The Unassuming Economist

A new IMF paper on asset price bubbles says that “One of the potential costs of prolonged capital controls is the formation of asset price
bubbles. House prices in Iceland have been rising rapidly in the recent period, prompting
concerns about possible overvaluation. Based on a cross-country comparison, time-series
analysis, and correlation analysis, house prices in Iceland do not stand out as particularly
misaligned. To formally test whether the housing market is overvalued, we employ the
Igan and Loungani (2012) model based on housing affordability, per capita income,
population, stock prices, credit, and interest rates. We find that there are currently no
misalignments between house prices and the fundamentals, which is consistent with the
recent analysis conducted by the CBI. However, housing supply-side constraints remain
significant, with new starts well below the historic norm. These, together with the ongoing
recovery in mortgage lending, the wealth and income effects of household debt relief and
Pillar III withdrawals to fund debt relief (and, until discontinued in 2015 budget, for
general consumption), increasing demand for vacation properties, and potentially large
wage hikes in the near-term, may lead to an overshooting of house prices. Policies that
could be explored (while keeping an eye on broader macroeconomic considerations) to
help minimize the risks of asset price bubbles in the housing sector include steps to: (i)
support measured increases in housing supply; (ii) maintain non-inflationary growth in
wages; (iii) prevent excessive leveraging; and (iv) increase household savings.”