics Forum.

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