Why Canada's housing crisis is a productivity crisis, too

On April 9, Ricardo Hausmann, the founder and director of Harvard’s Growth Lab, will deliver the first talk of The Canadian Standard of Living, Productivity and Innovation lectures — a series of events focused on strengthening Canada’s standard of living hosted by the Centre for International Governance Innovation and sponsored by Savvas Chamberlain. Here, he and Growth Lab senior research fellow Eric Protzer explore how Canada’s housing crisis is holding the economy back.

Canada’s lacklustre productivity growth is generally presented as an economic problem and its housing crisis is usually treated as a social problem. Those things are true, but there is also a deeper connection between the two.

Much of the debate over Canada’s weak economic performance asks why the country has not generated more innovation, more scale and more world-class firms. But there is another question, just as important: When positive productivity shocks do occur, why does Canada so often fail to turn them into broader national prosperity?

The answer lies in the interaction between two facts. First, growth in advanced economies has become increasingly biased toward knowledge-intensive activities that prefer large cities. Second, Canada’s urban regulations make it unusually hard for those cities to grow.

Over the past half century, cities in high-income economies have shifted away from manufacturing and toward skilled services, technology, finance, life sciences and other knowledge-intensive sectors. This is not just industrial change. It is also geographic change.

Older sectors often needed land, proximity to raw materials or room for large physical plants. Many modern sectors depend more on dense interaction among specialists. A major hospital works because many different kinds of expertise are available in one place. The same is true of software, finance, engineering, media and biotechnology. Production increasingly depends on bringing together many heads that know different things. Large cities have an advantage because they offer deeper pools of those specialized varieties of talent.

That is why growth has become more metropolitan. Canada’s population growth has become increasingly concentrated in the country’s 10 largest cities. In the 1970s and 1980s, they accounted for only a bit more than half of total population growth. In the most recent period, they absorbed more than 80 per cent. That is the spatial footprint of a changing economy.

So far, this is familiar territory: modern growth likes big cities. The deeper issue is what happens next.

The key concept is spatial equilibrium. People are free to move across cities within a country. They choose among job opportunities, wages, housing costs, commute times, schools and amenities. That means what happens in one city affects the whole economy.

Imagine that a city receives a positive productivity shock. Perhaps a cluster of firms becomes more innovative. Perhaps a university or hospital system reaches critical mass. At current wages, employers there want to hire more people and expand.

If housing supply is elastic, the result is straightforward. More homes get built. More workers move in. Employment rises. Output expands. Migrants gain access to better opportunities.

Workers elsewhere may also benefit as labour becomes scarcer where they live and as the booming city buys more from the rest of the country. In this world, a productivity shock in one city raises prosperity more broadly.

But now consider the opposite case. Suppose housing supply is completely inelastic because zoning is restrictive, approvals are discretionary, minimum lot sizes and parking rules suppress density and incumbent neighbourhoods resist change. Firms in the productive city still want more workers, but workers cannot move in at scale. Instead, they bid against one another for a largely fixed stock of homes. Prices rise. Rents rise. Population growth is stunted.

In that world, the productivity shock still exists, but it is transmitted differently. Instead of showing up mainly as more people doing more productive work, much of it is capitalized into land values. The gain is transformed into real-estate rents, not higher living standards.

This is the central point often missing from Canada’s housing debate. The problem is not only that expensive housing hurts families. It is that low housing elasticity prevents the country’s most productive cities from scaling up. It blocks the mechanism through which local productivity gains spread into national income gains.

Source: Harvard Growth Lab calculations based on Human Global Settlement Layer data.

Silicon Valley is the classic illustration. It enjoyed one of the most extraordinary productivity booms in modern history. Yet because housing supply was so constrained, much of that success appeared as astronomical land values, punishing commutes and exclusion rather than as the population growth that would have allowed more people to participate directly in the boom. Instead of spilling over into broad-based national growth, too much of the gain was absorbed into the price of artificially scarce urban land.

Canada shows many symptoms of the same problem. House-price-to-income ratios have risen dramatically. Mortgage and rent burdens remain high. The country’s major cities are expensive yet, compared with many successful peer cities outside the Anglosphere, not especially dense. Toronto, Vancouver and Montreal all have substantial room to accommodate more people in denser urban forms that are both livable and attractive.

Why has this happened?

Part of the answer is political economy. In Canada, housing regulation is highly decentralized and highly discretionary. Municipalities decide much of the zoning. Dense development often requires repeated political approvals rather than following simple, rules-based permissions. Councillors respond to current residents, not to the people who would like to move in but cannot afford to.

This creates a built-in bias toward exclusion. Incumbent homeowners in low-density neighbourhoods often oppose new development, whether to preserve familiar surroundings, avoid congestion or protect the value of scarce housing. Whatever the motive, the effect is the same: A small group of insiders can use local institutions to limit entry into places where the wider economy increasingly needs more people to live.

This is why the issue should not be presented as a simple story of enlightened provinces versus selfish municipalities. The real issue is a trade-off. Giving incumbent local communities broad rights to stop local densification also gives them broad rights to stop national growth.

That is not because local democracy is unimportant. Communities should have a voice. But the current allocation of power allows a narrow set of residents to impose very large costs on outsiders: younger households, renters, immigrants, employers, would-be residents and the wider provincial and national economies. When local vetoes prevent the expansion of housing in the cities where productivity growth is concentrated, “community control” stops being purely local. It becomes a decision about national prosperity.

Canada’s housing regime was built for a different economy. It made more sense when growth was more geographically dispersed across land-intensive sectors. It makes much less sense in an economy where success increasingly depends on dense urban concentrations of specialized talent.

That is why reform should focus on the two institutional features at the heart of the problem: excessive decentralization and excessive discretion.

Provincial governments are better placed than municipalities to manage this trade-off because they represent broader constituencies and internalize more of the gains from urban growth. They need not dictate every detail of urban form. But they should set firmer provincial rules under which cities operate.

That means more housing should be allowed as of right, especially near jobs, transit and commercial corridors. Minimum lot sizes, parking mandates and similar barriers should be scaled back. Approvals should become faster, simpler and more rules-based. Development charges should not be used to shield incumbents from the cost of growth by loading the bill onto newcomers. Municipalities should continue to shape design, amenities and infrastructure, but they should not retain open-ended powers to suppress the housing supply on which economic growth increasingly depends.

Japan offers a useful benchmark. Its system is more standardized, more permissive of densification and less vulnerable to discretionary local blockage, yet its cities are among the safest, most orderly and most admired in the world. In Canada, British Columbia has begun to move in this direction by requiring more multifamily housing and setting housing targets. Other provinces should build on that logic.

There is, of course, no single silver bullet for Canada’s productivity problem. Better innovation policy, stronger competition, more business investment and more effective commercialization all matter. But none of these will achieve their full potential if the country’s most productive cities are prevented from remaining competitive as they grow.

Canada cannot build a 21st-century economy with a 20th-century housing regime. The industries driving modern growth want dense urban environments because that is where complex, specialized knowledge can be assembled. If those cities cannot add enough housing, the gains from productivity are converted into higher land prices instead of more output, more opportunity and higher living standards.

That is the real trade-off before Canada. Empowering incumbent communities to block densification preserves the status quo but gives those communities the power to block entry, to block urban growth and, increasingly, to block progress.