The Canadian Association of Accredited Mortgage Professionals was already in damage control mode prior to Flaherty’s mortgage rule change announcement. Earlier in the week, CAAMP chief economist Will Dunning released a report titled, ‘Good Lord please don’t change the mortgage rules!’…..more or less.
I will likely devote future posts to other data contained in the report, but this post will deal entirely with one statement made by Mr. Dunning.
As is the case with most mainstream economists, Mr. Dunning has an exceptionally difficult time determining where the horse ends and the cart begins. To wit:
“The rapid growth in Canadian mortgage debt is related to a very strong economy. The employment rate – the percentage of adults who have jobs – rose rapidly in the second half of the past decade, and reached all-time record levels during 2007 and 2008. This resulted in a need and demand to rapidly expand the housing stock.”
I would word that differently. Certainly the rapid expansion in debt has been associated with a strong economy…..but in the sense that it CAUSED the appearance of economic growth. Debt has a funny way of doing that. By way of a simple example, consider a family that borrows 100K to live large. They certainly have the appearance of economic prosperity while they’re spending the money. It’s not until the tide goes out and the money must be repaid do you find out that they’ve been swimming naked all along.
When an entire society embraces the notion that saving is no longer necessary, renting is for chumps, granite countertops, stainless steel, and annual cruises are basic human rights, and 30 year olds should be living in larger and more luxurious homes than their parents live in after a lifetime of work……well….a credit bubble is born. And as that credit permeates the economy, it makes its way to the parts of the economy that would not otherwise thrive were people not willing to spend all their income and then some on stuff they can mostly live without. So sure, the economy looks great in that circumstance. Jobs are abundant. But does the abundance create the debt or the other way around?
Does a rise in employment create housing/credit demand or does housing/credit demand create a rise in employment?
This is an exceptionally important question. Depending on the answer, it gives a vastly different picture of the short to mid term economic prospects in Canada. If stable employment has been the driver of the housing boom and unparalleled expansion in debt, then the entire economy should be alright. In this case, the expansion in debt would be sustainable over the longer term as job creation has not been dependent on rising debt levels, meaning that they should not be affected when consumers inevitably move to repay their mounting debts.
But if the economy and employment have been buoyed by a sizzling housing market and an unprecedented expansion of credit, the future looks markedly different. In this scenario, once the inevitable repayment of consumer debt begins, you would expect it to significantly affect employment, leading to a potential feedback mechanism of rising unemployment, lower consumer spending, and more rising unemployment.
How might we determine which dynamic is presently at play? Well we could start by noting that our economy is currently 65% dependent on consumer spending for growth. This is a far cry from the 55% that was the norm for most of the previous 50 years.
So what has this consumption done to the unemployment rate? The following graph provides some insight. It shows the annualized change in US consumption and the annualized change in US unemployment. You’ll note that consumption leads unemployment…..the blue leads the red. True it’s not Canada data, but both economies rely overwhelmingly on consumer spending to generate growth, so it applies equally on either side of the border.
In Canada we have had an expansion in our reliance on consumption to fuel growth and employment over the past decade. And yet at the same time we have seen an unprecedented rise in consumer debt to its all-time high of about 150% of personal disposable income here in Canada. Note the particularly acute expansion in debt since 2000.
I find it interesting that Mr. Dunning quite clearly indicates that the greatest growth in employment occurred in the second half of the last decade……right about the time that CMHC began loosening its mortgage insurance standards. It’s no surprise that this led to an employment boom. When mortgage insurance requirements are loosened, it pulls demand forward. The rising demand creates a parallel rise in home sales, both new and resale. Rising new home sales in particular have a way of boosting employment…
The loosening of mortgage insurance requirements and the associated real estate boom has resulted in home ownership rates that have risen to their highest level on record. Despite what some demographers might suggest, this is not solely attributable to an aging population as home ownership rates have risen across all age groups.
All of this, plus rapidly falling interest rates, have buoyed house prices well above their measures of fundamental value.
As prices have risen, people have eagerly tapped their home equity to provide additional capital to fuel the rise in consumption….hence consumer spending has become an increasingly large segment of total growth.
To connect this back to employment, this extra consumer spending has made its way throughout our economy buoying sectors of the economy that would not otherwise flourish.
Got it? Rising credit in Canada made possible by loosening lending standards has flown primarily into real estate…..the rising value of homes has caused a subsequent and parabolic rise in HELOCS and other personal lines of credit as people have felt richer and were therefore more willing to spend their new-found wealth on stuff they could live without (vacations, extra cars, boats, other toys, other homes, etc.)……this has caused our consumption as a percentage of GDP to rise…….the extra consumption has buoyed parts of the economy that would not otherwise have flourished to the same degree……unemployment has remained low while growth has remained high.
This is my take on the economic boom of the past decade….particularly the past 5 years. It was primarily the unparalleled expansion in debt that caused the low unemployment and appearance of economic prosperity, not the other way around. So to those commenters who would suggest that ‘credit bubble watchers’ like me do not consider the income side of the equation……now you have your rebuttal.
As I have noted before, several things can be expected following the bursting of a credit bubble. Once consumers move to restore their tattered balance sheets, expect significant deflationary forces to be felt in any credit-reliant asset priced in local currency…….namely real estate.
Expect unemployment to remain stubbornly high and economic growth to remain stubbornly low. I wouldn’t be shocked to see Canada wrestle with 10% unemployment for several years once the realignment begins.
Expect the feedback mechanism that buoyed the economy on the way up to cut just as deeply on the way back down. Rather than having rampant credit demand buoying all aspects of the economy, the lack of demand for credit will cause falling home prices, falling consumer confidence, and rising unemployment. While our credit bubble was not on par with that in the US, they are an excellent model of just how difficult it can be to stimulate credit demand in a post-credit bubble economy.
Those who have actively paid off their debts and have diligently saved will be best positioned to take advantage of the fantastic opportunities that lie ahead.
I’m not a doom and gloomer…..but this is how I see things. It won’t be economic carnage, but I see much more pain on the horizon than most others do. There will be organic growth on the other side of the mountain, but it will be a rough few years as the economy delevers.
If this post has rained on your parade and you need a picker-upper, check out this great quote from the CAAMP report:
“In fact, some might argue that with the (mortgage) changes implemented in April 2010, Canadian (lending) criteria are currently too tight.”
Come on. That’s got to make you chuckle. Nice try, Mr. Dunning. The only people who would advance such a notion are those whose livelihood depends on the continued loosening of mortgage terms to entice new buyers to step up to the plate. Pretty brazen of you, good sir.