Increasingly supported by recent data, prominent economics professors Atif Mian and Amir Sufi present a consumer debt-related theory of the financial crisis with potentially dire consequences for Canada's economic future.
In their best-selling book, House of Debt, published in May, Princeton University's Prof. Mian and the University of Chicago's Prof. Sufi argued that the rapid growth of the U.S. economy before the financial crisis was caused by rising housing prices. As home prices climbed, consumer confidence and spending accelerated. When the housing bubble burst, consumer spending collapsed as well.
In a recent blog post, Prof. Mian and Prof. Sufi present recent economic data showing the ongoing negative effects arising from this connection between home prices, spending and growth in U.S. gross domestic product.
The most compelling chart in the report compares post-crisis consumption growth for the U.S. states with the largest and smallest declines in housing prices during the recession.
The difference is stark. At the end of 2012 (the last full-year data point available), per-capita consumption in the states hardest hit by the housing crisis had recovered to about 105 per cent of 2006 levels. In the states least affected by the housing boom and bust, consumption was much better at over 120 per cent of 2006 spending.
The authors write: "It wasn't just the fact that house prices collapsed. It was also because these states had the highest debt levels when house prices crashed. It was the combination of the two that decimated household spending in these states."
Applied to the Canadian economy, this conclusion leads to some disturbing conclusions, particularly for those living in the hottest housing markets, such as Vancouver and Toronto. It suggests that it's not only a correction in housing prices we need to fear, but also a low-growth consumption hangover in the aftermath, as Canadians feel less wealthy, and rein in spending while paying down debt.
There are, importantly, significant differences between the 2006 U.S. housing market and the 2014 Canadian housing market. The lack of competition in the mortgage market – there was no Canadian equivalent to Countrywide Financial Corp., a lender that was investigated for possible fraud relating to home loans and mortgages – means domestic lenders have not been as aggressive and are not as vulnerable to losses. The Canada Mortgage and Housing Corp. should also protect the major lenders from the brunt of the financial pain, should the housing market fall quickly and borrowers default. This will likely prevent a complete meltdown in overall credit growth.
At the same time, the seemingly bulletproof strength of domestic housing prices is now accompanied by household debt levels that, by some measures, are higher than the precrisis debt peak south of the border. No matter what the catalyst (although higher interest rates are the most likely candidate), a period of debt deleveraging and slow consumer spending and GDP growth is almost assured for domestic households.
Canadian investors need to think long and hard about buying retail stocks and other sectors with exposure to domestic spending. When the housing correction finally happens, the long-term outlook for domestic consumption growth will become very bleak, very quickly.
Follow me on Twitter: