Real estate, high debt, bad loans the start of a financial crisis

Bank of Canada governor Stephen Poloz has stepped into the great Canadian housing debate by stating that real estate may indeed be overvalued, and by as much as 30 per cent. If true, this could become a huge problem with devastating effects on the Canadian economy.

Dramatic increases in asset prices — what economists call a bubble — can lead to dangers, especially when we are dealing with bubbles in real estate. Eventually, bubbles do what they do best, they burst when prices become unsustainable, at which point prices come down. 

The financial crisis that started in the US and quickly spread around the world in 2007 and 2008 had at its root a real estate bubble which burst.  So clearly, the consequences cannot be minimized.

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It is difficult to foretell the exact impact of a bubble, since there are many factors involved.  The US case was particularly devastating because of widespread fraud and the prevalence of subprime loans, mortgages that were given to people who basically could not afford them. Moreover, in the US, policy makers were denying a bubble even existed. 

Neither scenario appears to be the case in Canada. Although on the rise, the subprime market in Canada is not that pronounced.  Also, we have the advantage of realizing that we may be living in a bubble, which should give policy makers time to devise the proper policies to mitigate its impact.

In fact, Poloz took a first step in this direction by publicly commenting on the situation, which is rather unconventional.  He is hoping this will send a strong signal.

When bubbles forms, there is a general increase in overall wealth. This is good in a way, but the problem is that along with the increase in wealth, there is also an increase in personal borrowing.

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In other words, as the value of houses goes up, households will often use the equity to borrow and get themselves into more debt.  This fits the Canadian story quite well.  Household debt is now at a record 162% of disposable income, according to the latest numbers released by Statistics Canada this week. And it is still growing. This means that the growth we experienced before the crisis was largely driven by household debt. 

The flip side of the coin, however, is even worse. When the bubble bursts, there is a decrease in wealth.  As the value of your asset comes down, say by 30 per cent, the value of the debt stays the same, which places households in a very precarious and fragile financial position. Indeed, for most households, the house is the only asset they have. The effects are real and can be considerable.

Some will downplay the potential threat to the Canadian economy. In fact many will downplay the impact of a bubble bursting.  That would be foolish. 

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Bubbles are never a good thing. The IMF estimates a housing burst can have devastating effects on GDP, and the aftermath can last several years.

All this means the Bank of Canada must move very carefully with respect to monetary policy. It must carefully weigh the consequences of increasing rates against leaving them low.  The Bank of Canada is in a tough spot, and clearly it knows it.

On the one hand, if the Bank of Canada leaves interest rates too low, it may encourage more borrowing and more debt, thereby contributing further to price increases.  On the other hand, if it raises interest rates, it risks bursting the bubble.  Moreover, while debt servicing is now quite low, this is entirely due to low interest rates.  As rates increase, it will only exacerbate matters and put a squeeze on aggregate demand, thereby threatening to trigger another recession.

Personally, I never thought low rates of interest were the major cause of bubbles. In history, there are many periods of low rates of interest, which are unaccompanied by asset bubbles.  The biggest culprit, however, is the lack of regulations.

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So we need to adopt strict regulations that will slow down the rate of household borrowing. We must adopt stricter lending rules, outlaw subprime laws outright, and turn our attention to credit card debt.

Regulations are easy to adopt, but it requires political will to do so.  Governments often shy away from them, thinking it amounts to meddling in markets. But there is no reason to believe such meddling is bad, if it contributes to greater stability and lowers the risk of another financial crisis — and in this case, avoids a debt deflation.

Never have we been at such an important crossroad in Canada: high debt, bad loans, unstable world economy, and a stock market melting before our eyes.  The Bank of Canada and the federal government have an opportunity to adopt good policies to ensure prosperity and growth.  Will they have the courage to do so?

Louis-Philippe Rochon is an associate professor at Laurentian University and co-editor of the Review of Keynesian Economics.