TD Economics Monday released a rather gloomy report, putting the odds of a U.S. recession at 40 per cent, and arguing that that Canadian economy is more vulnerable to recession than it was in 2008. It highlights reduced capacity for governments to respond given that interest rates are already very low, and given that household and government debt are significantly higher than in 2008.
I would go one step further and argue that the odds of a Canadian double-dip recession are quite high. I agree with TD that our capacity to respond through easier monetary policy is weak, but would argue that we can and should respond through fiscal policy.
As Jim has argued on this blog, underlying growth in the first quarter was very low: 80 per cent of the real 1 per cent growth rate registered in the quarter came from inventory accumulation Consumer spending was flat, and government spending was falling as fiscal stimulus came to an end.
We get the data for the second quarter (April through June) at the end of this month, and it is a bit of a mug's game to guess if the numbers will be negative. Some of the available data are, however, not very promising. Monthly real GDP growth was zero in April and down 0.3 per cent in May. Data for the second quarter which are already in, show a significant widening of the merchandise trade deficit and declining manufacturing sales. There has been modest job growth, but wages have recently been lagging prices. (In July, average hourly earnings of permanent workers were up 1.2 per cent year over year compared to a 3.1 per cent increase in the CPI.) However, retail sales have still been rising; and housing starts and sales still seem to be still holding up.
In thinking about the outlook moving forward I re-read an excellent May 2010 post from Jim Stanford applying Steve Keen's framework of analysis to the Canadian economy. In a nutshell, Jim argued, following Keen, that growth has to originate in credit expansion in some part of the economy, and that even a slowdown in credit growth (as opposed to an outright contraction) can severely weaken real GDP and employment growth. (This framework allowed Keen and others to correctly forecast the Great Recession, which arose from financial asset bubbles fuelled by an unsustainable increase in private debt.)
" (t)he implication of Keen's analysis is that when the expansion of the private debt burden does stop (as it must sometime), it will wreak disastrous results on spending power, GDP, and labour markets. It's not just that a decline in debt would be associated with another downturn; that's something most of us are well aware of. Because our economy has become so dependent in recent years on the rapid (and obviously unsustainable) expansion of private debt, merely stopping (or substantially slowing) the growth of that debt would knock a giant hole in aggregate spending -- enough to send us into a double dip."
Canada came out of the recession faster than the U.S. because, somewhat surprisingly, very low interest rates led to a recovery and then expansion of the residential real estate market, and because our fiscal stimulus was larger and better targeted than in the U.S.
Low interest rates are still fuelling the expansion of household credit, especially residential mortgage debt which rose by $75.4 billion or 7.6 per cent in the year to May, and is still rising on a month to month basis. (See Bank of Canada Banking and Financial Statistics, Table E2.) The most recent reading on house prices from the Teranet index (which, like the Shiller index in the U.S., looks at price changes for exactly matched pairs of sales) shows that housing resale prices in May were up 4.36 per cent from one year ago, and up 1.28 per cent from April. Consumer credit, some of it fuelled by home equity loans based on rising house prices, is also still rising.
This continued expansion of household credit may support growth in the most recent quarter, but seems highly unlikely to continue. Instead, a correction of housing prices which could set the stage for U.S.-style household debt deleveraging, seems very much in prospect. (See posts on the housing bubble on this blog by myself, Jim Stanford, David Macdonald and Toby Sanger.)
Following Dean Baker, a housing bubble can be identified by key ratios -- the rate at which housing prices are rising relative to all prices, the ratio of house prices to incomes, and the ratio of house prices to rents. Since about 2000, house prices have been rising much, much faster than consumer price inflation and well ahead of the growth of household incomes and rental costs. The average house price is now 5.2 times greater than average household income, up from a normal ratio of 3.2 times in the 1980s and 1990s. Due to increased mortgage debt, the ratio of household debt to disposable household income is now at a record high of 147, just a bit below the U.S. level before the housing bubble burst. TD estimates that house prices are 10-15 per cent over-valued, and that seems pretty conservative.
Low interest rates have kept debt servicing costs low and maintained some semblance of affordability for a surprising long period of time. But what must come to an end will indeed come to an end.
As and when household credit growth slows, the economy will have to be driven by either (1) an improved trade and balance of payments balance with the rest of the world (2) expansion of business investment or (3) increased government deficits.
Given that business investment in Canada is led by the export-oriented resource and manufacturing sectors, scenarios (1) and (2) are closely linked. Current data show that total business credit is still growing -- up 5.9 per cent at an annual rate in the second quarter -- but slowing. The balance of payments on current account is negative and apparently deteriorating based on the latest trade data. If there is a recession in the U.S. and Europe and the Canadian dollar remains at or near parity, it is hard to believe that we will get the needed acceleration of investment and net exports.
Yet, if we are to avoid recession, such an acceleration will be needed, not just to offset any deceleration of household credit growth, but also to offset the ongoing fall in government borrowing. The total government deficit is now 5.2 per cent of GDP (first quarter) and falling, down from a 2010 second quarter peak of 6.3 per cent of GDP.
By way of conclusion, the odds of a Canadian recession seem to be pretty high if we contemplate no change in fiscal policy.
This article was first posted on The Progressive Economics Forum.
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