A series of policy errors has trapped the Canadian economy in a near-zombie status. Household debt levels are high, leading to a fragile system. The only benign way of reducing this fragility is to induce high wage inflation, which is precluded by the unthinking attachment to the inflation target. There is no reason to expect the system to collapse on any particular forecast horizon; rather the economy can muddle along in a low-growth path. The fact that the brain trust that inflicted this low-growth destiny on the Canadian economy in the name of improving economic efficiency is ironic, but this reflects the general failure of modern policymaking. The situation in Canada may mainly be of interest to Canadians, but it does provide yet another data point for the general thesis that trusting the policy preferences of the financial sector is inherently a bad idea.
This article is not meant to be a detailed analysis of the policy failures, rather it sets out a summary of my views. It could easily serve as the introduction to a report that describes the origins of “The Great Canadian Economic Collapse of <insert date here>.” For regular readers, this is a restatement of long-held views, and so it should be similar to what I have previously written.
What Went Wrong?My “zombification” thesis is not based on what has happened over the past few months or years; rather, the inception of the problem can be traced to decisions going back more than two decades. As a result, I see little need to point fingers at any particular individuals or political parties for the problem; the errors have been systemic, and embraced by the main political parties.
The thesis is straightforward: the rise in house prices since the late 1990s is mechanically inseparable from the rise in household debt. Although the current data flow is hardly reassuring, there is no reason to believe that the system must collapse because household debt has hit some magical “unsustainable” level. It is entirely possible that house prices have hit a “permanently high plateau.” (At least relative to the prices that generally prevailed during the mid-1990s, which were quite low when compared to other developed countries in most Canadian markets. Even a correction of 20% to house prices may eventually be hard to spot on a long-term price chart.) Household debt ratios would presumably still rise, but the growth rate would level off as household finances reach a “steady state” with respect to home prices.
Zombification does not imply a disorderly collapse. Instead, policymakers are stuck staring into the abyss: they cannot afford to let housing implode. Even if the main banks are protected by mortgage insurance, the household sector would laid waste. It is impossible to have a healthy banking system if all the banking system’s customers are on the edge of bankruptcy. (Macro-prudential policies are just spitting into a hurricane under such circumstances.)
Therefore, policymakers have to treat the possibility of a housing sector collapse with extreme caution. Unfortunately, there is no way out. There are two ways of reducing the debt/wage ratio: mass defaults, or a rapid increase in wages. A mass default would result from the crisis that we are trying to avoid. The other way out seems unlikely: the Bank of Canada would respond to rising wages by hiking rates, which is the standard trigger for a housing market collapse.
Instead, policy has to be set in such a way that we remain stuck in low-growth stasis.
The Policy ErrorsThe policy errors made were straightforward.
- The most important was the loosening of the down payment requirements by the Canada Housing and Mortgage Corporation, which was started in 1999 (there were some trials starting earlier). Canadians cannot take mortgages with less than a 20% down payment, unless they purchase mortgage insurance. This insurance mainly comes from the CMHC, although there have been attempts to allow private sector competitors. The loosening of standards was done in a series of steps, and some of that loosening was reversed after the Financial Crisis. However, one key loosening remains: previously, the maximum mortgage size was capped at a low level that allowed purchase in most markets, but were too low for the highest-priced markets. If those low limits were still in place, the current high prices would be obviously unsustainable.
- The Bank of Canada drank the New Keynesian Kool-Aid™. Like every other New Keynesian central bank, they slashed rates in a panic during every down turn, and they refused to hike rates in a symmetric fashion. It is a mathematical certainty that they would end up at the “zero lower bound.” This one-way trip for interest rates was gratifying for secular bond bulls, but it also raised the animal spirits of the housing market. Canadian mortgages are short term when compared to the United States; the effective maximum maturity for rate fixing has been five years. (Mortgages have longer amortisation periods, but the interest rate is renegotiated after five years. There have been attempts to make 10-year mortgages more attractive; I do not know whether this has lengthened the average maturity much.) As a result, heavily mortgaged Canadian households would take a rate renormalisation right on the chin, whereas American households tend to rely on 30-year fixed conventional mortgages, and are somewhat insulated from the policy rate.
- Policymakers have prioritised inflation targeting above all else, on the theory that it would raise growth rates. The risk of a housing collapse did not appear in the models that “proved” that low inflation raises growth.
- The idea that the “wealth effect” was a costless way to boost growth (as a side effect of lower interest rates) captivated economists in the 1990s.
- Fiscal policy has been running too tight, locking the Bank of Canada into an untenable position.
Political EconomyIt would be easy to explain the situation as being the result of “neoliberal” policies. However, it is just as easy to explain this as the result of chronic short-termism and poor understanding of policy consequences among Canada’s governing elites.
The mortgage insurance system as it was constituted in the early 1990s worked; the key was that few households took the insurance. It opened opportunities for home ownership, but most households were pushed to wait until they saved up the 20% down payment. (There is an analogy to the Job Guarantee; it’s a sign of success that few people are using the programme.) However, the people running the system in the 1990s did not understand this, and the bright idea was to expand the programme. The government programme ended up backing the financing of the majority of housing market entrants.
From an old school political economy perspective, Canada ended up in the worst of all possible worlds. We Sovietised the household credit process, but we pretended that the system was still market-based. Say what you want about the Soviet Union, they at least understood that they were running a command economy. The private sector just extracts rents as they process applications as quickly as possible, and then dump the risk on the CHMC. Economic analysis in the mainstream media is dominated by commentary of bank economists. Normally, these economists follow a pro-free markets platform; however, there is remarkably little criticism of a programme that coincidentally benefits their employers.
These poor policy choices have trapped future governments in a strait jacket. There is almost no room for policy experimentation in any direction, as anything that might trigger rapid rate hikes risks bringing down the system. We are stuck waiting for a supply side miracle that raises capacity, and we have investment-led growth. Although that happened in the 1990s, repeating the experience would not be easy. Why would businesses ramp up investment in a low demand growth environment?
The Messy Analysis of InstitutionsPredicting the consequences of the liberalisation of mortgage insurance was presumably not easy, even though it appears obvious in retrospect. (I was still teaching engineering when the process was started, so I certainly did not predict it.)
Mainstream theory that has a bedrock assumption that households and firms optimally plan is not going to be helpful, even if we incorporate whatever wrinkles researchers have added to the rational expectations assumption. The entire premise of the Canadian mortgage insurance system when it was still working was paternalistic: households and the financial sector had to be stopped from blowing themselves up.
Post-Keynesian theory provides a more sensible starting point for analysis. For example, the Financial Instability Hypothesis of Minsky seems to offer a very good description of how the old system helped reduce the odds of a crisis. (I am lumping Minsky within the “broad-tent” notion of post-Keynesian economics.)
The problem is that the analysis would likely be qualitative, and it may have been difficult to offer quantitative predictions or recommendations. (For example, what would be a safe level for the maximum insured loan size?) Based on the historical data, mortgage borrowing was extremely cautious, and the policy changes made probably looked safe to do. We now have access to an expanded data set, but it has arrived too late to forestall problems.
Concluding RemarksSo long as we avoid a global crisis of some sort, Canadian policy makers have enough freedom of action to prevent a meltdown in the housing market. However, the actions needed to prevent a crisis are helping lock the economy into a low growth path that offers little chance of reducing the overhang of household debt.
The fact that poorly thought out reforms that would allegedly raise growth rates is what has locked us into a low-growth regime is ironic, but is entirely typical of post-1990 policy.
(c) Brian Romanchuk 2017