Baby, we got a bubble!?

[brockm]

You know, my fundamental point, that a lot of people seem to miss when I criticize the solvency of Canadian banks, is that we have a banking system -- not just in Canada, but worldwide -- which is wholly dependent on central banks for stability because of the nature of fractional reserve banking.

After the Great Depression, in which a total 5% of deposits were actually lost, the world shifted towards having governments backstop the financial industry and become intractably embroiled within the way the financial markets function.

In fact, government debt is one of the major vehicles of money creation and the overwhelming way in which international settlements are handled.

Governments have become dependent on cheap credit to finance their burgeoning debt. Consumers have become dependent on cheap credit to finance their spending habits. And thus, artificially pegged, low interest rates have come to be seen as absolutely essential to the economy as a whole.

The degrees to which liquidity risk even exists today in financial markets is fundamentally based on the relatively tiny fractions of capital that back all the transactions to begin with.

Real estate, in this case, is merely a vehicle for much of this created money. The excessive amount of it is distortionary and is sending the false signals to builders and everyone that consumers can afford higher and higher prices. Thus, incentivizing real estate investors to pile into the market.

Take away the punch bowl, by raising interest rates to even a neutral inflation level relative to CPI and this market would implode.

The rate of debt accumulation to income is absurd. It represents an ongoing and ever growing serious inflation risk to the economy writ large. It is sending the wrong signals to investors and it is sending the wrong signals to consumers.

It takes only back-of-paper-napkin math to see the crisis in the making. The OECD has underscored it. And our great hypocritical monetary overlord Mark Carney has been warning about it for two years.

I say hypocrite, because as Carney runs around warning Canadians to the dire risk of consumer debt, it is his monetary policy that supports the environment in which the accumulation of that debt is possible. He wants the low interest to stoke risk taking, investment, and shore up liquidity. But he wants that cheap money sloshing around to get used "responsibly" by everyone. Which is like telling people not to get fat.

 

[interested]

You know, my fundamental point, that a lot of people seem to miss when I criticize the solvency of Canadian banks, is that we have a banking system -- not just in Canada, but worldwide -- which is wholly dependent on central banks for stability because of the nature of fractional reserve banking.

After the Great Depression, in which a total 5% of deposits were actually lost, the world shifted towards having governments backstop the financial industry and become intractably embroiled within the way the financial markets function.

In fact, government debt is one of the major vehicles of money creation and the overwhelming way in which international settlements are handled.

Governments have become dependent on cheap credit to finance their burgeoning debt. Consumers have become dependent on cheap credit to finance their spending habits. And thus, artificially pegged, low interest rates have come to be seen as absolutely essential to the economy as a whole.

The degrees to which liquidity risk even exists today in financial markets is fundamentally based on the relatively tiny fractions of capital that back all the transactions to begin with.

Real estate, in this case, is merely a vehicle for much of this created money. The excessive amount of it is distortionary and is sending the false signals to builders and everyone that consumers can afford higher and higher prices. Thus, incentivizing real estate investors to pile into the market.

Take away the punch bowl, by raising interest rates to even a neutral inflation level relative to CPI and this market would implode.

The rate of debt accumulation to income is absurd. It represents an ongoing and ever growing serious inflation risk to the economy writ large. It is sending the wrong signals to investors and it is sending the wrong signals to consumers.

It takes only back-of-paper-napkin math to see the crisis in the making. The OECD has underscored it. And our great hypocritical monetary overlord Mark Carney has been warning about it for two years.

I say hypocrite, because as Carney runs around warning Canadians to the dire risk of consumer debt, it is his monetary policy that supports the environment in which the accumulation of that debt is possible. He wants the low interest to stoke risk taking, investment, and shore up liquidity. But he wants that cheap money sloshing around to get used "responsibly" by everyone. Which is like telling people not to get fat.

This is an interesting analysis Brockm

I have 2 comments:

No one can abruptly take away the punch bowl because that is like taking drugs or alcohol away from an addict. The withdrawal often is very severe and in the pursuit of trying to get the individual (economy) off drugs/alcohol (low interest rates), the patient may have severe unintended or intended consequences which one could argue are no better than the addiction in the first place....read "bankruptcy of the banks/economy" which I at least fail to see how this is constructive in the longer term.

The second bolded paragraph referring to the hypocrisy of Carney I think is somewhat unfair. Yes it is hypocritical...interest rates should rise, prices should crash, governments should essentially go bankrupt, and we should return to a gold standard. The problem with this scenario is the amount of "pain" to the population would be intense, dare I say even worse than the severe depression of 1932-1933 which followed the stock market crash of 1929. I am sure you are not advocating for this result.

Hence, Carney has no choice but to try and warn people in perhaps the faint hope of avoiding a hard/crash landing. He has to play after all within the parameters of managing the Central Bank for the Benefit of Canada and I believe we both would agree the above result is not an acceptable solution.

cdr: The article in post #5596 is indeed frightening but as you correctly point out, not unknown. The reality is that failure of 1 major bank would be catastrophic and 2 I think would mean the "end" of Canada. If the US banks are too big too fail (with some of them single handedly accounting for 10 to up to 20% of all deposits) I would suggest that Royal and TD are closer to 20-25% each.

The US offer to all banks in 2008 was picked up by many banks from different countries operating in the US who qualified. That the Canadian banks took these loans was just sensible at the time, in light of brockm's further clarification in the post I just responded to.

The reality is that if any of the major banking systems fail (Europe, China, USA) (unions in the case of Europe)and even lesser countries the devastation will be unprescedented. Frankly, too frightening to even think of. So we continue to "tinker" with the system and all politicians can do in the short medium term is encourage people who are jumping into debt with no anticipation of a downturn is keep raising flags.

One last point: If Carney raised interest rates...the C$ goes up vis a vis the USD. Given 65-70% of our trade goes to a weak US economy at present, this inflicts severe pain on the Canadian economy...triggers more loss of jobs, weaker economy, and possibly starts the downward real estate spiral. Once started, it is difficult to predict where the spiral lands. Hence best to proceed in baby steps. Note: it will always start at the margin. The speculator/flipper poorly capitalized will lose and that is OK, even perhaps deserved. But as seen in the US now, even responsible, well capitalized home owners are under water or can't move because they can't sell their house. So I am not sure what exactly different Carney could do.

Sorry CN Tower and others....I know once again too complicated a post but a complicated thesis I am trying to put forth.

 

[brockm]

I am unfazed by the arguments that we must maintain a weak currency. This is just more economic central planning. I would float rates, allow competitive currencies, and I'd also unilaterally remove all tariffs and trade barriers. Including removing the labour market opinion requirement for prospective economic migrants.

But I'm crazy like that.

 

[interested]

I am unfazed by the arguments that we must maintain a weak currency. This is just more economic central planning. I would float rates, allow competitive currencies, and I'd also unilaterally remove all tariffs and trade barriers. Including removing the labour market opinion requirement for prospective economic migrants.

But I'm crazy like that.

I respect your view. I don't think you are crazy "like that". I just don't think anyone will thank you if we did what I believe you are implying acutely. Simply too much pain/suffering and confusion. In the long run, would work...but every country would have to be on the same page for it to be effective. Otherwise, I think we just shoot ourselves in the foot if the US does not do the same.

 

[brockm]

I respect your view. I don't think you are crazy "like that". I just don't think anyone will thank you if we did what I believe you are implying acutely. Simply too much pain/suffering and confusion. In the long run, would work...but every country would have to be on the same page for it to be effective. Otherwise, I think we just shoot ourselves in the foot if the US does not do the same.

Where we disagree strongly is on the premise that we can unravel this mess in a way which minimizes pain. I think that form of thinking is a fatal conceit.

Liquidating malinvestment is always painful. But it is a necessary process to rebalance an economy. The process of doing it slowly merely perpetuates the malinvestment through bailouts, arbitrary subsidies and loan programs, etc.

Look at all these failing solar companies in the US and Canada that were invested in as part of the government's attempt to "create jobs". Bankruptcies have been rampant.

All the government did is squander even more capital. To believe government can play a role in helping to effectively make better investment decisions than the market is to believe that elected politicians know better than the collective knowledge of consumers. It is what Hayek called the "pretense of knowledge" in his Nobel speech.

Government isn't making the situation better.

The economy is trying to liquidate the companies that can't turn a profit. It is trying to reprice goods at their cost and marginal utility. The government is standing in the way of allowing the market to do this.

The continuation of this bubble an the continue expansion of the consume credit bubble underscore this.

 

[interested]

^^^
there was an interesting book called power cycles written about 20 years ago. It talks about major cycles every 60-70 years and a rebalancing of asset classes.

Governments work on short term time references: 4 or 5 years. Therefore no long term thinking.

Blame the population and politicians. Do you think you could get elected to do what you are suggesting here:

I could see that campaign: Elect me. I promise I will crash the Canadian economy to "rebalance it". I am going to let car companies, banks etc. fail. (Not that I don't think it is right by the way...I am playing Devil's advocate). A lot of you will lose your jobs. Many of you will not be able to feed your families. Your pensions if you are old will disappear or be severely restricted. But all this medicine is for your own good.

Wait a minute...isn't that what they are doing in Greece? Has to happen. People revolting in the street. Governments failing or being turfed. Unemployment soaring.

Now you can tell me things will be better in 5 years....maybe. But that is a tough sell.

Please note brockm....I am not disagreeing it should not be done as you are suggesting. I just think it will be so painful it won't be "voluntarily" undertaken. Rather, things will have to deteriorate to the point of no return and the solution "forced" on the population/politicians.

 

[cdr108]

IMO the both of you are correct but the damage was done when BoC overnight rate was reduced to 0.25%, further inflating the money supply, which mostly ended up in consumers hands paying for inflated asset classes (ie. R/E, commodities, stocks, etc) rather than private sector companies accessing cheap funds for capital investment and increased hirings.

if the canadian economy/banks are so great to weather the financial crisis vs. other nations, then in 2008 it was completely unnecessary to drop the BoC overnight rate from 4.00% (2008-01-22) to 0.25% (2009-04-21) and maintained there until 2010-06-01. 375 basis point drop over 5Q and kept there for another 5Q !
http://www.bankofcanada.ca/rates/interest-rates/canadian-interest-rates/

It's at 1.00% now since 2010-09-08 but Carney had added so much fuel to the fire, that some consumers have engourged themselves so badly that it will affect everyone in the end when the damage unfolds.

iIRC, r/e prices dropped 10-15% in Toronto during 2008, but Carney et al's actions re-inflated the bubble much much more.
even Carney has stated certain markets (ie. TO condos) are 35% over-valued and the deflation or popping of the bubble will be painful but necessary.

personally, i think Carney should bite the bullet and increase 1/4 point (25 bp) next announcement in July 2012 and 25 bp every Q thereafter (or variation of thereof). that's only 100 bp increase over 4Q vs the 375 basis point drop over 5Q. in this example, it would still take another 3 years (ie. 12Q) to get back to where we were before at 4.00% in 2008 !

surely we can weather that ... it can/should be done, otherwise, when inflation truly kicks into gear Carney will be forced to do more - larger increases in a shorter period of time and that would surely be a shock for the large mortgage holders and economy overall.

also, i believe that fluctuations with our CDN $ will be minimal with the gradual BoC overnight rate increases as it'll be mostly priced in and anticipated.

 

[interested]

^^^
cdr, as I know you are aware; Carney has a lot more problems than worrying just about housing.

Rises in interest rates will mean companies will hesitate even more to invest...further job losses.
C$ will increase relative to USD and other currencies: manufacturing and competitiveness even more hurt.
Result, further unemployment. Etc.

You get my gist. I still agree he has to go up but I don't think he can do 1/4 point every quarter. However, once he does go up, he must do at least 3 -4 rate hikes over 6-9 months in my opinion ; in other words in quick succession so as to send the market the message that care must be exercised going forward. I would hope that the 1% increase would be enough to get people to think without doing too much damage to the overall economy.

 

[interested]

From Sherry Cooper and the Financial Post.

http://business.financialpost.com/2012/05/01/putting-torontos-housing-boom-in-perspective/

Housing is a key sector in any economy and many developed countries pride themselves on a high level of homeownership. Certainly that is the case in Canada and the U.S., and increasingly the case in emerging economies such as China where homeownership has grown very rapidly. But, as we have painfully seen in recent years, over-investment in housing creates fault lines that result in enormous economic instability and dislocation.

Case in point is Spain, where the housing bubble has caused an economic disaster. For nearly a decade starting in 1999, house prices exploded in Spain as both domestic buyers, and more notably, foreign buyers poured money into residential real estate. Europeans, Russians and others were using the Costa del Sol as their vacation hideaway and condo building in all parts of Spain exploded. The return on investments in residential real estate majorly outpaced the return on any other asset class, so even ordinary Spaniards bought second and third homes expecting to rent and flip them for astonishing gains.
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The growth boom in Spain was focused on housing, and households invested a significant portion of their assets in residential real estate. At its peak in 2008, nearly 80% of Spanish household assets were in real estate, well above current levels in the U.S. and Canada. For Canadians, the share (39% in 2011Q4) is close to a record high, at least as far back as 1990 when the data first became available. The Toronto condo boom has raised the spectre of a Spanish-style housing bubble fuelled in large measure by foreign capital and domestic investors — but the numbers so far pale in comparison to what happened in Spain or the U.S.
Advertisement

As the U.S. housing market is bottoming, Spain’s housing collapse likely has much further to go and it is taking the Spanish economy down with it. In Spain, house prices have already fallen 21% from their peak in Q1 2008 and some estimate that they will ultimately be down more than 55% before this is over. This compares to the total decline in U.S. house prices of just under 35%.

Normally, in such a situation, one part of the adjustment process is a devaluation in the domestic currency; but, because of the euro, this adjustment mechanism is not available. Instead, a hugely painful internal devaluation of wages and prices must occur.

The housing bubble in Spain was proportionately 2.5 times bigger than in the U.S. and the decline in the U.S. dollar has helped to offset some of the effect on the U.S. economy as net exports and corporate spending cushioned some of the impact. In Spain, there is no such cushioning, so the economy is in free fall and exacerbating the situation are the draconian fiscal cuts forced on the Spanish government by the stronger countries of Europe. The overall jobless rate has risen to nearly 25% and youth unemployment now exceeds 50%.

In addition, mortgages in Spain, unlike the U.S., are recourse loans so there are no ‘strategic foreclosures’ where homeowners walk away from their homes, but keep the rest of their assets. In Spain, as in Canada, losing your house means losing everything. Even with unemployment at Great Depression levels, homeowners are trying to make their mortgage payments, but many are at risk of losing everything. As well, banks are reluctant to foreclose to avoid further reductions in their already depleted capital. It has been reported that, in some cases, they are reducing monthly payments by converting amortized loans into bullet loans, increasing the risk to the bank.

Most Spanish banks have not fully reported the decline in their asset values. The cost to the government to return their banks to solvency is likely larger than currently recognized. Moreover, Spanish bank exposure to commercial real estate is also relatively high and commercial developers are largely near bankruptcy.

Lessons Learned for Canadians

Too much reliance on housing appreciation for wealth accumulation and retirement security is very dangerous. Retirement nest eggs in Spain have been obliterated, and nest eggs in the U.S. have shrunk considerably. Too much household debt is also very dangerous. It increases vulnerability to interest rate risk and to economic risk of income losses or job losses. Canadians are in much better shape than so many in the rest of the world, but Canadians have taken on far more risk than ever before. As more and more of us depend on RRSPs rather than traditional pensions and will need to rely, as well, on home equity to assure financial security, we are more vulnerable than ever to market swings and economic risk. At a time when more of the population than ever before is running out of runway before retirement, stepped-up saving and significant debt reduction are more important than ever.

Dr. Sherry S. Cooper is chief economist with BMO Capital Markets

I think she brings up some very solid points. Extrapolating; in Florida, Arizona in "retirement properties" prices did go up as much as 3x their 2000 value by 2006. Similarly Spain 2 and 1/2 times....coastal retirement property speculation.

Toronto does have the advantage of about a doubling over 10 years, not being a "retirement community", and the Recourse mortgages.

 

[brockm]

From Sherry Cooper and the Financial Post.

http://business.financialpost.com/2012/05/01/putting-torontos-housing-boom-in-perspective/

Housing is a key sector in any economy and many developed countries pride themselves on a high level of homeownership. Certainly that is the case in Canada and the U.S., and increasingly the case in emerging economies such as China where homeownership has grown very rapidly. But, as we have painfully seen in recent years, over-investment in housing creates fault lines that result in enormous economic instability and dislocation.

And this is where I stop reading Sherry. In fact, in my National Post column on this subject I touch specifically on this attitude. I quote myself:

It is considered an economic truism that “real estate is the backbone of the economy” and that real estate leads us out of recessions. So, governments focus on construction and home-buying subsidies as a first-measure to deal with economic downturns. But this “truism” is a recent phenomenon that finds its soul in the end of the Bretton-Woods consensus 30 years ago.

Housing has utility, insofar as it protects us from the elements and brings us pleasure. But it is not a wealth-creation vehicle. My house doesn't produce widgets. In fact, my house consumes resources and depreciates -- in real terms. I must continually invest capital into the house in order to keep it in a usable condition.

But what we see in the form of price appreciation in the housing market, is largely just a monetary phenomenon. As I mentioned in that article, from the 19th century, all the way up until Nixon killed the Bretton-Woods consensus, average housing costs tracked the underlying inflation trend.

Economists like Shelly have since become convinced that the rapid inflation in housing prices since the 1970s is merely endemic of a wealthy economy. And then they conclude that policy prescriptions should be undertaken to re-enforce the importance of housing to our economy. It's a feedback loop of insanity layered on top of more insanity.

 

[interested]

Economists like Shelly have since become convinced that the rapid inflation in housing prices since the 1970s is merely endemic of a wealthy economy. And then they conclude that policy prescriptions should be undertaken to re-enforce the importance of housing to our economy. It's a feedback loop of insanity layered on top of more insanity.

I agree with you. But I again ask, are you willing to accept the massive displacement to withdrawing all support and allowing the "floor" to be where ever it hits suddenly?

While the notion may be "pure" in economic terms, in real terms for real people the results in my view would be devastating.

 

[cdr108]

^^^
cdr, as I know you are aware; Carney has a lot more problems than worrying just about housing.

Rises in interest rates will mean companies will hesitate even more to invest...further job losses.
C$ will increase relative to USD and other currencies: manufacturing and competitiveness even more hurt.
Result, further unemployment. Etc.

You get my gist. I still agree he has to go up but I don't think he can do 1/4 point every quarter. However, once he does go up, he must do at least 3 -4 rate hikes over 6-9 months in my opinion ; in other words in quick succession so as to send the market the message that care must be exercised going forward. I would hope that the 1% increase would be enough to get people to think without doing too much damage to the overall economy.

i don't believe a rise in interest rates will do any of the above.
if they haven't invested or hired already with such low rates, it won't matter with higher rates.
the reality is many corps are sitting on cash and increased rates might be welcoming.

i believe that fluctuations with our CDN $ will be minimal with the gradual BoC overnight rate increases as it'll be mostly priced in and anticipated. sure, it will go up for the first couple of days before the anticipated (ie. leaked) and after the announcement by 1% and then fall back down.
additionally, a high C$ it's always bad. some manufacturers took advantage of the higher C$ and bought equipment from outside of Canada.

i'm concerned that our day of reckoning in Canada will be caused by the housing market (and the over-indebted consumer because of it) if it's not immediately reined in. the bigger the bubble and over-indebted consumer, the larger the fall as it's consumer spending that drives the economy. whenever a larger portion of income goes to fixed household spending, there's less discretionary spending in other aspects.

 

[interested]

i don't believe a rise in interest rates will do any of the above.
if they haven't invested or hired already with such low rates, it won't matter with higher rates.
the reality is many corps are sitting on cash and increased rates might be welcoming.

i believe that fluctuations with our CDN $ will be minimal with the gradual BoC overnight rate increases as it'll be mostly priced in and anticipated. sure, it will go up for the first couple of days before the anticipated (ie. leaked) and after the announcement by 1% and then fall back down.
additionally, a high C$ it's always bad. some manufacturers took advantage of the higher C$ and bought equipment from outside of Canada.

i'm concerned that our day of reckoning in Canada will be caused by the housing market (and the over-indebted consumer because of it) if it's not immediately reined in. the bigger the bubble and over-indebted consumer, the larger the fall as it's consumer spending that drives the economy. whenever a larger portion of income goes to fixed household spending, there's less discretionary spending in other aspects.

I believe the lack of investment is exactly for the reason you said. Businesses remain concerned about the health of the economy and generally a stronger dollar is more difficult for the economy as evidenced by countries trying to devalue their currencies vis a vis each other.

That said, I concur fully with your concern that the longer we inflate this balloon, the harder the landing will be.

I personally would condone the 1% increase in the shorter term to hopefully stop the madness in Toronto and Vancouver. I am not so sure that one we remove these 2 major cities, adding perhaps Calgary and Montreal to the mix, that more than 1/2 the country however will feel the fix applied for these cities. It needs to happen, the sooner the better, and we need to take the painful medicine, or it will be "imposed" on us just as it has in Greece, Ireland, Portugal, and now Spain and Italy.

 

[ILuvTO]

you'd be surprised at the number of people that don't know that fact.

it wasn't a 'bailout' per se; however, they did increase the liquidity available to the banks by buying the non-CMHC loans and taking the risk off the banks books and transferred it to CMHC (aka taxpayers)

Agreed. Anecdotally, few of my friends and acquaintances knew about this.

 

[ILuvTO]

You know, my fundamental point, that a lot of people seem to miss when I criticize the solvency of Canadian banks, is that we have a banking system -- not just in Canada, but worldwide -- which is wholly dependent on central banks for stability because of the nature of fractional reserve banking.

After the Great Depression, in which a total 5% of deposits were actually lost, the world shifted towards having governments backstop the financial industry and become intractably embroiled within the way the financial markets function.

In fact, government debt is one of the major vehicles of money creation and the overwhelming way in which international settlements are handled.

Governments have become dependent on cheap credit to finance their burgeoning debt. Consumers have become dependent on cheap credit to finance their spending habits. And thus, artificially pegged, low interest rates have come to be seen as absolutely essential to the economy as a whole.

The degrees to which liquidity risk even exists today in financial markets is fundamentally based on the relatively tiny fractions of capital that back all the transactions to begin with.

Real estate, in this case, is merely a vehicle for much of this created money. The excessive amount of it is distortionary and is sending the false signals to builders and everyone that consumers can afford higher and higher prices. Thus, incentivizing real estate investors to pile into the market.

Take away the punch bowl, by raising interest rates to even a neutral inflation level relative to CPI and this market would implode.

The rate of debt accumulation to income is absurd. It represents an ongoing and ever growing serious inflation risk to the economy writ large. It is sending the wrong signals to investors and it is sending the wrong signals to consumers.

It takes only back-of-paper-napkin math to see the crisis in the making. The OECD has underscored it. And our great hypocritical monetary overlord Mark Carney has been warning about it for two years.

I say hypocrite, because as Carney runs around warning Canadians to the dire risk of consumer debt, it is his monetary policy that supports the environment in which the accumulation of that debt is possible. He wants the low interest to stoke risk taking, investment, and shore up liquidity. But he wants that cheap money sloshing around to get used "responsibly" by everyone. Which is like telling people not to get fat.

In fairness to Carney, he can't raise and lower rates in response to one sector of the economy, in this case housing. This is where the government needs to step in and do things like raise the minimum down payment, decrease CMHC involvement, and lower the amortization period.

At the end of the day I agree completely with everything you are saying. The only wild card in the equation, and a big one at that, is the mentality of the people, and how they would respond to a quick and dirty deleveraging? Right now central bankers are pumping new money into the system to essentially replace all the old money that went up in smoke via bankruptcies, lower house prices, etc. They are creating an illusion of stability, and trying to engineer an orderly deleveraging. This has given people a false sense of security and allowed things to remain relatively calm. If we were to engage in a quick and dirty purge of all the malinvestment, would we end up with mass panic and hysteria which would lead to bigger problems than those we are currently facing? I don't know. If you ask someone like Ron Paul about what is happening he will say central bankers are price fixing. If you were to ask those same central bankers they would tell you they are bringing price stability to the market. Who is wrong, and who is right is anyone's guess. As someone that believes in the textbook logic of pure free market capitalism, I still question from time time how it would truly work in the real world when taking peoples emotions into account.