Canada's Housing Bubble Can Be Traced to Carney

The nation's former central bank chief was an excellent crisis-era central banker but failed to nail the dismount.

Now at the Bank of England.

Photograph: WPA Pool

There’s a pretty big housing bubble in Canada. By some measures, such as household debt to disposable income, it’s even bigger than the one in the U.S. a decade ago. If it bursts -- which seems pretty likely, and readers should know that I have investments in Canada that stand to benefit if that happens -- people are going to look for someone to blame. Let me help.

To put what’s happening in Canada in context, let’s first look at the U.S. Following one of the biggest stock market bubbles ever in the early 2000s, the Federal Reserve led by Chairman Alan Greenspan feared that a crash-induced loss of confidence could lead to a serious recession or even a depression. I was a trader at the time. The mood was apocalyptic. But the actual recession, in terms of the “real economy,” turned out to be quite mild. Gross domestic product went negative, but not for consecutive quarters, so it didn’t even meet the technical definition of a recession. Then, a strong recovery began.

Greenspan engineered an epic monetary policy response to the downturn by cutting interest rates from 6.50 percent at the end of 2000 to 1 percent in 2003 and leaving them there until mid-2004, even though by that point it was clear that the recession was over and the recovery had begun. When the Fed did begin to raise rates, it was only at a pace that was “measured,” which turned out to be a quarter of a percentage point at a time. Look, dozens of books have been written about the financial crisis, and there were a confluence of factors that contributed to it, but too-easy monetary policy allowed a stock market bubble to morph into a housing bubble. In economics it can sometimes be difficult to determine causation. This is easy.

Now, the financial crisis was pretty awful, leading to millions of job losses and political upheaval that continues to this day. One would think that as a central banker in country A, if you witness this in country B, you would do everything in your power to avoid it. One would think.

Mark Carney was Governor of the Bank of Canada during the financial crisis and widely viewed as being a “star” central banker, eventually being hired away to run the Bank of England. Carney cut interest rates early and often leading up to the financial crisis, including a surprise 50-basis-point reduction to 3.50 percent in March of 2008 shortly after taking office. He recognized the severity of the crisis early on, and took decisive action when others believed that “subprime was contained.” Carney eventually cut rates to 25 basis points in 2009 and started a policy of “conditional commitment,” meaning that the Bank of Canada would keep rates at the zero lower bound conditional on inflation for at least a year. Everyone understood that inflation wasn’t going up, so this had the effect of lowering yields on bonds with longer maturities.

Carney, perhaps even more than former Fed Chairman Ben Bernanke, was an excellent crisis central banker. Unfortunately, he did not nail the dismount.

After it became clear in 2010 that the developed world had exited the financial crisis, Carney raised rates just a little, to 1 percent, and then left them there until 2013, when he joined the Bank of England. It is true that other central banks never got off the zero bound at all, but Canada’s recession was shallower and the recovery stronger. It has now been almost nine years since the overnight rate was last above 1 percent. You can guess what happened next: a long period of negative real interest rates that led to an enormous misallocation of capital -- again in residential real estate. A few years later, huge housing bubble -- the same exact mistake as Greenspan.

This is a little frustrating for central-bank watchers like me. The conventional wisdom is that if you leave rates too low for too long it leads to inflation in the prices of goods and services. That is what happened in the 1970s, but is not what is happening today. Lately, long periods of negative real interest rates haven’t led to goods inflation, it has led to asset price inflation in stocks, bonds and houses. So perhaps a different framework is needed for central bankers.

As for Canada, it is still trying to figure out what to do about the exploding housing market. Pressure is starting to build on Stephen Poloz, Carney’s successor, to raise rates. That would help, but it is far too late. Poloz actually cut rates two years ago, partially because of recession fears and partially because he is obsessed with the foreign-exchange rate. Crude oil prices collapsed on his watch, which didn’t help.

If Canada has a hard landing, accompanied by a severe recession or a depression, Carney’s (and to a lesser extent, Poloz’s) mistake will have been unforgivable. That’s easy to say with the benefit of hindsight, since the world is full of central bank Monday morning quarterbacks. But let’s be clear, this mistake happened because Carney had a bias toward easier policy. He was in no hurry to hike, even when it became apparent that Canada had escaped the worst of the crisis. What Group of 10 economies need are central bankers with a bias toward tighter policy. We now know what happens when you leave interest rates too low. Entire civilizations are ripped apart. Are there any consequences to leaving them too high?

Why not give it a try?

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