The Price of Burgers in New York

I would like to comment on a Preet Banerjee article in the Globe and Mail this weekend, that skirted over the issues of house prices and consumer debt in Canada.

“Looking at debt-to-income is only part of the story. You need to see what that debt was spent on. In other words, why do so many analyses ignore the other half of the balance sheet: assets? A lot of that debt is mortgage debt. Housing has done well, so on the asset side, we are doing much better. Our net-worth to-income ratios are higher. “

I beg to differ Preet, most serious analysts are well aware that assets are the other half of the balance sheet. 

If borrowings had been applied to consumer goods we would have had more inflation, a rise in interest rates and an “arrested development” of the debt mountain. 

As it is, we have excess asset focussed money supply growth that has pushed up asset prices.  The relationship between asset prices and the future real growth in output of an economy is important: asset prices need to reflect income and future growth in income; if the present value of these assets exceed the discounted present value of income (or output growth effectively) needed to finance these assets (and to provide future demand for these assets) then asset prices will need to fall; if asset prices fall, and investors cannot finance the debt, they are likely to default, which reduces money supply, tightens credit and impacts economic demand, output and asset values.  It is precisely because debt has been used to push the price of assets above equilibrium values that the risks of debt are so high. 

It is also worth noting, that we only need the marginal investor to default, not the entire nation of homeowners, for the impact on asset prices and hence debt to gain momentum: assets are priced at the marginal transaction.

Secondly, our lending practices are more conservative. We don’t have as many people, proportionately, in over their heads.

If lending practises were more conservative then debt levels would not have reached current levels.  The fact is that much of Canadian GDP growth post 2008 has come from this debt fuelled property boom.   The immediate risks to the Canadian financial system may not be as significant given the differences in underwriting practises, but the risks to the economy are significant and real.  All this debt represents money supply (and hence lending) that has been permanently allocated to one area of the economy: it is a great weight on future growth.

Third, while there may indeed be a drop in housing prices, it may not cascade into a financial system meltdown anywhere near what happened in the U.S. If you have 50 per cent equity in your house and the price drops 30 per cent, you get angry but you don’t necessarily default on payments. The sub-prime mortgage market in Canada is virtually non-existent. Anyone with a mortgage balance outstanding close to the value of their home is also required to have mortgage default insurance.

Again, it is the marginal debt holder and the marginal default that leads the way, and it is the debt accumulated in the last few years as prices have risen that will impact the economy.  These homeowners do not have the luxury of 50% equity.  Also, many homeowners have taken out home equity lines of credit taken on their homes, some of which will have been used to fund expenditure: if the economy moves into a recession, consumers may well default on their obligations to their lines of credit.  

So, while we could very well see housing price declines, the conclusion that it would lead to something more grave may not be warranted.

Canada has boomed (in relative, though not absolute terms) over the last few years, but it is a marginal economy highly dependent on commodities, financials and for the last few years a debt fuelled housing boom.   I am sure we cannot rely on housing for growth and stability, and with the long term outlook on financials also surely weak in terms of GDP contribution, it is a worry that the bedrock of Canadian growth appears dependent on the marginal growth of the commodity hungry developing and emerging markets.  

The level of debt that has built up in Canada is a concern.

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