Making Economics Meaningful – How Official Inflation Figures Obscure Reality

Since 2008 (that evergreen financial milestone) central banks have tried to stimulate economies by keeping borrowing rates extremely low. The idea was that people and corporations would be encouraged to borrow and spend money since the cost of that borrowing would be so cheap. This would eventually stimulate the economy through growth, help people get back to work and ultimately lead to inflation as shortages of workers began to demand more salary and there was less “slack” in the economy.

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Following the financial crisis lending rates dropped from historic norms of around 5% to historic lows and remained there for most of the next decade.

Such a policy only makes sense so long as you know when to turn it off, the sign of which has been an elusive 2% inflation target. Despite historically low borrowing rates inflation has remained subdued. Even with falling unemployment numbers and solid economic growth inflation has remained finicky. The reasons for this vary. In some instances statistics like low unemployment don’t capture people who have dropped out of the employment market, but decide to return after a prolonged absence. In other instances wage inflation has stayed low, with well-paying manufacturing jobs being replaced by full-time retail jobs. The economy grows, and people are employed, but earnings remain below their previous highs.

Recently this seems to have started to change. In 2017 the Federal Reserve in the United States (the Fed) and the Bank of Canada (BoC) both raised rates. And while at the beginning of this year the Fed didn’t raise rates, expectations are that a rate hike is still in the works. In fact the recent (and historic) market drops were prompted by fears that inflation numbers were rising faster than anticipated and that interest rates might have to rise much more quickly than previously thought. Raising rates is thought to slow the amount of money coursing through the economy and thus slow economic growth and subsequently inflation. But what is inflation? How is it measured?

One key metric for inflation is the CPI, or Consumer Price Index. That index tracks changes in the price or around 80,000 goods in a “basket”. The goods represent 180 categories and fall into 8 major groupings. CPI is complicated by Core CPI, which is like the CPI but excludes things like mortgage rates, food and gas prices. This is because those categories are subject to more short-term price fluctuation and can make the entire statistic seem more volatile than it really is.

CollegeInflationArmed with that info you might feel like the whole project makes sense. In reality, there are lots of questions about inflation that should concern every Canadian. Consider the associated chart from the American Enterprise Institute. Between 1996 – 2016 prices on things like TVs, Cellphones and household furniture all dropped in price. By comparison education, childcare, food, and housing all rose in price. In the case of education, the price was dramatic.

Canada’s much discussed but seemingly impervious housing bubble shows a similar story. The price of housing vs income and compared to rent has ballooned in Canada dramatically between 1990 to 2015, while the 2008 crash radically readjusted the US market in that space.

The chart below, from Scotiabank Economics, shows the rising cost of childcare and housekeeping services in just the past few years, with Ontario outpacing the rest of the country in terms of year over year change when it comes to such costs.

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My desktop is littered with charts such as these, charts that tell more precise stories about the nature of the broader statistics that we hear about. Overall one story repeatedly stands out, and that is that inflation rate may be low, but in all the ways you would count it, it continues to rise.

DIe6Fh2UMAEDmaIIn Ontario the price of food is more expensive, gas is more expensive and houses (and now rents) are also fantastically more expensive. To say that inflation has been low is to miss a larger point about the direction of prices that matter in our daily lives. The essentials have gotten a lot more expensive. TVs, refrigerators and vacuum cleaners are all cheaper. This represents a misalignment between how the economy functions and how we live. 

DJs5AdwXoAANcDTEconomic data should be meaningful if it is to be counted as useful. A survey done by BMO Global Asset Management found that more and more Canadians were dipping into their RRSPs. The number one reason was for home buying at 27%, but 64% of respondents had used their RRSPs to pay for emergencies, for living expenses or to pay off debt. These numbers dovetail nicely with the growth in household debt, primarily revolving around mortgages and HELOCs, that make Canadians some of the most indebted people on the planet.

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In the past few years, we have repeatedly looked at several stories whose glacial pace can sometimes obscure the reality of the situation. But people seem to know that costs are rising precisely in ways that make life harder in ways that we define as meaningful. When we look at healthcare, education, retirement, and housing it’s perhaps time that central banks and governments adopt a different lens when it comes understanding the economy.

The Housing Bubble Jane Jacobs Built

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When Jane Jacobs died in 2006, her Annex home sold for a reported $3,000,000. A lofty sum, but a fitting metaphor for the career of a woman so central to how we’ve come to understand cities and urban growth.

Cities, almost everywhere, are under a crunch to meet the needs of growing populations and affordable housing. In Canada two cities stand out as being places to go when you are looking for work, Toronto and Vancouver, and notably they have both been beset with rapidly inflating housing prices. And while I have covered this topic many times (many, many, many times), recently various governments have seen fit to try and wrestle the housing monster to the ground before it explodes and does long term damage to the economy.

First, a BC law was passed on foreign buyers. Totalling 15%, early signs are that it has worked in Vancouver and Victoria. Sort of. In late October several news outlets published the startling result that “Home Sales Plunge 38.8%”, which is helpfully misleading. The gross number of home sales on a year over year result (that is October 2015 vs October 2016) was 61.2% of what it had been in the previous year. 3646 homes were sold in October 2015, and 2233 were sold in October 2016. A corresponding decline in price for the same two periods was non-existent. Prices were actually up year over year, by 24.8%, though the average price had dropped by 0.8% from September.

The next set of laws has come from the federal government, which is trying to improve the financial health of those seeking mortgages by setting higher thresholds for banks and CMHC insurance qualifications. More recently imposed than the BC foreign buyers tax, we’ve yet to see what kind of impact these new rules will have, but I’m willing to posit a guess.

Like the BC law, the new national rules will do more to curtail the supply of property than it will reduce price and limit demand. The reason for this is that governments are attempting to tackle the part of the housing problem they feel most comfortable in, taxing and regulation. And while we know fundamentally very little about how many foreign buyers there are and what impact they are having on the Canadian market (among other obtuse aspects of Canadian realty, you can read about these issues here.), regulation and taxation are well understood tools that most politicians feel comfortable using even when the problem may still not be well understood.

What governments are loath to do though is tackle the part of the problem they could have the greatest impact on, which is supply. Governments, municipal and provincial, have a big say in what can get built and at what speed. But cities like Toronto frequently challenge their own growth, trying to straddle the boundary between their future needs while obsessively preserving some idea of a perfect version of itself.

 

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Proposed highway construction for Toronto

 

The efforts the city and province have made, to try and “densify” urban corridors while leaving the neighbourhoods of detached homes in between them untouched, is probably failing in some measure. First because the neighbourhoods themselves aren’t super excited about 20 story buildings going up within the line of sight of their homes. Second because many people don’t see themselves raising families in condos, leading to an abundance of 500 – 700 sq-ft spaces that only serve first time buyers, but not growing families.

The resistance that neighbourhoods put up to growth can be almost comical. From petitions to “Stop Density Creep” to city councilors objecting to condos not being “in keeping with the community” in our most urbanly dense sectors, citizens and their representatives can be almost hysterically opposed to any changes that might affect them.

tumblr_mtxtnjdxzb1s9jvclo1_1280And so we come back to Jane Jacobs. There is unlikely anyone more influential on how we think of cities than Jane Jacobs. She’s responsible for many great ideas about livable spaces, about how sidewalks and cities need people to thrive, the benefits of cities for bringing different people from different socio-economic backgrounds together and the importance of making cities for people, and not cars. When she lived in New York she fought against the likes of Robert Moses, and the push for more highways (frequently built at the expense of poorer neighbourhoods). When she brought her family to Toronto to avoid the Vietnam war (her kids were of drafting age) she moved into the Annex and fought against plans for the Spading Expressway (now Allan Rd) and campaigned so that its southern portion was never built.

But Jacob’s legacy has born some strange fruit. Though Jacob’s herself did seem to support growth of cities and solid development, the movement she helped birth and guide has become paranoid, myopic and NIMBY-istic. Here in Toronto we both benefit from her insight, and are hobbled by it as well. We have learned to love cities as places for people, but have grown suspicious of the development needed to accommodate our growth.

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Against those challenges, stricter regulations for new home buyers and a tax on foreigners seems to do very little to solve the one problem we do have, not enough supply. While tightening the lending restrictions is important to stemming the growing debt burden saddled on Canadians, the goal should still be to restore a healthy real estate market to our major cities, both a certain way to avert a massive housing bubble implosion and a way of making homes more affordable. That seems to be a challenge our elected officials aren’t up to yet.

Pay No Attention to the Bubble Behind the Curtain

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From The Financial Post Magazine, Sept 15, 2015: “Canada’s Ever Growing Housing Bubble”

In the Wizard of Oz we were told that to enter the Emerald City, everyone had to wear green tinted glasses to “protect their eyes” from the “brightness and glory” when in fact it was the method by which the city itself was made to appear green. The first great illusion of the Wizard in the book. Canadian housing feels much like this. The worse the situation gets the more we are assured that the “brightness and glory” of the housing market is unassailable or simply not an issue, and we are invited to don our own emerald glasses.

Toronto LifeThe latest installment challenging that gilded view of housing and mortgages come from the November Toronto Life. Titled “Mortgage Slaves” it is a depressing look into the world of shadow banking and sub-prime mortgages here in Toronto, which far from popular belief is a lively and growing business. Private lenders and shadow lending can turn the reasonable prospect of paying a mortgage into a spiralling mess of debt. The family they interview took a moderate second mortgage for renovations, and promptly found themselves in financial trouble. Seeking help they refinanced several times with private lenders, moving their borrowing rate up from a reasonable rate of interest to 12%. Ten years on and they owed more money than they had paid for their house and were poised to have their home sold from under them.

FSR MFC LendingPossibly the most frightening thing is that Canadians borrow $10 billion a year for their down payments, meaning that the whole point of down payments is undone. And it is here that we see how problems arise. Housing has gone from being one of the most conservative practices to one of the most aggressive. Down payments are small, you still only need 5% to get a mortgage. The secondary banking business is growing, precisely in the area we don’t want with less credit worthy families. Housing prices are ballooning at rates far in excess of what would be deemed sustainable. The CMHC, the people insuring many of the mortgages and who will be on the hook for significant defaults, also believes that the housing market is vulnerable to a correction.

Home prices adjusted for inflationThe response from political parties during the last election isn’t just underwhelming to these problems, it was counter productive. Harper had promised to raise the maximum you could borrow from your RRSP for the First Time Home Buyers Plan. Trudeau’s plan was arguably worse, allowing you to dip more than once into your RRSP. The best plan was from the NDP to cut taxes to build more rental units.

The IMF, the Bank of Canada, the CMHC and The Economist all believe that our housing market is over valued. The response from banks, private lenders and politicians is to shrug and tell us not to worry. There is complicity from home owners and realtors, who are enjoying seeing the rising home valuations and the flurry of activity that it brings. Economists don’t worry because despite the high level of debt, Canadians don’t owe all that debt at once but over decades. So what’s the concern?

Economist HousingBut it should not take a MENSA level intellect to determine that nothing good can come from growth in the continued drop in quality of the banking system or in the quality of debt on issue. Politicians and citizens have to face a reality that high house prices are only good too a point, and that taming the housing market will pay greater dividends than the eventual fall disinterested parties are predicting. But most importantly, young Canadians should know that buying a house at any cost does not define financial success. But it could spell financial failure.

Danger Creeps: Housing Bubbles and Crying Wolf

I can not find a better metaphor for Canada's housing market than this image from the movie UP! (Which is a film I highly recommend)
I can not find a better metaphor for Canada’s housing market than this image from the movie UP! (Which is a film I highly recommend)

If you’re looking for some good reading Google “Canadian Housing Bubble” and you could fill a library with the amount of material available. There isn’t a week that goes by without some new article somewhere screaming with alarm about Canada’s precarious and overvalued housing market. I’ve written many myself, but in conversation almost everyone admits that regardless of the danger nothing seems to abate the growth in home values.

From the Globe and Mail, published May 13, 2015
The history of the average five year mortgage in Canada going back to the mid 1960s. It’s hard to believe that Canadians once paid interest rates in excess of 20% to buy a home. Today rates are at an all time low and unlikely to rise anytime soon. From the Globe and Mail, published May 13, 2015

This defying of financial gravity gives ammunition to those that doubt there is any real risk at all. The combination of low interest rates, willing banks, rising prices and an aggressive housing market has given a veneer of stability to an otherwise risky situation. Combined with the “sky is falling” talk about the house prices and it is easy to understand why many simply accept, or outright dismiss, the growing chorus of concerns about house prices.

26621859Nissam Taleb’s book “The Black Swan” highlighted that negative Black Swan events tended to be fast, like 2008, while positive Black Swan events tended to be slow moving, like the progressive improvement in standards of living since the end of the Second World War. But it would be fair to say that creating a negative event requires a prolonged period of danger creep, a period where a known danger continues to grow but remains benign, fooling many to believe that there isn’t any real danger at all.

I would argue we are living in such a period now. The housing market is continuing to grow more precarious and many Canadians are finding that their own financial well being is connected to their home’s appreciating value. Between large mortgages and HELOCs, Canadians are deeply indebted and need their home prices to continue to inflate to offset the absurd level of borrowing that is going on.

As an example of how the “danger creeps” have a look at this article from last week’s Globe and Mail which highlights a young couple living in Mississauga with a burdensome debt and an unexpected pregnancy. They are classified as some of the “most indebted” of Canadians; house rich and cash poor. By their own estimates they are over budget every month and 100% of one of their incomes goes exclusively to pay the mortgage, stressful as that is they aren’t worried. It may seem irresponsible on their part to buy such a home, but they couldn’t do it if there weren’t many others complicit in making such a bad financial arrangement. Between lax rules from the government, a willing lending officer and well intentioned families that help out, it turns out that creating a financially fragile family takes a village.

A nation of debtors is a vulnerable one indeed. I’ve often said that financial strength comes through being able to withstand financial shocks, and this is exactly where Canadians are falling short. It’s the high debt load and minimal savings (and that these two issues are self-reinforcing) that make Canadians vulnerable. A change in the economic fortunes would force many Canadians to deleverage and in the process would inflict further damage to the economy and likely many homes onto the market.

Such an event is strictly in the “uncharted seas” sector of the economy. No one has a clear idea what it would take to shift the housing sector loose, or what would happen once it did. And that’s just the unknown stuff. With interest rates at an all time low it would also only take a small increase in the interest rate (say 2%) to bump up many people out of their once affordable mortgage and into unaffordable territory.

That’s the problem with slow growing danger, it has a glacial pace but when it arrives it is already too large to be dealt with easily. In one of my favorite movies, the Usual Suspects, Kevin Spacey utters the line “The greatest trick the devil ever pulled was convincing the world he didn’t exist”. That’s something we should all be wary of, the longer the housing market stays aloft the more convinced we become that not only is it not dangerous, but that there was never any danger at all.