New research by the International Monetary Fund strengthens the case for Canada to get a handle on its runaway household debt.
The IMF analysis shows that not all housing busts are equal. A relatively solvent economy can absorb a sudden drop in home prices. However, when the collapse is preceded by a large expansion in household debt, the reduction in economic activity is much larger. Similarly, when housing busts trigger recessions, the recessions are nastier when household debt is higher. The downturns tend to last for at least five years.
Often the reflex explanation for the drop in economic output is the wealth effect: a less valuable home makes consumers feel poorer, so they spend less.
But the IMF study concludes that price effects are an unsatisfactory explanation for the scale of the decline that follows a housing bust that was preceded by a big increase in household debt. “It seems to be the combination of house price declines and pre-bust leverage that explains the severity of the contraction,” the authors write. In other words, the wealth effect combines with an impulse to pay off debt that severely crimps overall consumption.
The findings explain why the Bank of Canada ranks Canada’s household debt – which is equal to more than 150 per cent of gross domestic product – as the biggest domestic risk facing the economy. The potential consequences of doing nothing are severe.
The conclusions are based on a sample of 25 economies, which yielded a sample of 99 housing busts. The authors divided those busts into two groups: those that involved a large run-up in the household debt-to-income ration during the three years leading up to the bust, and those that did not.
The results add to a growing body of evidence that suggests the heavy debt load households in developed countries took on ahead of the financial crisis will impede the recovery. With economic growth still weak in the United States almost three years after the recession ended, that appears to be exactly what is happening.
Canada’s unemployment insurance system and relatively tough banking regulations could soften the blow of any housing collapse.
The IMF study examined seven policy responses to housing busts, and suggested that the economic impact is muted when consumers can rely on state assistance. A weak banking system exacerbates the downturn by retrenching from credit markets. Because Canada’s financial institutions are forced to hold substantial buffers, they should be able to weather an economic storm.
However, the suggestion on the value of safety nets was based on an analysis of Scandinavian countries in the 1990s, where governments provided unemployment insurance payments equal to 65 per cent of wages, on average. That was well above the OECD average of 47 per cent.