Monday, June 17, 2013

Have Canadian Households Embraced Riskier Activity by Choice or Necessity?

On June 13 the Bank of Canada ("BOC") released its bi-annual Financial System Review ("FSR") which can be downloaded from this site. In contrast to the central bank's quarterly Monetary Policy Report which always concludes with "Risks to the Outlook" that are, by bank policy, "roughly balanced over the projection  horizon" the FSR explicitly states downside risks. In the most recent release those risks were articulated as follows:
Nevertheless, the Canadian financial system continues to be vulnerable to a number of key risks. These risks are similar to those highlighted in the December FSR and emanate primarily from the external environment: sovereign and banking stresses in the euro area; deficient global demand; elevated household indebtedness and imbalances in some segments of the Canadian housing market; and increased risk taking arising from a prolonged period of low interest rates. [emphasis added] 

In addition to the Risk Assessment section the FSR contains three reports: The Basel III Liquidity Standards: An Update; The Market for Collateral: The Potential Impact of Financial Regulation; Monitoring and Assessing Risks in Canada's Shadow Banking Sector. The latter is summarized by Maclean's columnist Erica Alini in her piece, "The shadow banking sector has been feasting on government-insured mortgages"
These are all worth a read but predictably the media singled out the BOC's concern about household debt. For example here (Quinn June 14, 2013) states:
Household debt reached a record 165 percent of disposable income in the fourth quarter, and Finance Minister Jim Flaherty tightened mortgage rules last year to avoid what he called signs of overheated condominium markets in Toronto and Vancouver. Statistics Canada will publish first-quarter debt figures later this month. The central bank forecast today that the debt to disposable income ratio will stabilize this year. Other signs of “constructive evolution” of household imbalances include slowing housing starts and resales since mid-2012, according to the report.
 Here is the now infamous chart of how Canadian household debt has marched upwards since 1990:

Looking at a shorter time span (2005-2013YTD) the BOC has observed levelling off of house prices:

Yet that house price to disposable income ratio remains significantly higher than the average level (1981-present) in Canada:

The Economist newspaper uses a different measure (Prices against average income) but shows a similar story comparing Canada vs. United States during the period 2002-2013YTD

Extending this time series out to 20 years here are Prices against average income (Canada vs. United States) 1992-2013YTD

Now going back another 10 years there is a generation of Prices against average income (Canada vs. United States) 1982-2013YTD

The immediate takeaway from this is that in aggregate the cost of home ownership for Canadians has been higher for a generation when compared to their neighbours south of the 49th parallel. When one considers that the cost of capital is also higher in Canada, mortgage interest deductability is absent save for the precious few willing to financially engineer it by methods like the Smith Manoeuvre and its derivatives, and long term mortgage rate terms (i.e. above 5 years) are a rarity for Canadian consumers, it should be pause for thought for those looking at such a measure (be it 'prices/average income' or 'household debt/disposable income') as a meaningful comparison with the American experience to be a predictor of a possible inflection point and future downturn. 
The Canadian financial system weathered the global financial crisis better than most other systems due to the oversight of its financial regulators (OSFI), the relatively conservative nature of its banking oligopoly, and a critical behavioural aspect: the steadfast resolution of Canadian consumers to meet and not renege on their debt obligations.

Is the latter a result of Canadian bankers better adhering to the 4 Cs of credit --character, capacity, collateral and capital-- before sending off mortgage and loan applications for approval? That is possible but unlikely. The front line of any financial institution, from the office of a local bank branch to the sales desk in capital markets (broker/dealer) is a main point of entry for risk into a diversified money center bank's balance sheet. There   are enormous pressures on individuals to sell as many products (to the end consumer) as possible and do so within the parameters of a standardized risk-reward trade-off that would not require extra oversight from risk management. Essentially, the more that the process can work like a smooth functioning assembly line the better for any wrench in the cog would slow down the revenue stream. To wit, the bigger the mortgage that can be approved the better. Such opportunities have grown since the early 1980s: the importance of finance and concomitant financialization of the economy has seen steadily increasing debt loads in the household sector whose wage growth has been moribund. As (Palley 2007) states:
The financialization thesis is that these changes in macroeconomic patterns and income distribution are significantly attributable to financial sector developments. Those developments have relaxed constraints on access to finance and increased the influence of the financial sector over the non-financial sector. For households this has enabled greatly increased borrowing.  [emphasis added]    
Typically, the concept of home ownership has often been framed in terms of being an Anglo-Saxon phenomenon --with North America and Britain at one end of the spectrum and Europe at the other. Yet when we look at core European countries we observe that Canadian 'affordability' is greater than that of either Belgium or The Netherlands which is experiencing the start of a serious downturn at the moment.
Prices against average income (Belgium vs. Canada vs. Netherlands vs. United States) 1982-2013YTD

There are always multiple dynamics at play and each nation's case needs to be considered on its own merit. Coming back to Canada, my colleague David Wishart (visit his blog, The Dismal Science here) made the astute observation of household debt accelerating in Canada after 2003 after increasing steadily in lock step with nominal GDP from 1981-2003. His words below:

Things started going wrong in 2003. What changed? CMHC removed the price ceiling on the mortgage amount it would insure. The Blue line represents how much debt the total amount of employed labour is carrying, which is a better indicator than household debt per capita because these are the actual people servicing the debt. As of 2011 it was at $130,000, so for a couple that's $260,000 which is 3.39 times after tax household income. In 2003 this ratio stood at 2.33 times. That's an increase of 5% yoy, which is greater than GDP growth, suggesting it's not sustainable, which the current slowdown in housing is making evident. [emphasis added]

Something unwritten in the media is the concept of debt being made available to consumers. It is usually framed solely as lower rates after the great financial crisis encouraging riskier activity: this is what the Bank of Canada writes, and it is what the much of the media parrots but it isn't necessarily accurate.

Going back across the pond to the Emerald Isle we can see what happens when House Prices outpace Wage Growth:

Michael Taft, on his blog, Unite's Notes On The Front, articulates it as such:
First, household debt did not become a crisis because people ‘went nuts’ buying houses without any regard to anything. It was a systemic crisis – deeply rooted in the base of the political economy. Faced with this systemic phenomenon people had two choices when purchasing shelter. They could either take on a lot of debt buying a house, or they could travel far away from work to buy a house they could afford (adding transport costs and losing home-time for their efforts). People’s behaviour did not cause the property boom, it was merely a response. They did not and could not control the price of housing – that was driven by a runaway market manipulated by a golden circle of myriad interests. 
And there were no substitution goods. Renting in the private sector was not an option for most household types as this sector was woefully under-developed.

Second, the household debt crisis did not arise through the normal functioning of the ‘market’. As we saw above, house price increases were consistent with average wages and construction costs in the period between 1990 and 1996. Builders weren’t losing money during this period. They weren’t building and selling houses for philanthropic reasons. They were making profits and employing workers. But the speculative gap arose because the normal functioning of the market was perverted. How do you think financial institutions make a living? They earned profits by loading households with debt. A number of interests made a lot of money with the complicity of Government policy (tax reliefs, tax cuts, lax planning regulations, boom-incentivising development fees for local authorities, etc.) and irresponsible financial regulation.

The household debt crisis is a political and social issue. It is not – and let’s be absolutely clear – it is not an issue of individual profligacy or household irresponsibility. That people get into financial trouble through imprudent conduct happens all the time – but to suggest that that the property crisis was simply the aggregation of individual financial recklessness is merely a self-serving attempt to shift blame. [emphasis added]
This fits well into the Canadian context -especially when one considers that rate at which residential real estate costs have skyrocketed past the rise in incomes. As has been noted before in this blog, deleveraging in Canada is inevitable. The yet to be determined end game is whether it will come in a smooth or turbulent fashion. The bet here is for the former as households will be forced to hold back on consumption in order to service an increasingly large stock of debt.

Financial System Review (2013): p.1, (accessed June 16, 2013).
Alini, E. "The shadow banking sector has been feasting on government-insured mortgages." Maclean's, June 14, 2013. (accessed June 16, 2013).
Quinn, G. Bloomberg, "Bank of Canada Says Household Imbalances Will Be Slow to Correct." Last modified June 14, 2013. Accessed June 16, 2013.
Palley, T. Financialization: What It Is and Why It Matters*. working paper., The Levy Economics Institute and Economics for Democratic and Open Societies, 2007.
 Taft, M. Research Officer, UNITE the Union, "Unite's Notes On The Front." Last modified June 13, 2013. Accessed June 13, 2013.

Wednesday, June 12, 2013

Reasoning about Rationality: Why Bubbles are both Banal and Necessary ~ William Janeway

What follows is the link to William Janeway's lecture at the Field's Institute in November 2012: Reasoning about Rationality: Why Bubbles are both Banal and Necessary
The introduction is by Matheus Grasselli. Those interested in the slides, they can be downloaded here. The lecture is about 50 minutes in length followed by a 20 minute Q and A. For those interested in reconciling the innovation process amid conventional wisdom that evokes rationality and efficiency at every turn, this is the next best thing to reading his book, Doing Capitalism in the Innovation Economy: Markets, Speculation and the State.

If there is anything to take away from the lecture it is Janeway's belief, backed up by forty years as a successful capitalist in general and influential venture capitalist in particular, that bubbles are endogenous to financial capitalism; bubbles always burst; and bubbles can be focused on anything from tulips to real estate to information and communication technologies ('ICT') --some of which are productive, others not.

When the occasion arrives that the focus of a bubble is a fundamental new technology then there will be associated bubbles in the build out of that network and the search for what to do with that network. In the current context think about the advent of ICT in the early 1980s begetting the tech boom of the 1990s begetting the dot come mania of the late 90s which in turn have found capital looking for opportunities in areas ranging from social media, to big data and 3D computing in the 2010s. The latency of technological development repeats throughout history. It is arguably getting shorter but the uptake of green technologies appears to bear out the traditional view.

There is a wonkish flavour to the lecture where Janeway dissects tenets of neoclassical finance theory by going over much of the literature. Some of the papers he cites can be found here on Graselli's course page for Asset price bubbles: economics, mathematics and statistics. It should be noted that while Janeway earned a PhD in economics from Cambridge University under the supervision of Richard Kahn, he did not pursue academia as a vocation. He saw the writing on the wall whereby what he had learned at Cambridge would not be welcomed within the hallowed halls of tertiary learning in America --already so immersed and enamored was U.S. establishment with marginalism and Walrasian equilibrium where money is just a veil over barter. In a recent speech (Janeway October 11, 2012) he stated: 
In 1971, I left Cambridge University with a doctorate in Economics and an extraordinary intellectual endowment. Supervised by Richard Kahn, I had passed four years immersed in the economics of Keynes – not, that is to say, Keynesian Economics. This meant recognition, first, of the integration of economics and finance at every level, from the most micro scale of the individual consumer, entrepreneur and – especially – investor to the aggregate scale of the macroeconomy. Second, it carried with it a profound skepticism with respect to the notion of efficient markets and the promise of stable equilibrium. Third, it meant recognition of the inescapable ontological uncertainty under which economic and financial decisions are made. In consequence, I found that I could not teach Samuelson’s Neoclassical Synthesis, which what was on offer in the Departments of Economics across America. [emphasis added]
To sum up Janeway's lecture in a 2 x 2 matrix (below), it is that while bubbles always burst, those that burst in the equity market do relatively little harm compared to those in the credit markets as the latter compromise the banking system and paralyze the real economy.

Now, the idea that bubbles in the equity market do relatively little harm has less weight in the modern context when the social contract has been whittled away and people are forced to take on market risk for the sake of their own future retirement income (think of DC plans replacing DB plans). However, the general thrust of his argument remains valid: when the locus of speculation interests with the object of speculation in the top right quadrant (focusing on non-productivity enhancing asset investment) then a bursting is far more harmful than if a bursting were to occur in the bottom left quadrant (focusing on equity market funds going into productivity enhancing assets). In Janeway's way of thinking, there are necessarily one hundred busts for every gem. 

Summarizing Janeway's lecture in a 2 x 2 matrix

Janeway, . LSE public Lecture, "What I learned by Doing Capitalism." Last modified October 11, 2012. Accessed June 12, 2013.

Tuesday, June 11, 2013

Robert J. Gordon (The End of Growth) vs. Erik Brynjolfsson (The Key to Growth)

Whose argument for what the future has in store is compelling?
Granted, TED conferences at best are champions of style over substance and reek of corporatism rather than thoughtful academic rigour to those critically inclined.
Notwithstanding these glaring gaps, the talks do provide a means to encapsulate a view; the view in question here is one of growth.
Sorting through the entrails of the global financial crisis, much of the developed world is afflicted with sub par growth --particularly in the case of a region like the Eurozone where that result has been self inflicted and prolonged.
First up, Robert J. Gordon, lays out four reasons US growth in particular may be slowing: declining innovation, unfavourable demographics, burgeoning debt and growing inequality, all of which, Gordon argues, could move the US into a period of suspended animation from which there is no way to innovate out of.

Click above or link here to Gordon's talk:
The counterpoint comes from Erik Brynjolfsson who argues that we are suffering from the growing pains of a radically reorganized economy. Interestingly, despite Brynjolfsson's positive spin of the modern computer as a general purpose technology producing cascades of complementary innovation, he concedes that the increase in productivity has not resulted in a concomitant increase in wages (he frames it as a decoupling of productivity from employment).
There is also the unmentioned issue of what happens to those who work in jobs that are: (i) tradeable so that one's labour must compete against a global pool; and (ii) in the process of being codified as a piece of software so that the skills are no longer priced competitively in the marketplace. Brynjolfsson provides the puff pastry palliative of "racing with the machine rather than racing against it" and that "we shape our destiny". This is little comfort to those who will be downsized, off shored and cannot (re)train fast enough to keep up with what is deemed valuable in the marketplace.

Click above or link here to Brynjolfsson's talk

Monday, June 10, 2013

Mark Blyth gives a no holds barred Google Talk on Austerity

HT to Stephen Kinsella for putting the video on his site.
The only disclaimer here is that Blyth does not hold back and doesn't suffer fools so the language is a colorful --as it unarguably should be-- retort against the notion of expansionary austerity (which I have written about here).

It is unfortunate that there were not more smart people from Google in attendance.

Thursday, June 6, 2013

The reports of recovery are greatly exaggerated

Hearing the soundbites concerning QE tapering by the U.S. Federal Reserve and higher yields at the medium-long end of the curve, and hearing that the University of Michigan consumer sentiment index rising to a level, 84.5 in May, that has not been seen since July 2007, one may believe that prospects for a return to good times are good.

Add to this the red herring of policy uncertainty decreasing and one may think that  recovery was around the corner. Continue this line of thinking with the news Friday morning that the United States economy added  175,000 jobs in May and one may think that we have truly turned the corner. One would be wrong; the prospects for a sustainable recovery are greatly exaggerated.

Expectations have been lowered; the goal posts have been moved. There was a time when the addition of 250,000 jobs after just after the bottom of a business cycle was considered a minimum baseline but this is no longer the case. Counter pose the US NFP release with Statistics Canada's Labour Force Survey: an economy 10 times smaller added 95,000 jobs and there is some perspective.
This chart from Reuters Macroscope illustrates the road yet to travel: at May's rate of job growth, payrolls would reach pre-recession levels in the summer of 2014. (For perspective, the current level of job growth would mean that the United States would reach conventional measures of so called full employment by 2023).
Source: Reuters Macroscope

This is not to say that there cannot be an uptick in U.S. growth courtesy of consumption; there can albeit temporarily.

Reflation enabling GDP growth in the short term is possible but sustained growth back to the trend rate observed from the 1992-2007 is unlikely.

If a picture is worth a thousand words then 22 charts, courtesy of Huffington Post and Mother Jones are worth considerably more. (References to the original at the bottom of the blog post).

This post is a reiteration of the thesis that growing inequality cannot be glossed over and ignored; it leads to greater economic instability.
[Note that your blogger has never advocated for equality in terms of outcomes but for greater equality of access to opportunity. The dynamics of power never die but the bi and multilateral agreements that we live under and the competition policies which are enacted are enabled by all levels of government and have profound affects on the lives of people.]
Ultimately, it is the power of ideas that must prevail and here are the charts to show that the reports of American recovery are greatly exaggerated.
Sustainable recovery should be built on a solid foundation --ostensibly middle class households-- that can propel growth forward so that the flow of funds in an economy drives demand. When that class is suffering from income stagnation it means (absent taking on debt to enable immediate consumption) that effective demand in the economy will also be lower.

Another headwind for the middle class / middle income cohort is tertiary education, something that theoretically adds to the human capital of future wage earners. With the dearth of employment growth after the Great Recession, the prospects for students leaving post secondary education are dwarfed by the prospect of servicing their debt stock. This debt must be serviced --there is no debt jubilee available-- and the flow of students' future incomes will go largely to servicing that debt, yet again dampening future consumption for the majority.

Which brings us to a final point: what about the rich? Unfortunately, they cannot make up for the rest.

The idea that wealth trickles down is refutable but the notion that the rich save much more than expected has not been discussed as much as it should. Using an orthodox neoclassical utility maximizing analytical framework, Christopher D. Carrol of The John Hopkins University, in his paper "Why Do the Rich Save So Much?" arrives at conclusions that contradicts supply side ideology and the traditional "Life Cycle hypothesis".
Here is the paper's abstract:
This paper considers several alternative explanations for the fact that households with higher levels of lifetime income (‘the rich’) have higher lifetime saving rates (Dynan, Skinner, and Zeldes (1996); Lillard and Karoly (1997)). The paper argues that the saving behavior of the richest households cannot be explained by models in which the only purpose of wealth accumulation is to finance future consumption, either their own or that of heirs. The paper concludes that the simplest model that explains the relevant facts is one in which either consumers regard the accumulation of wealth as an end in itself, or unspent wealth yields a flow of services (such as power or social status) which have the same practical effect on behavior as if wealth were intrinsically desirable. [emphasis added]
Here are Carroll's conclusion:
A variety of evidence, both qualitative and quantitative, strongly suggests that people at the top end of the wealth and income distributions behave in ways that are substantially different from the behavior of most of the rest of the population. In particular, it is difficult to explain the behavior of these consumers using the standard Life Cycle model of consumption.

A leading alternative to (or perhaps just an extension of) the Life Cycle model is the Dynastic model in which the decision maker cares about the utility of his descendants.

The Dynastic model, however, has problems of its own, starting with the testimony of many wealthy households who say that providing an inheritance is not a principal motivation for saving and ending with the fact that childless wealthy old people do not appear to dissave

In a way, the model reconciles Fitzgerald and Hemingway. Fitzgerald was right that rich do not behave simply as scaled-up versions of everyone else. They choose to save more and to accumulate faster because they can "afford" the luxury of doing so. But Hemingway was right to suggest that the rest of us would probably behave the same way, if only we had more money. [emphasis added]

Diehm, Jan, and Kathy Hall. "Middle Class Jobs, Income Quickly Disappearing (INFOGRAPHIC)." The Huffington Post, Online edition, sec. Business, June 06, 2013.
 (accessed June 6, 2013).

Severns, Maggie. "The Student Loan Debt Crisis in 9 Charts." Mother Jones, June 05, 2013.
 (accessed June 6, 2013).

Carroll, Christopher D. Why Do the Rich Save So Much. manuscript., The Johns Hopkins University, 2000.