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The Progressive Economics Forum

Recession Ahead?

TD Economics yesterday released a rather gloomy report, putting the odds of a US recession at 40%, and arguing that that Canadian economy is more vulnerable to recession than it was in 2008.  It highlights reduced capacity for governments to respond given that interest rates are already very low, and given that household and government debt are significantly higher than in 2008

I would go one step further and argue that the odds of a Canadian double-dip recession are quite high. I agree with TD that our capacity to respond through easier monetary policy is weak, but would argue that we can and should respond through fiscal policy.

As Jim has argued on this blog,  underlying growth in the first quarter was very low:  80% of the real 1% growth rate registered in the quarter came from inventory accumulation Consumer spending was flat, and government spending was falling as fiscal stimulus came to an end.

We get the data for the second quarter (April through June) at the end of this month, and it is a bit of a mug’s game to guess if the numbers will be negative.  Some of the available data are, however,  not very promising. Monthly real GDP growth was zero in April and down 0.3% in May. Data for the second quarter which are already in show a significant widening of the merchandise trade deficit and declining manufacturing sales. There has been modest job growth, but wages have recently been lagging prices. (In July, average hourly earnings of permanent workers were up 1.2% year over year compared to a 3.1% increase in the CPI.) However, retail sales have still been rising; and housing starts and sales still seem to be still holding up.

In thinking about the outlook moving forward I re-read an excellent  May, 2010 post from Jim Stanford applying Steve Keen’s framework of analysis to the Canadian economy.  In a nutshell, Jim argued, following Keen, that growth has to originate in credit expansion in some part of the economy, and that even a slowdown in credit growth (as opposed to an outright contraction) can severely weaken real GDP and employment growth. (This framework allowed Keen and others to correctly forecast the Great Recession, which arose from financial asset bubbles fueled by an unsustainable increase in private debt.)

” (t)he implication of Keen’s analysis is that when the expansion of the private debt burden does stop (as it must sometime), it will wreak disastrous results on spending power, GDP, and labour markets.  It’s not just that a decline in debt would be associated with another downturn; that’s something most of us are well aware of.  Because our economy has become so dependent in recent years on the rapid (and obviously unsustainable) expansion of private debt, merely stopping (or substantially slowing) the growth of that debt would knock a giant hole in aggregate spending – enough to send us into a double dip.”

Canada came out of the recession faster than the US because, somewhat surprisingly, very low interest rates led to a recovery and then expansion of the residential real estate market, and because our fiscal stimulus was larger and better targeted than in the US.

Low interest rates are still fueling the expansion of household credit, especially residential mortgage debt which rose by $75.4 Billion or 7.6% in the year to May, and is still rising on a month to month basis. (See Bank of Canada Banking and Financial Statistics, Table E2.)  The most recent reading on house prices from the Teranet index (which, like the Shiller index in the US looks at price changes for exactly matched pairs of sales) shows that housing resale prices in May were  up 4.36% from one year ago, and up 1.28% from April.  Consumer credit, some of it fueled by home equity loans based on rising house prices , is also still rising.

This continued expansion of household credit may support growth in the most recent quarter, but seems highly unlikely to continue. Instead, a correction of housing prices which could set the stage for US style household debt deleveraging seems very much in prospect. (See posts on the housing bubble on this blog by myself, Jim Stanford, David Macdonald and Toby Sanger.)

Following Dean Baker, a housing bubble can be identified by key ratios – the rate at which housing prices are rising relative to all prices, the ratio of house prices to incomes, and the ratio of house prices to rents. Since about 2000, house prices have been rising much, much  faster than consumer price inflation and well ahead of the growth of household incomes and rental costs.  The average house price is now 5.2 times greater than average household income, up from a normal ratio of 3.2 times in the 1980s and 1990s. Due to increased mortgage debt, the ratio of household debt to disposable household income is now at a record high of 147, just a bit below the US level before the housing bubble burst. TD estimates that house prices are 10-15% over-valued, and that seems pretty conservative.

Low interest rates have kept debt servicing costs low and maintained some semblance of affordability for a surprising long period of time. But what must come to an end will indeed come to an end.

As and when household credit growth slows, the economy will have to be driven by either (1) an improved trade and balance of payments balance with the rest of the world (2) expansion of business investment or (3) increased government deficits.

Given that business investment in Canada is led by the export-oriented resource and manufacturing sectors, scenarios (1) and (2) are closely linked.  Current data show that total business credit is still growing – up 5.9% at an annual rate in the second quarter – but slowing. The balance of payments on current account is negative and apparently deteriorating based on the latest trade data.  If there is a recession in the US and Europe and the Canadian dollar remains at or near parity,  it is hard to believe that we will get the needed acceleration of investment and net exports.

Yet, if we are to avoid recession, such an acceleration will be needed, not just to offset any deceleration of household credit growth, but also to offset the ongoing fall in government borrowing.  The total government deficit is now 5.2% of GDP (first quarter) and falling, down from a 2010 second quarter peak of 6.3% of GDP.

By way of conclusion, the odds of a Canadian recession seem to be pretty high if we contemplate no change in fiscal policy.

 

 

 

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Comments

Comment from David Macdonald
Time: August 23, 2011, 10:41 am

Thanks for a great, although gloomy, summary of the current economic landscape going into the fall.

Comment from Paul Tulloch
Time: August 23, 2011, 12:25 pm

Don’t be afraid of gloom and doom, somebody has to be realistic about the future and hopefully with enough sober thought about where we are heading, we might convince the glee club members of Flaherty et al, that indeed if they act ahead of time, it could prevent some major calamities from occurring. For example, they could quit being so optimistic when we get to rate decision days. Or they could help persuade banks from raising mortgage rates, like some did today.

Under the current framework of pushing austerity and cuts, Harper’s crew potentially will not change course until the sky actually falls. We can manage this credit bubble, but it has got to be performed in a surgical fashion, we can stitch up the wound, instead of beating it open with the austerity hammers we are using. Of course it will mainly be worker blood and guts on the floor so I am not sure this crew cares.

3 years of pain and adjustment by a further precariousness of the labour market due to the recession and no jobs strategy, but 3 days of stock market volatility and you would have thought it was the end of the world. Hmmmm, so much double talk.

Comment from Marc Lavoie
Time: August 23, 2011, 1:13 pm

Andrew:

I agree with you that the likelihood of a second recession, even in Canada, is high.

I also agree that a slowdown in credit growth is likely to have a negative effect on aggregate demand and hence on economic activity.

I am rather less enthusiastic than you are about Steve Keen’s accounting, endorsed by Jim Stanford. They are claiming that total aggregate demand, whatever that is, is equal to GDP plus the change in credit. This does not make much sense to me.

There is also a certain amount of double-counting since investment is often financed by credit.

Furthermore, if I get one million dollars in loans to purchase a house, credit goes up by one million; and if the seller of the house puts the proceeds in a bank account, this will have no effect whatsoever on GDP or economic activity. It may only have an impact on the price of houses.

Comment from Keith Newman
Time: August 23, 2011, 3:10 pm

Unfortunately I concur that things don’t look too good, although I tell myself that the US economy has actually been picking up slightly when the revised GDP numbers are considered (1st quarter 0.4%, 2nd quarter 1.3% on an annual basis). However if the US does indeed fail to renew its stimulus measures when they expire our net exports will be hit and we’ll be in trouble in the absence of increased government spending.

A small additional comment following on from Marc’s re credit expansion per se not increasing economic growth:

It is spending that creates economic activity and while that usually is accompanied by credit expansion it doesn’t have to be. For example a government program that led to an increase in consumption by getting high income households to spend some of their financial assets would also do the trick. I wonder if the home renovation subsidy program didn’t accomplish that.

Comment from Andrew Jackson
Time: August 24, 2011, 6:14 am

Marc -

I confess to being a bit confused about precisely how the financial flow accounts fit into the national accounts growth accounting framework

I take Keen and Godleys central point to be that growth should ideally be driven by investment – financed in part through credit and part through retained earnings – which would increase future incomes through productivity growth.

Growth has instead been driven by debt financed consumption growth and residential investment growth well in excess of household income growth. That shows up in the financial accounts as an unsustainable growth of private debt to GDP over the past many years, almost all of it on the household rather than the corporate side.

While that growth in household debt has been accompanied by the growth of household assets, that side of the balance sheet is highly vulnerable to a house price correction.

It follows that a fall in the rate of growth of household credit or an increased household savings rate will depress consumption and housing construction unless offset by growth in business investment or government spending, which will be hard to engineer since household borrowing is quite large relative to GDP growth.

Comment from Andrew Jackson
Time: August 24, 2011, 9:22 am

” I define aggregate demand as income (GDP via the income measure) plus the change in debt, which is in turn expended on output (GDP via the production method) and net asset sales.” Keen

Comment from Paul Tulloch
Time: August 31, 2011, 6:51 am

looks like we have called it correctly here on the PEF, 2nd quarter data showing a decline in GDP.

And exports lead the way. The one that scares me the most, and is an indicator that we will not be coming out of this so soon, is the massive inventory buildup in durable goods. It is higher than at any point throughout the great recession, and it has been building since the start of the year.

http://cansim2.statcan.gc.ca/cgi-win/cnsmcgi.pgm?Lang=E&Accessible=1&ArrayId=T931&ResultTemplate=V3764&RootDir=CII\&Interactive=1&OutFmt=HTML2D&Array_Retr=1&Dim=-

Comment from Paul Tulloch
Time: September 6, 2011, 9:25 am

Stephen Gordon argues today in the Economy lab at the G&M that we do not have a recession coming and stimulus monies in Canada are not needed right now or in the US storm economic that now is on us. He bases this on the fact that construction employment in Canada has not been hit like that of the USA. And it is very true that construction industry employment level differences between the two countries are quite profound.

However, Stephen, again- again! is blowing up equipment in the lab. A robust construction industry about 2/3 of it when looking at $ value of building permits, is based upon residential construction. We all know that it is precisely that sector in the USA that suffered badly. We all know quite well how easily a housing bubble can burst and flatten an economy. Somehow, Stephen tries to lure us into believing a healthy housing bubble is nothing to worry about and that somehow that is reason enough not to take precautionary measures to ensure that bubble does not burst.

Ultimately that is what all the adults in the room are talking about, how can we avoid what has occurred in the states. If there should be one lesson economists learned from the great recession, holding dry powder until after the battle is over, is hardly a winning strategy.

You got to know very clearly that with a USA slowing economy, Canada is riding a commodity and a housing bubble, and there is not much more that is keeping us safe from a USA outcome

I thought it was very very irresponsible for Stephen to make such grand conclusions based on construction sector employment. Somebody needs to get that guy out of the lab. Wow, he just is so oblivious to reality or precautions of what could become reality. Did he not see the last quarter GDP???

We need a plan to transform our commodity/ housing bubble based economy into a robust, long term sustainable economy and that means we need a jobs based plan of action. If anything the historically high level of construction levels since the start of the housing bubble has been making me feel more worried, not relieved. We all know construction work is a downstream industry. Now if that construction sector employment was 2/3 in non-residential construction then fine, I would be on board the Gordo gravy train.

And no- I am not at that train, thankfully, because that train is about to go off the track.

Comment from Stephen Gordon
Time: September 15, 2011, 5:37 pm

Paul Tulloch: You really need to work on your reading comprehension skills.

Comment from Travis Fast
Time: September 16, 2011, 8:53 pm

Stephen,

You will perhaps have to forgive Paul: he reads for the spirit of the argument. Those who lack a spirit will of course find Paul’s reading practices vexatious.

Comment from Clint Ballinger
Time: January 12, 2013, 8:58 am

Re: Comment by Lavoie (Furthermore, if I get one million dollars in loans to purchase a house, credit goes up by one million; and if the seller of the house puts the proceeds in a bank account, this will have no effect whatsoever on GDP or economic activity. It may only have an impact on the price of houses.) and replies by Jackson – I am working on getting some discussion of Keen and MMT going, but I am starting with the effect of private debt and asset price inflation/FIRE sector bubble and effects on the poor and lower middle class. http://clintballinger.edublogs.org/2013/01/12/question-on-steve-keenmmt-discussion-total-size-of-private-debtfire-sector-bubble/

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