Economic dynamics revisited
I recently took issue with a statement made by Will Dunning in the most recent CAAMP report. Mr. Dunning made the dubious claim that housing demand has been created by strong employment. Without a doubt that statement has held true through most of our nation’s history. My position is that as our economy has moved away from production and manufacturing and towards consumption, the new driver of economic ‘growth’ has been the rapid expansion in consumer debt. Consumer spending and consumption are obviously always a part of any economy. The end goal of all manufacturing is consumption. The problem arises when consumption as a percentage of GDP deviates rapidly and markedly from its long-term mean. In Canada we have seen a rapid rise in consumption from 55% to 65% GDP.
This has been driven by a new consumer mentality towards debt, which has seen total debt levels explode as a percentage of personal disposable income. Tied at the hip has been a redefining of what constitutes ‘normal’ consumption. This proliferation of household debt has permeated through our economy as bank-generated credit spends just as well as freshly minted currency. And make no mistake, credit creation is running rampant.
This has buoyed sectors of the economy that would not otherwise have flourished were such a broad swath of the population not willing to spend more than they earn on stuff they can generally live without.
All of this is connected to a secular shift in perceptions…..a change in mass psychology. At some point we abandoned the collective notion that a house is a place to live and wealth is built by spending less than you earn and saving/prudently investing the difference. Instead there was a wholesale embracing of a new paradigm….the house as a means to riches, while saving became viewed as something you do when you’re a few years from retirement. We also became exceptionally comfortable with debt; Staggeringly so when compared to the mentality of past generations.
And so, as more people embraced this new paradigm, home ownership rates have risen markedly. Lending standards have been loosened to allow more and more people access to the new-found Canadian dream. ‘Unjust’ barriers to home ownership were torn down. The down payment went out the window. The 25 year amortization became a thing of the past. The government stepped up its mortgage insurance business to such an extent that today 97% of mortgages to first time buyers are backstopped by CMHC, a government agency….taxpayers by extension. Demand soared further.
The mentality that house prices could only go up became ingrained in our psyche despite all evidence to the contrary. People who would never consider buying 300K worth of stocks with only 15K in equity nevertheless plunged headlong into home ‘ownership’, never considering that perhaps a home without equity really is just a rental with debt. The renter has just gone from renting space to renting money….but with much more risk.
The feedback mechanism was complete when people realized that they had home equity in abundance and could access it easily and cheaply. Why save to buy that boat/second car/vacation/second property/toy/trinket/etc when you could pull it out of your home equity at prime plus 1%. The simultaneous cratering of the Bank of Canada overnight rate certainly added fuel to this fire.
And as this money circulated through our economy, the economy prospered. Jobs were abundant. Lured by the easy riches of the housing market, more property virgins piled in. Circle complete.
This is the current dynamic we find at work in the housing market and broader Canadian economy. Everything I have said above has been quantified and expanded upon using factual data in various posts, so none of this is conjecture.
If you’ve read this site for any time now, you know what comes next. The exact timing is impossible to nail down as it involves a change in the ‘animal spirits’ that drive mass psychology. When that happens is anyone’s guess, but I’ve advanced what I feel is a pretty reasonable timeline. The exact timing is somewhat of an academic issue….the (un)sustainability of our present economy is not in question. We don’t face economic carnage or a Japanese style uber-deflation, but we face headwinds unlike any we’ve seen in this country in decades.
With that rant out of the way, let’s turn our attention to some of the key facts contained in Mr. Dunning’s report. For this I will simply outline Mr. Dunning’s statement and my take on the same data:
“There is very little evidence that there has been a speculative mindset and no evidence of excess housing development in Canada.”
The report itself acknowledges that data on single family investment homes is sparse, so naturally there is ‘little evidence’ of a speculative mindset. Well, not so fast. We could certainly look at anecdotes. Though they cannot be used to establish broader trends, when taken together they can provide meaningful insights.
VREAA just made an interesting post about the ridiculous speculation taking place in Vancouver right now. But Vancouver has long been ridiculous. No shock there. It will mark ground zero of the coming correction.
Widespread consumer sentiment towards real estate is also an excellent indicator. Extreme positive sentiment in any market is very difficult to separate from speculation. If people are overwhelmingly convinced that something is an excellent investment, do they not position themselves accordingly? We know that current sentiment on real estate is extremely optimistic. We also know that certain segments of the market such as the condo markets in most large centres have extremely high investor presence.
The data ultimately speaks volumes. We know that net household formation in Canada has been very stable at 175K per annum for the past decade. Yet in that time, housing starts have run at well over 200K. I’d be curious to hear how Mr. Dunning would explain this without using the term ‘speculation’.
It seems to me that we have had additional supply created over the past decade. Whether that has been absorbed as recreational property or investment property is a bit of a moot point. I maintain that the primary motivator that has driven this excess demand has been the perception of future price increases. The two questions that arise then are:
1) How will housing starts respond to a flat/declining market? If they fall as would be expected, it would certainly exert a toll on the employment count of the construction industry which currently stands at 1.3 million.
2) How will people respond to a flat/declining market when the perception of future price gains is called into question?
The CAAMP report also highlights current mortgage arrears data-
“Data from the Canadian Bankers Association – which covers 7 major banks – shows that there was a rise in mortgage arrears during the recession. Prior to the recession the arrears rate was less than 0.30%. During the winter of 2008/09, however, the arrears rate increased rapidly. Since the end of the recession, the arrears rate has fallen slightly. The most recent data (as of October 2010) shows an arrears rate of 0.43%. While the increased rate is indicative of increased financial difficulties, it is lower than was seen during most of the 1990s (when the average arrears rate was 0.50%).”
Just a couple of quick thoughts on this point. Let’s remember that mortgage arrears are at the highest point in a decade, yet interest rates are still hovering near historical lows. The 90s saw a terrible real estate market in much of Canada, yet the 5 year fixed rate hovered near 9% for much of the decade. Here we are today with an arrears rate creeping back towards levels last seen in the 90s, yet the 5 year rate sits at half of what it was then. A normalization of interest rates would crush the housing market. Contrary to what some commenters seem to believe, the 5 year fixed rate is not controlled by the Bank of Canada. It is set in the bond market. For those who insist that the government would never allow interest rates to exert such a toll on the housing market need to understand exactly how those 5 year mortgages are financed, especially since it is the 5 year rate that determines the amount of financing for ALL mortgage approvals.
RRSP use among younger generations at lowest point in a decade
I’ve always maintained that the government’s quest to ensure easier access to home ownership for first time buyers will have unforeseen consequences. Here’s one of them.
“Nearly one half (45%) of young adults aged 18 to 34 have not yet started saving for retirement, according to the 21st annual RBC RRSP poll conducted by Ipsos Reid. Moreover, just four in ten (39%) young adults have an RRSP, a five-point drop from last year’s poll and the lowest figure in nearly a decade.”
When the government makes credit more abundant and encourages it to flow into real estate, this is one of the logical repercussions. House lusting new homeowners are seeing a significant and rising portion of their income devoted to carrying costs, leaving little left over for other important tasks…..like saving for retirement.
No amount of ‘education’ on the part of the government will encourage this generation to save for retirement. The prevailing public sentiment about home ownership and the associated stigma with renting is just too powerful. Thankfully markets are wonderful teachers. As I have long maintained, the housing correction will also usher in an era of ‘enlightenment’ where people realize just how tattered their finances really are. Then and only then will this trend reverse significantly. But of course, if a wide swath of society comes to that realization simultaneously, the decreasing velocity of money, debt deleveraging, and increased savings will all ensure strong deflationary forces.