Reward Speculation, Punish Prudence

In my last blog post, I talked about how the origins of the Canadian housing bubble and how it will likely have a huge negative impact on the long-term finances of a generation. I was perhaps a bit one sided—hundreds of bankers still claim there is no bubble. So I’d like to talk about the claim of the anti-bubble arguments and discuss one way the Bank of Canada is looking to get us out of this mess.

Anti-bubble arguments

There are two main reasons that people claim there isn’t a housing bubble. The first is basically, “people can afford their mortgage payments”. The second is, “borrowings are reasonable compared to asset values.”

The problem is that both these arguments are dependent on the party continuing indefinitely. A recession could cause people to lose their jobs, becoming unable to pay for their mortgages, and simultaneously drive down asset values.

Higher interest rates could have the same effect. Canadians typically only have the rate on their mortgage locked in for five years. If interest rates go up, people may not be able to afford the higher rates. What’s more, asset values in general are inversely correlated to interest rates. If interest rates increase, the value of all assets–including real estate–decreases (because if I can invest in a home that makes 3% a year or a bond that pays 7% per year, the bond is a no-brainer).

The typical Vancouverite’s response to this argument is “interest rates can’t go up, because everyone would be screwed.” Perhaps they should ask someone in Greece whether the government controls long-term interest rates.

Correlation causes problems

These two “no housing bubble” claims are particularly problematic because people’s ability to pay loans and the ratio of debt to asset value are often correlated, both on the way up and on the way down. The time when people start failing to afford their mortgage payments will also be the time when falling asset prices will result in debt becoming unreasonably high compared to asset values.

This correlation can cause a crash. When borrowers can’t pay their mortgage and lenders refuse to lend because the asset values do not support the mortgage, it can caused forced selling, driving down prices. The reduction in asset values makes lenders even less willing to lend. This sort of self-perpetuating feedback loop was a major cause of the 2008 American real estate crash.

A recipe to save the world (or at least speculators)

The Bank of Canada sees this risk, and has recently begun to discuss a solution. It has seen huge segments of the population in the two largest cities make speculative bets on real estate at prices that are completely unaffordable over the long term. It knows that, when the real estate bubble pops, these speculators will be wiped out, and the economy will be trashed.

So, it’s now investigating whether the 2% inflation target should be raised to 4%. It claims that this strategy might be desirable because it cannot stimulate more with interest rates approaching 0%. (i.e. People have already leveraged themselves far more than is prudent and there isn’t a lot of space for rates to go down, so the BoC can’t stimulate the economy by encouraging even more borrowing). So instead, they cause inflation.

Inflation reduces the value of money, forcing savers to either spend it or lose it. Basically, by destroying savings, you can give the economy another hit of adrenaline that might last a few years. (And really, who needs to retire anyway? Retirees are bad for the economy.)

Higher inflation has another convenient effect, boosting wages. If wages increase, all that debt no longer looks so unmanageable and those high housing prices don’t look so high. So, in the short term, higher inflation can save the day. Prudent savers–the minority of the population–get destroyed, but you bail out all the housing speculators and keep the economy chugging away.

Well, until the impact of that stimulus fades, and you end up with a weak economy with no savings. (Maybe then you float the idea of 10% inflation, and see how the public reacts.)

The bottom line

The housing bubble is a hot potato. The goal of the Bank of Canada and the politicians is to keep expanding the bubble until it’s someone else’s problem–a strategy that has worked out well for Mark Carney. No public figure wants it to pop on their watch because the consequences will be bad, and they don’t want to be blamed. This “higher inflation” trial balloon is a solid attempt to steal money from the savers to kick that grenade another few years down the road.

(All that said, I’m kind of curious what will happen when the huge baby boom generation, its savings decimated by inflation, realizes that the money they saved for steak is only enough to buy cat food.)