If Canada wants to slay its household-debt dragon, it will have to cut down house prices at the knees. But there's an economic price to pay for that – and it goes well beyond a cooling of the residential real estate sector.
The Bank of Canada – one of the twin forces in Ottawa, along with the Finance Department, that are working to bring runaway consumer debt loads back under control – published a study this week that found that house prices are a key catalyst both for household debt and for spending. On the surface, this seems a pretty obvious conclusion; a higher house price means both bigger mortgages and bigger outlays of consumer's money on home purchases.
But the kicker here is that house prices appear to drive non-mortgage debt, too – the more valuable your house, the more debt you're likely to take on outside of your mortgage. And, since close to half of all non-mortgage debt is used to finance consumer purchases, higher house prices ultimately boost our national consumption, too.
This is the wealth effect so many people talk about in relation to house prices. The more valuable your house, the more implied wealth is contained in your household – and the more you can (and, it appears, do) take advantage of the wealth by borrowing against it to buy more things. The wealth effect is considered a key economic driver; by extension, wealthier households typically feed healthier stock markets, too.
The authors of the paper, Katya Kartashova and Ben Tomlin, put some hard numbers on these concepts. They calculated that the 52-per-cent rise in national house prices from 1999 to 2007 was responsible for a 19-per-cent increase in homeowners' non-mortgage debt. (Non-mortgage debt actually rose by more like 25 per cent, but not all of that could be attributed to higher home values.) This increased consumption by as much as $728 a year per household.
Multiply that by approximately 13 million households, and that's nearly $10-billion more in annual consumption – or roughly a 2-per-cent juicing of non-housing consumer spending. (A previous Bank of Canada paper estimated that non-mortgage debt accounted for roughly 5 per cent of all Canadian consumer spending last decade.)
When you consider that household consumption accounts for nearly 60 per cent of Canada's gross domestic product, it's easy to see how higher housing prices have filtered their way into stronger economic expansion on the consumer side. And this is entirely aside from the contribution from the home construction, resale and renovation sector itself, which accounts for about 7 per cent of GDP – and contributed half a percentage point to annual GDP growth in the past three years.
But now, Ottawa's efforts are working to throw those thrusters into reverse. New, tougher mortgage-lending standards put in place last summer have already done a credible job of putting the brakes on household debt – but only to a point. The Bank of Canada's study suggests that to take the next big step – actually reversing the course of household debts, sending them lower – policy makers are actually going to want a significant downward correction in home prices, something the housing market to date has stubbornly resisted.
A substantial downturn in prices – say, 10 to 20 per cent – would, in theory, not only reduce mortgage debts for new home buyers, but, significantly, push down non-mortgage debt to the tune of 4 to 8 per cent. That would get Finance Minister Jim Flaherty and Bank of Canada Governor Mark Carney a lot closer to solving the country's household debt problem, reducing what is considered a serious risk to the stability of the Canadian economy.
But the result is sure to be a further drag on an already struggling Canadian economy.
A downturn in consumer borrowing is going to put a serious lid on consumer spending growth – which up until now has been a critical driver in Canada's economic outperformance since the 2008-2009 global recession.
In the long term, this is the price to pay to get Canadians back living within their means, and the economy on more solid footing. But in the nearer term, the medicine could well feel worse than the disease.