Before the crisis…

1. Dealing with Housing Booms and Busts Deniz Igan, IMF-ResearchLIME Workshop Brussels - December 8, 2012 Disclaimer: Views expressed in the presentation and during the talk are those of the presenter and should not be ascribed to the IMF.

2. Before the crisis… • Monetary policy to focus on inflation and output gap (exclusively in AE, more flexible in EMs) • Asset prices a concern only through their impact on GDP and inflation • Benign neglect approach to boom/busts: • Bubbles difficult to identify • Costs of clean up limited and policy effective • Better clean up than prevent

3. Then came the crisis… • Bust had enormous consequences • Standard policies rapidly hit their limits • Limited effectiveness of less traditional policies • Large fiscal and output costs

4. Need to Reconsider Consensus • Benign neglect approach may be dead • But, problems and trade offs with more interventionist strategy remain: • Bubbles difficult to detect in real time • Risks associated with pricking bubbles • Traditional policies may be ineffective • And have large costs

5. Booms in housing markets are particularly dangerous • Not all asset-price booms should be target of policy • But how to choose? • Some consensus emerging that culprit is leverage (Nasdaq crash was fine) • Housing markets are special: • Leverage (link to crises) • Large storage of wealth • Major supply-side effects • Network externalities

6. Boom, Leverage, and Defaults

7. Real Effects of House Busts

9. Leverage and Link to Crises:Current Episode

10. Bottom line • Strong association between real estate boom-busts and financial crises/recessions • Leverage is key • What to do? • Monetary policy • Fiscal tools • Macro-prudential measures

11. General Points • When to take action • Deviation from yardsticks (price-income, price-rent, leverage, credit growth) • Bubbles difficult to spot but many policy decisions are taken under such uncertainty • Objectives • Prevent unsustainable booms and leverage buildup • Increase resilience to busts • No silver bullet • Broader measures: hard to circumvent but more costly • Targeted tools: limited costs but challenged by loopholes

12. Monetary Policy • Make borrowing more expensive and may limit leverage and risk taking • But: • Too blunt: costly for the entire economy (unless in context of general overheating) • Issues for small open economies • Effect on speculative component may be limited • Panel VAR suggests impact on house prices at considerable cost to GDP growth • 100 basis points reduce house price appreciation by 1 but also lead to a decline of 0.3 in GDP growth

13. Fiscal Tools • Debt-financed ownership favored: • allow deductibility of mortgage interest (DMI) • do not tax imputed rents and capital gains fully • But: • No link between favorable treatment and the crisis • Cyclical use is difficult and violates tax smoothing • Evidence: • Structurally, removal of DMI may help reduce leverage • Cyclically, transaction taxes may help • during busts • less so during booms with impact falling on transaction volumes rather than prices

14. Macro-Prudential Tools • Most ‘experiments’ in emerging markets, particularly Asia • Common tools: • Maximum LTV/DTI limits • Differentiated risk weights on high-LTV loans • Dynamic provisioning • Discretion rather than rule-based • Mixed evidence on effectiveness

15. Could macro-prudential tools have prevented crisis in EuroZone? • Greece and (to lesser extent) Portugal classic fiscally driven crises: • Large fiscal deficits • Relatively low growth (and very low productivity growth) • Large current account deficits • But Spain, Ireland, Latvia different • Prudent fiscal (at time of crisis, plenty of fiscal room) • But buoyant private sector • Asset price bubbles and credit booms • Large current account deficits (especially Spain/Latvia) • Common currency a constraint for all

16. Spain: Cannot stop a herd, but… • Dynamic provisioning in place since July 2000 • Housing demand shock (immigration and foreign investors): • Rapid growth in prices and credit • Construction boom • Lack of monetary/ER instruments • Bubble burst in 2007: • Dynamic provisions accounting on average for 10% of net operating income of banks • Total accumulated provisions cover 1.3% of consolidated assets while capital and reserves stand at 5.8%, providing some buffer

17. Tentative Lessons • Ensuring financial resilience and avoiding boom-bust cycles are not mutually exclusive • Macro-prudential policy still in its infancy • Pragmatic and discretionary, mobilized within existing institutional frameworks, targeted at specific markets • Some evidence of temporary cooling effect on markets and building enough buffers for bad times • Too early to judge impact on aggregate cycles and interaction with other policies

18. Tentative Policy Taxonomy • Macro-prudential tools first line of defense • Target leverage • Strengthen balance sheets • Monetary policy definitely to be involved when there are other signs of overheating • Fiscal tools hard to use cyclically • But removing distortions may help at the structural level

19. Important Open Questions • Who does what? • Where should macro-prudential authority reside? • Relationship among policies • To what extent are these independent tools? • Rules versus discretion • Far away from IT standards • Risks associated with excessively interventionist policy • Challenges from political economy perspective • Preventing circumvention and risk shifting

21. Hong Kong: Limited effectiveness of LTV limits

22. Korea: Effective LTV limits, but difficult calibration?