This is part of a Globe series that explores our growing dependence on credit – from the average household to massive institutions – and the looming risks for a nation addicted to cheap money. Join the conversation on Twitter with the hashtag #DebtBinge
There has been a lot of worry about the buildup of household debt in Canada.
As a proportion of income, household debt grew by almost half over the past decade to reach a record 165 per cent, with mortgage debt growing even more rapidly. As a result, house prices in real terms have risen 87 per cent and the house-price-to-rent index has grown to 162 per cent over this period.
These are large and dangerous-looking changes compared to other Group of Seven countries: Our household debt-to-income ratio is the highest. The house-price-to-rent ratio is the highest by a long shot. And household debt growth is among the highest. Many are concerned that an increase in interest rates or a correction of house prices would stress many indebted households and put our economy at serious risk.
Such risks naturally depend on who carries this debt, as some are better able to withstand corrections than others. Statistics Canada's Raj Chawla and Sharanjit Uppal published an important study that sheds light on this issue and the overall news is not all that bad: The incidence and level of household debt are higher among the better-educated (67 per cent); those with higher household incomes (87 per cent); and homeowners (89 per cent). Financial literacy and self-assessed financial knowledge were associated with higher debt levels.
On the potentially negative side, although the economically vulnerable (for example, the less educated and renters) hold a small portion of debt, it is more concentrated among some within these groups. With these facts, one can reasonably conclude that a market correction would likely not lead to a major economic upheaval, but it would seriously hurt some small groups.
What is the role of public policy in dealing with this debt challenge? In my view, recent policy pronouncements on this have been flawed.
Household debt is one piece of a puzzle – we cannot change one piece without affecting the whole. We teach economics students that there must be an equality of the supply and use of national savings, and that for every dollar of debt, there must be an asset. Suppose the use of national savings drops, either because of a drop in capital formation or the reduction of a budget deficit. What would happen? The excess supply of savings would depress interest rates and part of these excess savings could then be absorbed by an increase in household debt.
In this model, what would be the impact of a tightening of mortgage rules? Excess savings generated by this move would need to find a home (figuratively) through even lower interest rates or the encouragement of offsetting household debt, or the economy would have to slow down to reduce available savings. Clearly, such policies would either be ineffective (an offsetting debt increase) or undesirable (a weakening economy). Similarly, bold actions to eliminate budget deficits, when the economy is weak, would partly end up as offsetting increases in household debt.
The policy approach should be to look at the debt-asset picture holistically and deal with the root cause.
How does this model hold up if one were to examine the performance of G7 countries? We find a large variety of situations. Canada's high household-debt-to-income ratio is one reflection of a relatively low public-debt-to-GDP ratio, as the household sector has ended up absorbing some of the savings generated by the later. In France and Italy, high household debt has absorbed a large drop in private-sector capital formation. Germany and the United States do not now have a household-debt problem, because the savings generated by weak capital formation were offset by increased foreign assets. Britain had more moderate changes on all debt-asset fronts, relatively speaking.
This G7 experience shows the economists' view that equality of the availability and use of national savings must hold, and no single part of this can be changed on its own without engineering a change in some other component.
So how does Canada want to solve its household debt problem? Let us begin by thinking where else national savings should be absorbed.
Exports? If so, we have to either find a way to force the Canadian dollar to fall without lowering interest rates or get our exporters to think international. This isn't likely to happen.
Investment? We need to figure out a way for the business sector to increase capital formation, which doesn't look promising with the drop in oil prices. Indeed, the risk is the opposite, with likely lower capital formation being absorbed to some extent by a further increase in household debt.
Alternatively, we could at least slow the march toward eliminating government budget deficits at a time of a weak economy. That seems eminently doable, but we see the opposite happening with the federal budget.
Those who believe in eliminating budget deficits come hell or high water, and also believe in lowering household debt in the face of a weak economy, must also believe in Santa Claus.