Canada's Housing Bubble

Jonathan Tonge June 23, 2009 americacanada.blogspot.com

Topics:
1. How Fiscal and Monetary Stimulus Damages the Economy
2. Stimulus - North America's Addiction
3. Canada's Mortgage Debt
i) 1981-2009
ii) 2002-2009
4. Stimulus Hangover

HOW MONETARY AND FISCAL STIMULUS DAMAGES THE ECONOMY

Despite what you have been told, North American after-tax income has been stagnant for the past thirty years. With outsourcing and globalization to contend with, uncompetitive jobs left the marketplace and cheaper products flooded the store shelves.



Low unemployment and high national incomes are a hallmark of a good political career, or so at least it is thought. Yet capitalism thrives on its own independence. Politicians aren’t innovators or investors, nor can they actually increase the productive capacity of the national workforce. Foreign competition challenged the cost structure under which North American industry operated, including its incomes and the prices of its manufactured goods. To fight the immense deflationary pressures and to keep incomes high, our elected officials have only two tools at their disposal.

The first and most commonly known is the fiscal policy. It is most often referred to as the government budget, where it taxes or borrows money and spends the funds in the economy. Generally speaking, government spending is extraordinarily ineffective at stimulating the economy. Income earned by productive workers, most of which would have been spent on valued goods and services, is instead taxed and spent on unproductive projects that are "money losers". If the projects were money makers, then it would be safe to assume the private sector would already be doing them.

As a general rule of thumb, economists estimate that 25 cents on every dollar taxed is never returned to the economy. So in Canada's roughly 400 billion dollar federal budget, approximately only 300 billion is returned to make productive things that people want. Even that estimation is being generous.

The other tool nations have is monetary policy. Monetary policy is the responsibility of central banks and involves setting interest rates and the money supply. Lower interest rates encourage people to borrow and spend money, thus stimulating the economy. Monetary policy is usually set independently of elected officials so that the bank can make appropriate decisions to protect the long-term value of its fiat currency. Historically where politicans have been able to influence monetary policy, it has ended in disaster.

Austrian economics identifies the important relationship between interest rates and the economic cycle. When interest rates are permitted to fluctuate at free market rates, they signal to investors when to invest and when to save. When supply of savings is too high and/or demand for credit is too low, interest rates drop. When supply of savings is too low and/or demand for credit is too high, interest rates increase.

In this manner, high interest rates send the signal to investors not to invest and rather save money instead. The high interest rates offer a better reward then most investments. This action prevents malinvestment. Afterall, there is either too much investment currently, or on the other hand, there are too few savers of money in the marketplace. If there are no savers, then who will be able to buy the fruit of your investment two or three years down the road when it has finally been built?

When credit is cheap, it encourages people to invest and spend. If the low interest rate is set by the free market then it reflects a lack of investment or an unnecessary level of savings. In other words, when your investment is built, there will be plenty of individuals who can spend their savings to buy your product. Furthermore, there will most likely be a lack of competitors when the time comes.

So now you can see why liberally abusing monetary policy for two decades and artificially forcing interest rates down has spurred malinvestment. By 2007 the savings rate in the US was -2% of income. Investors aren't provided with any reward for hard-earned savings and are instead lured into highly leveraged investments like real estate.

North American monetary policy is fooling investors into making these decisions. Without the free market setting these rates, investors are lost at sea. It has triggered two of some of the largest bubbles in mankind's history. When the builder built his final US housing project, was their anyone left with any savings to buy it? Of course not. In Canada, the story will end the same.




STIMULUS - NORTH AMERICA'S ADDICTION

Between 1980 and 2008, North America used these policies to increase debt from 100% to 330% of GDP. Almost all of that money was spent in projects that could be considered malinvestment - that is, there won't be a return on that investment. To put that into perspective, the North American economy now owes 3.3 years of its current productive capacity to lenders – that is if ever intends to pay for what it borrowed.

The average age of the North American workforce is aging and is now 46 years old. The average worker expects to retire by the age of 63. This means that by borrowing 3.3 years of future productive capacity, the average worker now owes approximately 20% of their total future income potential. Note that this calculation is strictly repayments on the principal and does not include interest payments. It also assumes that the productive capacity of the US workforce (GDP) will remain constant and not fall – an unlikely prospect in the coming decade (please read on).

In the 1990's the service sector exploded in North America. As manufacturing profits shrunk below 6-7%, services were raking in margins that were well over twice that. We were led to believe that the economy was transforming itself into services and consumption. But the fact of the matter was that services could not be easily outsourced and therefore could exist under North America's inflated cost structure. With the evolution of digital networks the service sector is now faced with same aggresive foreign competition that crushed manufacturing.

Boomers comprise 46% of the total North American workforce. Along with the boomers came an influx of unionized and public sector jobs. Nearly one half of all current public workers are eligible to retire in 2008 to live off of government pensions. Of course we all know that nearly half of the US budget today is being borrowed. How can it possibly fund this liability?

So one might ask, what productive capacity are we really borrowing against? The fact is, if we even tried to reduce our spending deficit, North America's economy would go into recession and shrink, thus accelerating the debt-to-GDP ratio. The economy has been fighting deflation for thirty years, offset by massive amounts of leveraging. Just taking new leverage out of the picture would have a dramatic effect, let alone decreasing the existing debt.

But of course, no one is thinking that we will have to pay this back. That is the curse of low interest rates – it makes us all feel that we can carry debt forever.

CANADA’S MORTGAGE DEBT - A STIMULATING ENVIRONMENT

Yet home prices have skyrocketed? If incomes aren’t rising then what is causing all the demand for housing? Is Canada running out of land? Or as most of us have been told, that home prices just go up forever - It’s just the way it is?

No not quite yet. This world will run out of food and water well before we run out of places to build a home. 95% of our country is still uninhabited. So it must be the latter – that home prices just always rise. But is it possible that there is a third reason? Leverage.

In fact it is entirely leverage that has not only increased the price of homes, but actually stopped the prices from decreasing. Interest rates have fallen for nearly three decades and now sit at around 0.25%.





The result is a mortgage borrowing binge that allowed many dollars to chase a limited number of assets. Rising home prices allowed debt to continue to grow, offset by increasing net worth, all of which resulted in a 'growing' economy. Ultimately, the beauty of inflating real estate is that its construction and rennovations can't be easily outsourced to more competitive countries. So let’s now examine in detail how much leverage we’re talking about.

1981-2007



One argument we all hear is that home prices rise forever because of inflation. So looking at this graph, we might all dismiss the rising mortgage credit environment by assuring ourselves that most of it is caused by inflation.

Therefore, according to this graph one might assume that $1 in 1981 was worth $7.50 by 2007 (and $9.67 by 2009 – not on the provided graph). Well according the Bank of Canada’s inflation calculator, $1 in 1981 would cost $2.36 in 2009. In real terms total mortgage credit in 1981 was $224 billion (in 2009 dollars). Today it stands at $967 billion, approximately ten times the nominal amount in 1981 and 4.3x the real amount.

Let’s now dive into the latest housing boom which started in 1999-2000.

2002-2009



Using the argument of inflation, one might look at the baseline figures in the table above and assume that $1 in 2002 is now worth $2.02. However, according to the Bank of Canada inflation calculator that same basket of goods would only cost $1.16. That means if mortgage credit had moved in tandem with inflation, then total outstanding mortgage debt would only be at $552 billion in 2009. In real terms we have actually grown Canadian mortgage debt by 75% in 7 short years.

As homeownership is at a record high, and with upwards of 80% of Canadians net worth in real estate, noone wants to hear that the price appreciations have been completely fictitious. But they have. Over the next decade, all those massive gains will dissapear. But the debt will grow in size.

One a side note, and worth quickly mentioning, is that HELOC’s (Home Equity Line of Credit) actually fuel consumption more than any other type of financing activity.





STIMULUS HANGOVER

Is this all sustainable? No. Any rise in interest rates and everything will fall apart. Going forward we will eventually hit a point where we can't possibly grow credit any further, even at 0% interest. At this point the economy will be saddled with a massive debt but without new leverage entering it to support it. Without adding new leverage the economy will begin its long overdue deflationary spiral. As it sinks, the burden of the debt will grow and grow. Consumer spending will contract. Deflation will set in. The economy will shrink more, and the cycle will continuously feed itself.

The credit crisis in the US introduced zero percent interest rates. Yet leverage continues to contract. The stimulating power of monetary policy, even when combined with unconventional tools such as quantitative easing, is losing most of its effectiveness. The government is now relying primarily on its fiscal policy to stimulate its economy. But fiscal policy is not nearly as effective at stimulating the economy as monetary policy is. It is also much more expensive. The 2009 US federal deficit, with everything else constant, will add 15% more to the debt-to-GDP ratio.

Canada still has access to easy credit which is expanding at a rapid rate. Mortgage credit will grow by about 100 billion in 2009. It is a debt that represents approximately 8% of our GDP. Furthermore the provinces and federal government will borrow up to 100 billion in fiscal stimulus - representing another 8%. Excluding credit card, auto loans and corporate debt, in just one year we are borrowing 16% of our economy against it's productive capacity of tommorow. Yet Canada's economy will still contract by about 3% in 2009.

Fiscal policy as a current form of economic stimulus will be short-lived. It's final end will be marked by national bankrupticies or through massive expansions in the money supply. The beginning of the end will be marked by a lack of demand for government debt.

Embarrassing auctions of US Treasuries, where only a fraction of the available bonds are sold, are evidence that this phenomenon has already started. Primary creditors like China and the Middle East have been hit hard by the economic storm and with trade surpluses eroding, are choosing to spend their funds interally rather than lending to the west. The US Treasury's process of printing one trillion dollars as a form of quantitative easing has more to do with replacing lost demand for debt than its advertised purpose of lowering interest rates. In fact, quantitative easing has and will continue to add risk to the bond markets, steadily increasing bond yields the longer it is in place.

As underfunded pensions go broke, boomers will need to find new sources of financing to live day-to-day. No longer will they have two cars and a vacation home. No new furniture. No rennovations. They will be starving for cash. Boomers will dump real estate as their net worth's drop, and as they dump their most precious assets, flooding the market, prices will drop further. The cycle will feed itself.

Real home prices will rapidly deflate. As leverage is extracted, prices will collapse. All this at a point in time when the boomers were already going to be retiring, taxes must rise, the economy must shrink, and incomes must drop.

When we look back on this perhaps a decade from now, we may start to realize once again that interest rates should be set by the free market and forever removed as a tool for our politicians. Sometimes you can't delay the inevitable. Sometimes you need to make hard decisions and let a recession run its course. Sometimes you need to let assets and incomes fall in value so the market can properly support them.

But even now in our current crisis, no leader has made any hard decisions. Getting the credit taps flowing again seems to be the number one priority. And besides, it's too late now to do anything on a national scale. Way too late. Divest your assets and pay off your debts. It's everyone for themselves.

References:
Bank of Canada Inflation Calculator:
http://http://www.bankofcanada.ca/en/rates/inflation_calc.html

CMHC Graphs on mortgage debt extracted from CMHC Housing Now publication (Canadian Mortgage & Housing Corporation)
https://www03.cmhc-schl.gc.ca/b2c/b2c/init.do?language=en&z_category=0/0000000070

Information regarding North America's aging workforce provided by The State University of New Jersey - "National Governors Association"
http://www.nga.org/Files/ppt/0611SENIORWEBCASTKREPCIO.PPT#256,1,Keeping Seniors Connected to the Labor Market: