Welcome to the Great Debate, in which Globe Investor invites two experts to debate one of the big questions facing the business and investing world.
This month, we look at Canadian household debt levels. Today, our debaters present their rebuttals to yesterday's opening arguments defending and opposing the motion: Canada's household debt is a major threat to our economy.
For the motion: Ben Rabidoux, analyst and strategist at M Hanson Advisors
The question at hand is whether Canadian household debt levels represent a major risk to the economy. The subjective nature of the word "major" appears to be the point of disagreement in this discussion. I'm not sure it would be fair to limit the definition of a "major risk" solely to a recession or credit crisis.
That said, I would suggest that high house prices, which currently look at risk of a hard landing, high consumer indebtedness, and an economy that by most measures is more levered to this housing and credit boom than at any other point in the past 40 years, collectively suggest that the risk of a recession as the fallout of a consumer deleveraging is uncomfortably high - and rising. I suppose ultimately whether this represents a "major" risk depends on one's perspective.
Canadians have indeed responded to record low interest rates. While adding to debt burdens at this time appears "logical," I must reiterate a central point of my opening statement: As debt burdens rise in an environment of falling interest rates, the net result is to increase present aggregate demand within an economy while sacrificing future demand.
As I noted, some goods and services that would have been purchased in the future out of saved capital are instead purchased today on credit. The flip side of this statement is that consumption that would have occurred in the future is instead curtailed as income must be diverted from present consumption to repay debt incurred on past consumption. This "demand gap," which eventually must be contended with, can for a time be delayed provided interest rates decline while additional credit remains readily available to support consumption.
With interest rates hovering near all-time lows with very little downside potential, and more importantly, with the recent moves by regulators to curtail mortgage and consumer credit growth (most notably home equity lines of credit) which have been key drivers of rising house prices and consumer spending, it certainly appears that the credit binge of the past decade is set to unwind. I remain far from convinced that this will unwind in a benign manner. I see major implications for house prices, consumer spending, the economy and labour market as this dynamic plays out. I believe the risk of a recession in the next few years is very elevated precisely because of this dynamic. This, in my mind, constitutes a major risk.
With regards to some of the other points raised:
Affordability measures are not generating ordinary readings. RBC produces a quarterly affordability report that shows that affordability in most major metro regions in Canada is stretched relative to long-term norms at a time when interest rates remain near record lows. Also consider that this measure assumes a stable 25-per-cent down payment over time….more than a bit of a stretch. This is far from comforting.
While the interest-only portion of debt repayment, which seems to garner all the attention, remains below average, the estimated total debt repayment including principal is well above average.
Focusing on "the asset side of the ledger" is exactly what got analysts in the U.S. in trouble. According to OECD data, when the U.S. peaked in 2006, the household debt-to-asset ratio was roughly 26 per cent. As of 2010, the OECD calculated that this ratio was 25 per cent and growing in Canada. Today, the debt-to-asset ratio in the U.S. has exploded higher precisely because the underlying assets fell in value. In other words, during a credit boom, the credit very naturally flows into certain household assets such as real estate. As Americans learned, asset values can fluctuate wildly. Debt does not.
Against the motion: Eric Lascelles, chief economist at RBC Global Asset Management
It is clear that Mr. Rabidoux and I agree on many things. Canadian household debt absolutely constitutes a risk – probably even Canada's largest domestic risk.
Yet in the pantheon of threats to the Canadian economy, the household debt saga is much less problematic than such formidable external risks as Europe's battle to maintain solvency, a Chinese hard-landing scenario, a commodity shock or the messy business of the U.S. fiscal cliff. Any of those could easily knock the Canadian economy into recession or spur a financial crisis.
Canada's household debt figures centrally in my own muted forecast for Canadian economic growth. However, it does not constitute an outright recession risk.
But I've gotten ahead of myself. In a way, Canada's rising household debt has actually been a godsend. Think of it this way: as the global financial crisis struck, governments frantically stimulated their economies by pulling public spending forward. This action is widely heralded as having averted a global depression.
Canada managed to engineer a similar feat – without further burdening the public purse – by stoking its credit market. Households were incented to pull their own spending forward. This is a key reason why Canada has 300,000 more workers than pre-crisis, whereas the U.S. is still 5 million jobs short.
Of course, the "tomorrow" from which households have borrowed must eventually become "today." But let's not exaggerate the timing or consequences. The current global environment of slow growth, moderate inflation, elevated risk aversion, low policy rates and unorthodox stimulus is inconsistent with substantially higher borrowing costs. Markets and pundits have repeatedly – and wrongly – bet that materially higher interest rates were just around the corner. So long as interest rates remain fairly low, the household debt burden remains manageable.
Even when rates rise, the necessary deleveraging may not be as painful as some imagine. Inflation erodes the real debt burden over time. Rising incomes permit deleveraging without paying a dime of debt. The plump asset side of household balance sheets could be tapped to drain part of the debt.
Illustrating this, the U.S. household debt-to-income ratio has fallen by a whopping 22 percentage points over the past three years, and yet consumer spending growth there has outpaced disposable income growth. The U.S. personal savings rate is just a hair higher than Canada's.
What economic hit should Canada expect when the deleveraging and accompanying housing correction eventually set in? Pessimistically, reduced residential construction might slice 0.75 per cent off annual economic growth over a two-year period, a negative wealth effect might remove another 0.5 per cent a year, while a greater proclivity to save might subtract a further 0.5 per cent annually. When pitted against the recent trend of 2.5 per cent GDP growth, that would appear to leave only a meagre expansion.
However, just as the loonie has constricted growth during recent periods of relative prosperity, it would serve as a welcome shock absorber during a leaner period. Thus, even while deleveraging, Canada can probably manage growth of close to 2.0 per cent a per year, in line with the U.S.
Who won Day 2 of the Great Debate? Cast your vote here.