I wrote just over a week ago about a possible Canadian housing bubble and here is more evidence: Canadian housing is over-valued.

The distinction between higher prices and bubbly prices isn’t as subjective as it might sound. Like any other financial asset, there should be a fairly steady relationship between the price of housing and the stream of income — rent — it produces. Should be. The chart below, from The Economist, looks at the price-to-rent ratios across different countries, and measures how under-or-overvalued housing is, with negative numbers corresponding to the former and positive ones to the latter.

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Canada is quietly trying to deflate its bubble without any eye-catching headlines. And that means keeping interest rates low while making mortgages harder to get. Now, raising rates to pop a bubble sounds like the kind of hard-hearted long view central bankers pride themselves on, but it’s more hard-headed. Higher rates don’t just make housing (or any other asset bought with borrowed money) less affordable for new buyers; they make them less affordable for old buyers with adjustable-rate loans too. That sends prices spiraling down and savings racing up, as heavily indebted households, which Canada has no shortage of, try to rebuild their net worths. Higher desired savings outpaces desired investment — in other words, the economy collapses — and subsequently cutting rates, even to zero, won’t do much to reverse this, as houses and businesses are mostly indifferent to lower borrowing costs while they focus on paying down existing debts. It’s what economist Richard Koo calls a “balance sheet recession,” and it’s a good description of how an economy can get stuck in a liquidity trap.

But by keeping rates where they are and slowly tightening mortgage requirements, Canada hopes to engineer a more gradual price decline that won’t set off a vicious circle. In the best case, prices wouldn’t fall, except below the rate of inflation, so that real prices decline without hitting household net worths. This strategy is hardly unique — China has done the same the past few years — but it has the very Canadian name of “macroprudential regulation”.

This is something worth watching. I haven’t seen yet any speculation of how a downturn in the Canadian housing market might affect the United States. I don’t know how much connection there is between the Canadian and American housing markets. The Canadian market is certainly smaller than the US market; there was a big drop in Canadian housing starts from 2008 to 2009, a drop from 211,056 to 149,081, but housing starts in 2012 were back to 2008 levels at 214,827. In contrast, the US had 954,000 private housing starts in December 2012 alone. But, if a housing crash in Canada had a broader impact on the Canadian economy, then it may influence the American economy after all.