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Monday, September 9, 2013

Why The Canadian Economy Has Not Blown Up Yet

In my previous article, I argued that the Canadian economy is doomed as a result of its housing bubble. My argument is not based on house prices and only indirectly on excessive household debt levels; the mechanism for the slowdown will be the restructuring of the labour market. Too many people are working in Construction, and there is no mechanism in sight for them to transition to another other work, absent a long, painful recession (as seen in the United States, where the exact same process is still underway). But the question arises – why has this not happened already?

My argument is that there are two equilibria for the Canadian economy – one where there is self-reinforcing effects that cause stronger growth, and the other where the negative effects will cause a downward spiral, at least until the automatic stabilisers kick in*. (Many heterodox economists dislike the use of the term “equilibrium”; I am using it here as it is used in mathematics: a steady state condition.)  Canadian economic growth is currently mediocre, but the growth-reinforcing equilibrium is still in evidence.

One way of seeing why the housing bubble poses more risk than might be supposed is the fact that housing represents a very different type of economic good than other goods and services. The problems associated with reallocating production between different types of output do not appear in single consumer good models that are the backbone of mainstream economic modelling.

The table below discusses the forces that hold the economy in each equilibrium.

Good Equilibrium (Current State)
Bad Equilibrium (Potential Future Outcome)
Excessive housing market activity generates a lot of employment in Construction, Real Estate, Finance and ancillary activities (moving, Notaries, etc.) which are labour-intensive.
Less housing activity will force these sectors into downsizing.
A stable labour market supports household formation, which buoys house prices.
A weakening labour market leads to less housing demand. Boomerang children return to their parent’s house, reducing household formation.
A stable labour market encourages immigration.
With no job, why stick around in -30 Celsius winters? There is always churn in immigrant populations, and a weak labour market encourages the return to the home country.
A positive outlook for housing encourages the accumulation of condominiums by investors.
There is currently a large number of “trapped longs” in the condo market; there is a very large inventory of units that they will eventually have to sell.
Rising housing prices allows households to borrow against their home equity using home equity lines. This money is typically spent.
Falling prices will force the Canadian banks to pull back on credit lines. This will created a forced upward move in the Household Savings Rate.
Consumer credit losses are minimal.
As Hyman Minsky pointed out, it is difficult to generate credit losses when lending against assets that are rising in price. The impact of weakening credit standards are not apparent until the bubble bursts. Sub-prime lending was the “secret sauce” for American financial sector profitability pre-2008. Since then, not so much.
Housing turnover generates equity extraction via households leaving the housing market. Older households use this money to fund retirement spending.
Lower home sales reduces the ability of the older generation to “cash out” their housing wealth, which generates precautionary spending cutbacks.
Strong consumer spending creates jobs in Retail. There has been considerable additions to retail capacity, in addition to housing units.
Retail and Restaurants will be forced to retrench as consumers cut back, hitting another two labour-intensive sectors.
A considerable portion of Canadian manufacturing involves production of construction materials approved for local housing standards. (The only non-food, non-Auto goods produced in Canada that I run into when shopping are in the hardware store.)
Less construction means less investment by Canadian construction materials manufacturers (investment being both capital expenditure and inventory building).

The self-reinforcing nature of the current equilibrium has kept the Canadian economy growing, even though the parallels with the situation in the United States have been drawn for years. However, housing construction has moved from larger single family housing units towards condominiums. There is not a lot of good quality housing data available in Canada, but it seems almost certain that an increasing number of these condo units are being held in inventory by investors. This condo inventory probably represents a negative carry position for these investors in aggregate. The Greater Fool blog by Garth Turner analyses of good portion of what data are available.

This condo inventory accumulation represents the weak link in the current equilibrium: condo investors are putting increasing amounts of their capital at risk in order to subsidise the ongoing growth of the Canadian economy. This is a recurrent pattern among investors, but eventually investors hit their capacity to finance the accumulation of negative carry assets.

In upcoming entries, I will discuss the timing of when a change of equilibrium could occur, and the implications of the change of equilibrium.

* Both cases of self-reinforcing growth and self-reinforcing weakness are examples of positive feedback. The role of automatic stabilisers (largely generated by the Welfare State) represents negative feedback, as they damp oscillations. Many commentators incorrectly term the growth-reinforcing effects as a “positive feedback loop”, and a downward spiral as a “negative feedback loop”, based on the verbal connotations of “positive” and “negative”. As an ex-Control Systems engineer, this bugs me.

(c) Brian Romanchuk 2013

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