Canada: Keynes arrives Global Economic Outlook, Q2 2016

In Canada’s current low-inflation environment, the fiscal stimulus promised by the new government will likely be welcome. However, a potential housing bubble and high household debt pose risks.

Canada

Canadians voted decisively in the recent election—for the middle-of-the road party. This certainly makes Canada look like the odd country out in the developed world. European voters seem to be increasingly enticed by parties that emphasize nationalism over the European Union’s common purpose; and in the United States, presidential candidates exploiting populist themes have done surprisingly well against candidates associated with more cautious (and centrist) policymaking. Even in Japan, Prime Minister Shinzo Abe’s popularity rests on promises of significant change. Canadians wanted change, too—after all, they changed the party in office—but apparently, not too much change, as the Liberals are very much an establishment party.

Keynes comes to Ottawa

However, the Liberals did, in fact, promise a very significant and surprising policy innovation—one that has been otherwise rejected across the rest of the developing world. The Liberal Party vowed to provide a 10 billion Canadian dollar (CAD) fiscal stimulus. The actual budget, presented on March 22, was even more generous. The projected 2016–17 deficit is almost CAD 30 billion, up from just over CAD 5 billion in the current fiscal year. And the new government projects continued deficits through the entire period of its mandate.

That’s not a lot relative to the country’s CAD 2 trillion economy, but it is a profound change in course. Since the mid-1990s, when the federal government (also run at the time by the Liberals) took control of a seemingly runaway budget problem, Canadians have been proud of their country’s fiscal rectitude. Perhaps that’s why it was the Liberals, rather than the more leftist National Democratic Party, that were willing to go out on this particular limb. But the policy was in the platform, and voters made a clear choice to experiment with Keynesian fiscal policy.

Since the mid-1990s, when the federal government (also run at the time by the Liberals) took control of a seemingly runaway budget problem, Canadians have been proud of their country’s fiscal rectitude.

The new budget included a variety of spending and tax initiatives, ranging from more infrastructure spending to increasing child benefits.1 The policy’s impact is likely to be small, though more powerful at the current inflation rate. With inflation low, the Bank of Canada won’t need to tighten monetary policy, which might offset the impact of the stimulus. And with the oil sector suffering from low prices and continued slower growth in the United States, Canada can almost certainly use a boost in demand.

But Canada remains, relative to its neighbor, a small, open economy. That means that a lot of the fiscal stimulus is likely to leak out of the country. Canadian imports equal about one-third of GDP, so a first guess would be that one-third of the induced spending from the fiscal stimulus will go abroad (mainly to the United States). That will reduce the size of the multiplier from the additional federal spending considerably.

Estimates of the impact of a CAD 10 billion stimulus run in the range of raising GDP by 0.2–0.3 percent, so the larger program could boost growth by more than half a percentage point. In Canada’s current low-inflation, low-demand environment, a fiscal stimulus will likely be welcome. And Canada—with a debt-to-GDP ratio of under 30 percent—can afford it. But the stimulus could be more potent if it were combined with similar fiscal stimulus programs in the rest of the developed world.

Housing prices—the talk of (some) towns

Despite the slow growth of the economy, Canadians are worried about a housing bubble. But don’t be fooled—this bubble is not quite the same as the bubble south of the border that burst in 2007. Canada’s mortgage underwriting is in a much better state than mortgage underwriting in the United States was in the mid-2000s. Canada’s bubble is concentrated in two cities, Vancouver and Toronto, and may reflect some unusual fundamentals. Then again, the US housing bubble was relatively concentrated—and at the time many people thought that it was supported by fundamentals.

Figure 1 shows the recent acceleration of Canadian home prices. The overall price run-up is largely due to housing price inflation in Vancouver and Toronto. Other Canadian cities haven’t seen anything like these price rises. Three of the other four major Canadian cities, Montreal, Ottawa, and Halifax, have seen flat housing prices over the past few years. Calgary experienced some acceleration in housing prices as Alberta oil sands projects came online. But house prices in Calgary have been flat or down since the oil price started dropping in late 2014. Only two smaller cities—Hamilton (near Toronto) and Victoria (part of the Vancouver economic ecosystem)—have seen anything like this type of price growth.

Figure 1

Is this a case of “what goes up must come down?” High housing prices in Vancouver and Toronto can be attributed to two factors:

  • Both cities are already highly zoned and developed. This holds more for Vancouver, which is physically limited by the ocean and the mountains, than for Toronto. Just as nobody is surprised by unusually high prices for real estate in Manhattan Island, nobody should be surprised by higher prices for housing in Vancouver. Toronto could possibly expand—but at the cost of even longer and more traffic-choked commutes in the city, which already experiences the longest commuting time in Canada.
  • Vancouver and Toronto alone accounted for 42 percent of Canada’s population growth over the past 12 months, according to Statistics Canada’s monthly population survey.2 These are the cities Canadians want to live in. Low oil prices will simply intensify the preference for these attractive locations with strong economies.

But there are some worrying signs as well:

  • Canada’s membership in the British Commonwealth (and resulting accessibility to residents of Hong Kong before 1997) and its attractive rules for foreign investment may have allowed foreign investors to pile into the market. The importance of this factor is controversial.3 Many Canadians tell stories about wealthy home purchasers (especially from China) throwing handfuls of cash at high-end house sellers. If Chinese investment dries up, it could, of course, pose a significant risk to the housing market.
  • The Canadian press is starting to report about the type of problems that marked the US housing debacle.4 A subprime lender has even made headlines over fraudulent practices—although the lender itself investigated and fired the mortgage brokers involved.5
  • Canadian households have taken on a lot of debt recently—so much so that the Bank of Canada is paying careful attention.

Policymakers are worried enough to try to put the brakes on some housing sales, most notably by increasing required down payments for houses selling for over CAD 500,000. There’s no question that the housing market poses a significant risk to the Canadian economy—no matter how amazing it is to live in a city such as Vancouver, where you can sail in the bay in the morning and go skiing in the mountain above in the afternoon.

Canada’s membership in the British Commonwealth (and resulting accessibility to residents of Hong Kong before 1997) and its attractive rules for foreign investment may have allowed foreign investors to pile into the market. The importance of this factor is controversial.

The Canadian love affair with debt

Over the past 10 years, a lot of attention has focused on US households’ borrowing. But Canadian households have long been bigger borrowers than Americans. In the second half of the 1990s, Canadian household borrowing averaged 102 percent of disposable income, some 10 percentage points more than the same figure for the United States. And Canadian household borrowing rose along with US household borrowing through 2007. At that point, US household borrowing started to contract, but Canadians kept right on piling up the loans. Household debt in Canada is currently running at over 160 percent of disposable income.

This figure has generated concern among Canadian authorities. The rise in debt is likely related to the rise of housing prices (and subsequent need for larger mortgages by home buyers) as well as to low interest rates and financial innovation.

Household debt in Canada is currently running at over 160 percent of disposable income.

Figure 2 shows a key measure of household financial vulnerability. It compares estimates of debt-service payments as a percentage of disposable personal income in the United States and Canada. Canadian households typically have had to pay a larger share of income in debt service, except for a few years in the mid-2000s. After the US mortgage crisis, the debt-service ratio plunged in the United States and is now at a level last recorded in the early 1980s. The Canadian debt-service ratio also fell during the financial crisis, but it has stabilized at historically high levels of around 15 percent. Canada’s Office of the Parliamentary Budget Officer projects that the debt-service ratio will rise to 17 percent by 2020, based on rising house prices and rising interest rates over the next few years.6 That’s a historically unprecedented level, and much higher than anything experienced in the supposedly profligate United States during the height of the housing bubble.

Figure 2

Canada’s conservative financial system may help to insulate the country from any shock involving consumer debt. Also, it’s quite possible that much of the run-up in debt is specific to higher housing prices in Toronto and Vancouver, and therefore not systemic. But Canadian households’ love of debt is certainly a potential risk factor for the Canadian economy and therefore worth watching.