Canada’s credit bubble

Stats Canada has released some updated data tables for consumer and mortgage credit.  Let’s have some fun and look at the growth in credit vs. the growth in income and inflation over the same period.

Total inflation growth according to the Bank of Canada

Growth in labour income

Growth in consumer credit (not including mortgages)

Growth in mortgage credit

So we’ve seen an expansion in household debt that has massively dwarfed income growth and inflation and are now sitting at the highest level of debt to disposable income in our history.  How did we get here?

Some culprits

The Bank of Canada overnight rate upon which variable rate mortgages and lines of credit rates are based has cratered and remains well below historic averages.  It masks the reality of the underlying debt burden and exposes households to potential interest rate shocks.

This has been coupled with an ill-advised loosening of mortgage standards…

Note:  This dumb rule was changed later in 2008.  Maximum amortization is now 35 years, with minimum downpayment requirement of 5%……supposedly!  But there are ways around that…

So you could borrow the required down payment off a credit card, line of credit, or friend/family member and repay it after the sale closes and the funds are released.

Meanwhile savings, which would normally provide a cushion against rising interest rates, have dwindled, currently sitting at around 3%.

All of this is reflective of a secular shift towards consumerism and a widespread embracing of debt loads that would have been considered embarrassing by generations past.

The economic spin-offs involved in a credit binge:

The primary symptom of a credit bubble is an increase in consumer spending as a portion of GDP increases as it is funded increasingly through an expansion in consumer debt.  In the 25 years prior to 2005, Canadian consumer spending as a percentage of GDP ranged between 52.8% and 58.9%.  Today?

Now having a large percentage of GDP attributed to consumer spending is not necessarily alarming provided it is not accompanied by an increase in consumer debt.

Oh crap!  It’s not all consumer debt. But consumer debt averages over $25,000 per household, well into record territory.

The majority of household credit is mortgage credit.  It’s hard to tell whether the run-up in house prices was the cause of the increased credit or was a symptom of the increased credit, but needless to say, the two go hand in hand.

Rising home prices are highly correlated with HELOC growth.  CAAMP recently revealed that home equity extraction has boosted household income by nearly 9%.  Thus, in a circular feedback mechanism, rising home prices provide the fire for increased consumer spending via line of credit growth.  Employment is buoyed by the increased consumer spending and increased demand for housing.

How does this end?

Any honest and semi-coherent person has to acknowledge that this is not a sustainable trajectory.  Whether you want to label it a bubble is up to you.  But let’s at least agree that households cannot perpetually expand credit at a rate greater that the expansion of their income.  That much is factual.

But the question remains:  What will the normalization look like and how will it affect the broader Canadian economy?

That is the trillion dollar question.  Let me suggest once again that secular trends that change the perceptions of a large portion of the populace often shift suddenly and unexpectedly.  In my opinion, it is highly unlikely that we will see a gradual paying off of debt while the economy painlessly realigns itself with the reality of less aggregate demand.  That’s the soft landing thesis that is often suggested, though seldom observed in economics.

Rather, economic phenomena that deviate markedly from their long-term norms have a tendency of self-correcting, and in fact over-correcting in a relatively rapid manner.  In this case, it will likely become painfully evident to many people simultaneously that they have lived beyond their means and have saved too little.  That realization is unlikely to dawn on only a handful of households at a time.

I’ve suggested that this epiphany might come in the realization that their largest asset is not worth what they had hoped it would be.  A moderate fall in home prices followed by an extended period of flat growth (the dream scenario for the bull crowd) would still be enough to choke off HELOC growth and consumer spending by extension.   Remember that home equity extraction is highly correlated with home price increase.

But the moment of clarity may instead come in the form of a rise in interest rates beyond the token increases of the BoC (unlikely in the short term in my opinion), another global economic shock (China bubble popping is a far greater near-term economic threat), or it might just be that the economic ‘recovery’ illusion lifts and people see the underlying structural issues with our economy.  Or it could be that the endless stream of home buyers subsides as home ownership rates are already well into record territory.

The point is simply that the rapid expansion in credit has left the Canadian consumer and the broader economy at a heightened risk of an economic shock.  At best it has set the stage for near-term weakness in aggregate demand as consumers gradually pay down their debt.  At worst, it has set the stage for a significant mean-reversion that would have far-reaching economic consequences.  Regardless, I highly doubt this credit bubble will end in a benign manner.

-Ben