Cheap money fuels asset bubbles

Financial Review

 
PUBLISHED: 07 Jul 2012

Anna Bernasek 

If you could borrow money for nothing, would you? The answer probably depends on your personality and life situation. Certainly many people would jump at the chance to invest interest-free funds in the hope of making some money.

So, today, with interest rates at historic lows, in some cases zero in effect, shouldn’t we expect to see some kinds of speculative behaviour?

Well, yes. Asset price bubbles have been the consistent companions of low interest rates. And they’re still going on.

Take a look at Toronto, the fifth largest city in North America with close to six million residents. It’s caught in the grip of a major housing boom.

In March alone, prices increased 10 per cent, according to official data. Average nominal home prices have steadily advanced more than 85 per cent over the past decade. Bidding wars have broken out and talk of a housing bubble is on everyone’s lips.

David Townsend, a professor of Medieval Studies and English at the University of Toronto, just sold a small house in the centre of the city one week after listing the property.

In that week, 85 people came to take a look. Three made bids. The property went to a woman who had lost out to higher bids on at least three other properties. Determined not to lose again, she bid $70,000 over the asking price of $450,000.

The boom is especially prevalent in condos. Toronto has more high-rise building projects under way than any other city in North America, even New York City. According to a market researcher, 6070 new condo units sold in the first three months of the year, a record number of sales for a single quarter. Another 11,000 condo units are expected to be available for sale in the second quarter.

The Canadian housing boom caught the attention of the International Monetary Fund late last year. It warned that the Canadian housing market was vulnerable to a correction, especially in light of a slowdown in the commodities sector and a worldwide slowdown in growth.

“Adverse macro-economic shocks, such as a faltering global environment and declining commodity prices, could result in significant job losses, tighter lending standards, and declines in house prices, triggering a protracted period of weak private consumption as households reduce their debt,” the IMF wrote in an annual report about Canada.

Canadian officials have also weighed in, urging households not to take on too much debt. Yet all that seems to be having little effect while the Canadian central bank keeps official interest rates at 1 per cent. Some mortgage rates are as low as 3 per cent.

With interest rates so low, demand remains strong for housing in the centre of Toronto and that’s where many new buildings are going up. A compact city centre makes Toronto a pedestrian- and bicycle-friendly place to live.

The debate inside Canada about whether there’s a housing bubble or not seems eerily familiar. Those who argue against the bubble say that nothing like what happened in the US would happen in Canada.
Canadian banks were far more prudent than American banks, the argument goes, plus there has been no such thing as subprime lending.

Some commentators have argued there’s no evidence of a housing bubble in Toronto anyway. But that’s the disturbing thing about an asset price bubble. You only know with certainty that there’s a bubble once it pops.

If we’ve learned anything from the US housing bubble, it’s this: asset prices don’t go up forever. And when prices move the other way, debt exacerbates the problem.

Household debt levels in Canada are higher than the US at the peak of its housing boom. Official data shows that Canadian household debt rose to a record 153 per cent of disposable income in the third quarter of 2011 compared with 140 per cent in the US.

We’ve witnessed the apotheosis of Greenspanian monetarism, a tacit agreement that monetary policy will cure all ills.

Monetary policy has been remarkably effective in taming general inflation and moderating some types of recessions. But it hasn’t been effective against the inflation everybody loves: asset price inflation.

Designed to manage the real economy, monetary policy produces interesting side effects on the financial economy. Asset price bubbles are Exhibit A.

The trouble with asset bubbles is that they’re tremendously popular. Nobody in Toronto wants to stop the housing party right now. But when a debt-fuelled bubble eventually deflates, and it always does, the effects are noxious. Then everybody will be shocked – shocked! – that it was allowed to happen.