“History does not repeat itself, but it rhymes.”
-Not Mark Twain (According to Garson O’Toole, A.K.A. the Quote Investigator)
It might not feel like it, but the North American markets have been casually going up for almost 10 years now. The only real interruption was the crash in oil prices beginning in late 2015. It didn’t hurt Canada much contrarily to what a lot of people expected. As then Prime Minister Stephen Harper said at the time, “The oil industry isn’t remotely the entire Canadian economy”. Indeed, production of crude oil in Canada only represents about 3% of its entire GDP. So when the crude prices went south, all it took to keep the Canadian economy on track was a tiny interest rate cut and a bit of fiscal leniency from Ottawa et voilà! The land of maple syrup was marching forward again.
This whole crude oil story was probably an unwelcome distraction for politicians, but the recent recovery in oil prices shouldn’t be seen as the ringing of the bell announcing recess for policymakers and market participants. Another problem is simmering right in front of us. And it could soon start boiling over the pot in a time-to-put-the-spaghetti-in fashion.
Anyone who reads the papers or watch TV once in a while heard about our now famous overheating housing market. Just Google “Canada Housing Market” and you get a wide variety of prediction on whether it will end up crashing or not. Indeed there is cause for concern. A quick look at the Teranet/National Bank House Price Index shows prices have been climbing fast across Canada for a little while. The index has more than doubled in the past 10 years (the black line is the index level, the blue thing is the growth rate).
Guess where else the main housing index more than doubled in the previous 10 years before a crisis? That’s right. In the United States of America from 1997 to 2007 (Okay, in the 1980s Japan too, but we’ll stick to the U.S. comparison since they are our beloved neighbours).
The Case-Shiller Index shows roughly the same increase in the United States in the years leading up to the crisis. In addition, levels of mortgage frauds in the U.S. spiked in the years before the crisis. According to a recent Equifax report, the same is currently happening in Canada. High levels of fraud are often a reliable sign of a bubble in the making.
Now, there are many differences between the pre-crisis U.S. housing market and the current Canadian housing market. For one, in 2007 the overheating of the U.S. housing market was pretty much generalized to the whole country. In Canada, the real problems lie especially in Vancouver and Toronto where the increase in prices were even more dramatic (+175% in Vancouver, +150% in Toronto). For now, the markets in other cities are still relatively healthy. America also had this huge derivatives market to hide the risks and fuel the bubble, something that is relatively limited in Canada. So simply comparing two charts is too weak of an argument to support anything. But here’s the catch, the state of the housing market in Canada in just a symptom. The real problem lies somewhere else.
In recent decades a new school of thought named Modern Monetary Theory has emerged in macroeconomics. Its explaining power is quite remarkable and often does a better job at spotting macro problems than widely-used neoclassical models. MMT’s main building block is the idea that an economy can be divided in three distinct sectors: public, private and foreign (think government, consumer and businesses, other countries). These sectors trade with each other and each accumulate a stock of savings or debt depending on the amount of stuff they buy or sell. What’s important to understand is that the three sectors must always be in balance. What I mean by that is that the debt of one sector is the net savings of the other two. For example, if the government of Country A runs a huge budget deficit every year and its consumers and businesses spend more than their income, both sectors will accumulate debt. But since money doesn’t grow out of thin air someone needs to finance that debt, so in this case the foreign countries will run a huge surplus by exporting more goods and services to Country A than it imports from that same country. Since the foreign sector sells a lot of stuff to Country A, it takes more income than it spends so it accumulates savings. Those savings will then be used to finance the debt of Country A’s public and private sectors. Don’t worry if this gets hard to follow. The point is that if the public sector of country A runs a deficit and the private sector also runs a deficit, then the foreign sector needs to run a surplus. If the public sector and the foreign sector both run a surplus, then the private side needs to run a deficit. When a sector runs a deficit it accumulates debt, and someone needs to be there to finance that debt. It has to come from the other sectors. How does a sector finance debt? By running a surplus. A surplus means that the sector is taking in more income than it spends, therefore accumulating savings and using those savings to lend to the sectors in deficit. This is an extra simplified version of MMT, but it’s good enough for now.
Let’s use this model so analyze what’s going on in Canada right now. We’ve been running a significant current account deficit since the credit crisis. This means we buy more stuff from other countries than they buy from us. This also means the foreign sector is running a surplus against us, accumulating savings while financing a deficit in our private and/or public sector. Now what does our public sector balance look like?
As you can observe, the government deficit has been reduced to practically zero in recent years. So if the foreign sector is financing a deficit somewhere in Canada and it’s not in the public sector, it must be that Canadian businesses and consumers are taking on more and more debt.
And sure enough, during the same period, our private sector’s debt has grown from 233% to 267% of GDP. Not only private debt in Canada is growing, but it’s reaching alarming levels. To give you an idea, right before the credit crisis of 2008, the U.S. private sector debt stood at 220% of GDP (it’s now back under 200%). The Canadian private sector is the currently the most indebted of all G20 countries.
Speaking of the U.S., let’s look at their sectoral balances in the year leading up to the crisis. Starting with their current account balance:
As with Canada right now, the U.S. deficit with the foreign sector was steadily growing in the decade right before the crash. This again means that either the private or public sector (or both) was accumulating debt.
As you can see the public sector is partly to blame. In the first half of the decade the government was running a surplus. That means not only the foreign financing was flowing to finance the private sector’s debt, but the government’s surplus also had to finance a deficit somewhere. Since there was no deficit in the foreign sector, the government’s surplus was added to the foreign surplus in financing private debt. Starting in 2002, the U.S. government went back to running a deficit. So part of the foreign surplus at the time served to finance the public sector. But look at the size of the post-2002 public deficit. Whereas it peaked at a little above 3% of GDP, the foreign surplus reached 6% of America’s GDP. This means that even though half of foreign financial flows went to finance the government’s deficit, the other half was still financing growth in private sector’s debt.
Basically, the same sector imbalances that formed in the U.S. right before the crisis are happening right now in Canada.
Now, why do these imbalances matter? Think about this from Canada’s perspective. If the foreign sector is running a deficit, it doesn’t matter much. This deficit can be shared by Canada’s trading partners and even if one of them was taking too much debt, it’s not really Canada’s problem (unless this country is going up in flames and happens to be the largest importer of Canadian goods, but this is unlikely).
If our government runs a deficit for too long, it can always print more money to be able to service its debt. Too much of this could cause inflation, but at 92% of GDP, the level of government debt in Canada is not too alarming.
However, when consumers and business get too indebted, they cannot print money to pay back their debt. So what do they do when they can’t pay? They default. And when they default, banks suffer losses, and when banks suffer losses, they reduce their lending, and when banks reduce their lending, consumers and businesses can’t refinance their debt anymore, and when consumers and businesses can’t refinance their debt anymore, they have to pay back their debt, but since they cannot repay their debt, they default, and then the circle continues until a recession hits and the government starts running a deficit again to stimulate the economy back to life and help the private sector deleverage.
So things are not looking good for the Canadian economy. Too much private debt and an overheating housing market is just a classic sign of an upcoming economic recession. What’s certain is that sooner or later, the private sector will have to go through a period of significant deleverage, which will decrease consumption and restrain short term growth in the Canadian economy. It could take years before we see a correction as this debt-fueled party could last for a while. But to paraphrase Warren Buffett, we are dancing in a room in which the clock has no hands and just like for Cinderella, eventually midnight will come.