On credit, deflation, housing, and recovery…

I had a nice discussion with a good friend of mine the other day.  She knows my interest in economics and finance, and the discussion wound up making its way back to my main love, the future of the real estate market.  It was a bit of an epic discussion.  She is a long-time family friend and has 30 years more life experience than I do.  As for me, I’ve read a few things and come to some rather unconventional conclusions.  So it was perhaps the classic battle of the wisdom of age vs. the vigour of youth.

You can probably guess how the conversation went.  It was me trying to convince her that on a national level, real estate faced the most significant headwinds it has possibly ever faced.  I threw fundamentals at her.  I threw the basics of a credit bubble and massive debt levels at her.  I discussed the deflationary fallout of a busted credit bubble.  I discussed demographics.  I pointed out the connection between real estate, consumer spending, consumer confidence, employment, and economic growth.  These are all things discussed in my primers, and collectively they form the basic premise of this humble blog.

But what does all that theoretical jargon amount to in the face of a lifetime of experienced real estate appreciation.  Sure she had seen some rough patches for real estate, but they came and went.  Her ultimate conclusion was predictable:  Real estate may see a minor pullback, but it will bounce right back and hum along.  Oh….and I’m throwing my money away on rent.  Figures!

But what of that theoretical jargon?  Let’s review the main theses of this blog, which are really quite simple:

1)  Real estate is overvalued relative to historic measures of fundamental value.

2)  It has gotten to be so overvalued due to a society-wide credit bubble facilitated by CMHC and made possible by consumers’ willingness to tap their increasing home equity to buy crap they don’t need.

3)  We’re near the pinnacle in valuations, as sales are now stalling and people are waking up to the truth.  Mass psychology being what it is, it’s impossible to time the peak exactly, but we’re very close, if not already past it.

4)  The reality of debt bubbles is that they pull demand forward.  People would rather have something today and pay for it tomorrow.  What that means is that it’s party time for the economy on the way up, but a train wreck on the way down, as that debt must now be repaid, meaning less consumption going forward.  When we repay debt, we put money back in the banks who originated that debt.  If they can’t find another borrower to lend that money to (say perhaps because consumers have never been more indebted and have finally realized it), then it leads to less money floating around the economy chasing goods.  This, coupled with increased savings rates (a natural by-product of hard economic times) which reduces the velocity of money means that deflation is the main concern on the leeward side of a credit mountain.  Any asset that heavily relies on debt to purchase it (real estate) gets crushed in times of deflation.

5)  We under-appreciate the significance of real estate to the broader economy.  There is a massive connection between rising real estate values, the creation of money via credit in our fractional reserve banking system, the willingness of consumers to spend, employment, and economic growth.  It is the great connection.  It is a wonder to watch on the way up, as it is a virtuous feedback mechanism that buoys the broader economy, explaining why credit bubbles are always great for the economy in the short term.  But alas, all good things come to an end, and the very mechanism that drove growth now cuts back into itself, creating a self-feeding monster on the downside.  This is the monster the US is fighting and Japan has been fighting for 20 years.

From these theses I enjoy periodically delving into what I see as the associated social fallout.  I think we’re facing a renewed recession by Q3 2011.  I think we have a pension storm brewing, which will be a brutal source of tension within 5 years.  We will see austerity either willingly by our elected officials or in a roundabout manner through higher bond yields on our debt, consuming more of our tax base.  The accompanying attempt to curb public sector salaries or benefits will set the stage for nasty protests a la Greece, France, UK, Spain, and now in the US.  I see this also hitting within a couple years.

But again, what of all this theoretical jargon?  How is it actually playing out?

Well, in terms of mass psychology, I can’t help but think that the following articles from this weekend in the Globe will further open people’s eyes and bring this bubble talk to the forefront.  Remember that the great difference between us and the United States is that we still have confidence in our economic prospects while they don’t.  All it takes is a loss of that confidence to set the wheels turning and give birth to that self-feeding monster.  Articles like these are like monster eggs.  You never know what they’re gonna spawn:

The long shadow over Canada’s housing market

There are too many good quotes to just pick a couple.  It’s a must read!

Housing bubbles:  Vancouver a likely suspect

“The latest data show that affordability has deteriorated once again in Vancouver – homeownership costs account for almost 83 per cent of household income for a two storey home. How does anyone afford to buy a house in this city? Qualifying income is more than $155,000.”

Like I’ve said before, Vancouver is ground zero with Toronto condos a close second.

What about the connection between real estate and the broader economy?

The key to recovery:  US housing

It’s a great read and states what should be painfully obvious to any readers of this blog:  When housing falls, the economy goes with it.

Along the same lines, the article referenced above from the Globe had these nice snippets:

“The housing market of the last 10 years has been very important in terms of the wealth effect,” Mr. Tal said “And I can tell you, the next decade will be much weaker. Does this have consequences for the broader economy? Of course it does.”

“Housing-related spending – including the rental market and the sale of existing homes – accounts for about 20 per cent of gross domestic product in Canada”

“About 35 per cent of all jobs created through the recovery can be traced back to construction…But much of the work taking place today harkens back to sales made last year, when the industry set new sales records.”

And that is only the direct effect of construction.  When the spin-off employment is considered, it is significantly higher.  David Rosenberg of Gluskin Sheff calculated that 100% of the GDP growth coming out of the recession was directly attributable to either inventory restocking or real estate, both of which are now fading.

Finally, what about deflation and falling credit here in Canada? To answer this, I will direct you to a beauty piece by Jonathan Tonge:

Growth in consumer credit collapses by 50%

“After an unprecedented rebound in borrowing and spending in 2009, growth in consumer credit has collapsed over the summer. The current expansion level is half that seen in 09 when it was expanding at about $4 billion per month.”

Collapsing credit + higher savings rate will equal deflation.  Count on it.  Now you may point to rising energy or food prices and cry about inflation, but commodity markets are highly influenced by supply and demand, which impact prices beyond just the monetary supply, though that also can have an effect.

The point is that housing is not constrained by supply and demand, at least not in the longer term.  If there is a demand for housing, it will be met through construction.  The same cannot automatically be said of commodities.  If demand doubled tomorrow for crude oil, there is still a finite production capacity.  This is the key difference between commodities and housing.  One is predominantly driven by supply and demand or at least perceived supply and demand, while the other is driven by credit and consumer confidence.  So when credit falls and deflation takes hold, count on real estate to get spanked.  Commodities should fall also, barring supply issues, but not to the same extent, and possibly not at all.

There’s a famous Chinese proverb.  Some refer to it as the Chinese Curse.  It nicely summarizes the underlying premise of this blog:  “May you live in interesting times.”

Indeed we do!  And as such, I will do my best to continue to convey what I feel are the important drivers of economic events to come.  I hope you will benefit from any bit of insight this blog may provide.

Cheers and blessings as always,

-Ben

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14 Responses to On credit, deflation, housing, and recovery…

  1. Marc says:

    love your site, so glad to see some other canadians awake and aware.

    i am wondering on your thoughts on the future of retirement homes? my inquiry is of interest due to the fact that my father is building one to keep, however, some buyers have shown interest. i have been encouraging him to sell and pay off his mortgage, get off the grid, and properly invest knowing what is coming. my father is being difficult to say the least.

    what are your thoughts? i have tried to get him to read your blog, but he isn’t interested.

  2. breezer1 says:

    thanks ben, i enjoy your blog every day . i believe that you are more optimistic than me though. last figure i saw for household debt in canada was %146.
    with no interest mortgages and everybody with a pulse driving a newish vehicle and eating out on their credit cards , well its just not going to end well.
    combine this with the fiscal trouble with all of our trading partners and it spells depression .
    people also forget that our goberment can’t stop stimulating and that the taxpayer is on the hook for all these mortgages when they go belly up.
    but cheer up, they have a 2for1 at wendys tomorrow .

    • Hi Breezer

      I’ve used the term depression in my writing. I hold to a different definition for the word, not the usual definition of a +10% GDP contraction. I think it is useful in delineating the root cause of the economic malaise. I believe that a recession is a business cycle event, while a recession is associated with a debt bubble and secular shift in attitudes and spending patterns.

      Remember, things will never be as bad as the worst possible scenario, and never as rosy as the mainstream media depicts.

      Enjoy your Wendy’s!
      -B

      • Check that.

        “I believe that a recession is a business cycle event, while a recession is associated with a debt bubble and secular shift in attitudes and spending patterns.”

        Should read “I believe that a recession is a business cycle event, while a DEPRESSION is associated with a debt bubble and secular shift in attitudes and spending patterns.”

  3. Tim says:

    Excellent post. Excellent previous posts. Like to see a measured view of things, when all around this country seems to be approaching collective economic insanity.

    Hope you keep it up.

  4. Mot says:

    Excellent insights and public service, Ben. Thank you. For a long time i thought I was alone making similar arguments to friends and family who were boarderline fanatical abou the need to buy bs rent a house. It’s reassuring to see blogs such as yours and Garth Turners as well as many bloggers on these sites laying out solid arguments that support our position. All I get from the RE bulls is emotionally based arguments. Just this weekend I was called “fatalistic” when I voiced my view of the future of real estate in Toronto and Canada in general. I guess it’s better emotionally to cling to hope rather than peer behind the curtain to dispell the myth of the wizzard of oz. Even when these same people can barely cover their household budgets due to debt. Thanks again and please keep going.

  5. Toronto says:

    what are your thoughts on where one should put his money after selling a house?

    • Depends on the intended eventual use of the funds. If you’re planning on buying another home, you have to stay very conservative. Short term bonds and cash is about all I’d recommend with a time horizon of a couple years.
      If you’re investing for your retirement, you need a balanced portfolio that reflects your age and risk tolerance. Best to seek professional advice or educate yourself to manage it yourself.

      Cheers
      B

  6. But I don’t see how banks are going to loose out.
    At first, they created symbols out of thin air and advanced them to people as mortgages.
    Now, if they happen to take over unpaid house, they will get something tangible
    instead of the symbols they created.

    Am I right?

  7. Michelle says:

    Hi:

    I love your comments. I feel the same way. I have always said ” next decade will be called ‘ THE LOST DECADE”.

    Concerning oil, I do feel that it will eventually hit $ 45-50/barrell, if not lower. I feel oil has peaked in 2008, and is heading south for the next 15 years . My research suggest oil has 28-30 year cycles. Oil has gone up a bit because of the inventory recovery, and speculation that economy through Fed easing will help it to recover more strongly. I do not believe it will succeed.

  8. We consume 4X more oil than we discover. Our energy return on energy invested has steadily declined from 100 barrels of oil for every barrel invested to approximately 7 to 1 today. I agree that we may see oil prices fall over the next few years, but we’re already past peak production. Not sure how we’ll see oil fall for 15 years. I have to disagree on this one.

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