Wednesday, 1 July 2015

Those side-effects'll kill ya

It was reported on Tuesday that Canada's GDP shrank marginally in April, the fourth decline in a row.  Although the energy and resources sector was predictably the worst performer, the weakness was surprisingly widespread across major sectors of the economy. As a result, market expectations of another Bank of Canada rate cut, perhaps as early as this month, have solidified.

It seems unlikely that Bank Governor Stephen Poloz will resist the temptation to ease further. Speaking at a BIS meeting last weekend, Poloz compared the Bank's surprise rate cut in January to life-saving surgery, and dismissed the possible impact on Canadian households' record indebtedness as mere side effects: "If the doctor says you need surgery to avoid death, the side effects don't usually deter you, you just go ahead and manage them somehow". A new definition of manage, it would appear: ignore them, and hope they go away, because there's no sign that the Bank is doing anything at all about debt levels.

If we want to stay with Poloz's medical analogy, it might be appropriate to ask if the medicine is actually working.  Interest rates have been at record lows for half a decade, the exchange rate has depreciated by 25 percent in the last three years, the all-important US economy is moving smartly ahead -- and Canada's non-oil economy continues to struggle for traction.

It ought to be clear by now that the economy's malaise is structural, the result of the hollowing out of the manufacturing sector as a result of a series of free trade deals and the emergence of lower-cost competitors around the world. Many of the parts of the economy that would in the past have offset the weakness in the energy sector simply don't exist any more. With the Bank's reference rate already down to 0.75%, any further cut that Gov Poloz may decide upon amounts to no more than an empty  gesture, one that's highly unlikely to have any impact on the economy's underlying strength.

It will, however, have an impact on indebtedness.  Cheap money will continue to drive housing prices, especially in Vancouver and Toronto, to fresh records, and to push the household debt/income ratio to unsustainable highs. It's being reported that the same US investors who bet against the US housing market almost a decade ago (see Michael Lewis's The Big Short for a knockabout history of the time) are now setting themselves up to profit from what they see as an inevitable bursting of the Canadian housing bubble.

The economy will very likely start to do better in the coming months, whether the Bank cuts rates again or not; but any gains are likely to be swamped by the huge losses that will quickly be felt when the bubble bursts. We won't be calling them side effects when that happens.

And on that cheery note, happy Canada Day, Governor Poloz!    

Tuesday, 30 June 2015

The Greek vote

There's a line in one of the Greek tragedies, I think by Aeschylus, where the bad guy delivers a stern warning to the good guy, I think Prometheus, on the following lines:

ou mh frenwseis me, alla desmios fugwn swzh tode, h soi palin anastreyw dikhn*

That very roughly translates as "Don't defy me. You got away with it once, but if you do it again, I'll come after you". That seems to be the gist of what Frau Merkel and M. Hollande said to Greek PM Alex Tsipras, when he called them over the weekend to tell them he was going to hold a snap referendum. Tsipras ignored their pleas and is going ahead with the vote anyway. To what end?  

Of all the arguments that Tsipras et al have deployed in their negotiations with the Troika, by far the weakest is that the Greeks voted for him, so the creditors are denying democracy if they don't do what he wants. Presumably he'll be wheeling that argument out again if he wins the vote this coming Sunday, but it's unlikely to carry much weight in Berlin or Washington. If the Greek people vote, in effect, to stiff their creditors, they can hardly expect those creditors simply to accept the "will of the people" and pony up more cash.

Of course, it's very likely that the creditors are going to get stiffed either way. From the Troika's standpoint, the process now is as much about avoiding setting bad precedents as it is about solving the problem at hand. No developed country has ever missed a payment on an IMF loan, as Greece may well do within the next 24 hours: the Fund can't afford to create the impression that this is acceptable behaviour. Within Europe, all manner of countries, from Latvia to Portugal,  that have undergone painful restructurings of their own, will react very badly if Greece now gets rewarded for its intransigence. The Troika also needs to ensure, to put it bluntly, that Greece is now put through the wringer to a sufficient degree that no other heavily-indebted EU member is tempted to follow suit.

I wrote many months ago, when it first appeared that we were approaching the endgame with Greece, that both sides needed to prepare for a possible "Grexit".  There are plenty of signs that the EU has done so, but it's hard to be sure about the Greeks. The Finance Minister is adamant that Greece cannot be thrown out of the Eurozone, no matter how the vote goes. He may be right in a technical sense: years ago, EU bureaucrats I used to talk with were downright proud that there was no exit mechanism from the single currency. 

For sure, the Euro will still be circulating in Athens on Monday, but the amounts will steadily dwindle as those who can afford to do so remove their cash from circulation. If the implication of the Finance Minister's statement is that no plans have been made for the introduction of a new drachma, the damage to the economy, and to the lives of ordinary Greeks, could quickly become severe.     

There doesn't seem to be any good ending in sight. Years of mismanagement by politicians, enthusiastically voted for by the Greek people themselves, have left the country on its knees and almost friendless (unless you count Vladimir Putin, circling overhead like a buzzard).  The Greeks might have done well to heed the words of another great playwright, Shakespeare (Polonius, in Hamlet): "Neither a borrower nor a lender be, for loan oft loses both itself and friend".  Good advice, but then again, the Bard didn't live in a world of zero interest rates. 


* Yes, I know, I've left off the breathings and I can't seem to find the final sigma in my version of Word.

Friday, 26 June 2015

The bloated "middle class"

The Federal election here in Canada is still almost four months away -- October 19 is polling day -- but the issues on which it will be fought are starting to come into focus. One of them is, very clearly, the economic performance of the "middle class". The Tories argue, as you'd expect, that family incomes across the board have risen since they were elected ten years ago. If you only look at median income, they're right, but we'll come back to this later. Both the NDP and the Liberals say that "middle class families" are hurting, and they're offering various measures to put that right.

What do we mean by "middle class"?  When I was growing up in the UK, we talked about "working class", "middle class" and "upper class". The terms were a bit misleading, but there was a general consensus on what was what and who was who. You were working class if you mainly worked with your hands; middle class if you mainly worked with your brains; upper class if you didn't really have to work at all. Bill Bloggs the coal miner might earn more than Joe Blow the clerk, but Bloggs would be seen as working class, whereas Blow was middle class.

Now of course, many of the working class jobs of old -- mining, manufacturing and so on, have disappeared, at least in the richer countries, so the old definitions may not mean what they did. What do we have instead?  Well, consider this article in today's Toronto Star.  The very first paragraph contains the startling suggestion that Canadian families with incomes in a range of $40,000 to $120,000 (all figures in Canadian dollars) can be considered "middle class".

Seems like a very wide range, right? And a look at data from Statistics Canada shows that indeed, it is.  Unfortunately StatsCan doesn't include $120,000 as one of its data points, but a quick bit of interpolation allows us to estimate that of the almost 8.3 million households included in the count (these are "family" rather than "individual" households, so not the entire population), about 5 million have incomes in the $40-120,000 range. That's just about 60 percent of the total!

What seems to have happened here is that the old "working class" and "middle class" have in effect been merged and have adopted, or been assigned by lazy journalists, the "middle class" moniker. If there are three classes now, they are "poor", "middle class" and "stinking rich". This is just fine if you're writing knockabout articles for the lifestyle pages of the Sunday papers, but if you're trying to frame public policy, it just won't do.  How do you "target" policy for 60 percent of the population?

Here's another way to look at it. A household income of $40,000 (for a family) will disqualify you from getting a mortgage in any city in Canada. Given the importance that Canadians place on home ownership as a basis for accumulating wealth, that in effect means you are poor. An income of $120,000 will allow you to get a mortgage in any part of Canada except maybe Toronto and Vancouver -- and in cities like St Catharines, just down the road from me, or Hamilton, or Windsor, it will give you access to almost every home on the market. So not only is the income range much too wide to allow any sort of policy targeting, it's also too imprecise in terms of what each level of income actually means. That depends in large part on where in the country you live.

Now it's not clear that the income range quoted in the Star article is the one that the NDP and the Liberals will use as the basis for their policy proposals. However, the article also states that 52 percent of Canadians "self identify" as middle class; that's better, but still too high to allow for good policy. If either party tries to offer "something" to that broad a swath of voters, it will mean that those really in need -- the poor and the lower-income middle class (as self-identified) will get short shrift.

I mentioned off the top that we'd come back to median income as a way of measuring overall household prosperity. The Tories have already offered some sizable benefits to middle income earners, but a big part of their pitch will be the "all boats have risen with the tide" argument: median household income has risen by 5.1 percent under Harper's watch, to just under $77,000. Remember that the median is the figure at which exactly half of the population earns more, and exactly half earns less. Remember too that we live in an era of rising income inequality. It's entirely possible -- indeed likely -- that the rise in the median mainly reflects rising incomes at the top, while lower incomes stagnate. Just one more reason not to define the "middle class" too broadly.

UPDATE, 27 June: I think my interpolation of the income data from StatsCan went awry. I have reworked the numbers and now estimate that about 5 million households, or about 60 percent of the total, are "middle class".  I have corrected the text accordingly. This makes no material difference to the argument.  

On another note, the Toronto Star for today (27 June) bemoans the fact that the middle class is "shrinking". Consistency, please folks!

Tuesday, 23 June 2015

Legacy costs

The cost of the 2012 London Olympic Games -- somewhere in the region of 10 billion pounds Sterling, depending on how much of the ancillary costs you throw into the pot -- has largely faded from memory, thanks to the passage of time and the truly staggering amount (over $50 billion) that Russia spent on the Sochi Winter Games. Since the London Games ended, plans to bring the facilities into public use have generally gone well. Much of the main Olympic Park in east London is now open to the public, and just a few weeks ago, Sir Bradley Wiggins used the cycling oval to set a new one-hour distance mark.

There's one blot on the ledger, however: the Olympic Stadium. As this article reveals, the cost of converting the stadium into an arena suitable for soccer has now reached 272 million pounds Sterling.  The team that will move into the stadium, West Ham United (or Wet Sham, as their detractors prefer), will pony up a mere 15 mil' of that, and thereafter will reportedly pay a mere 2 million per year to play in what will be one of the most expensive, and surely one of the best, stadia in Europe. In the meantime the taxpayers of Newham, which is the home of the stadium and is one of the poorest municipalities in the UK, are paying 40 million toward the renovation costs.

The high cost of the conversion is the direct result of the original plan to downsize the stadium and then use it exclusively for track and field. However, as track and field events in the UK generally can't draw flies, it was belatedly realized that this was not viable, and a soccer tenant was sought. The specs for a soccer stadium and a track and field venue are very different: the existing seating was too far away from the action to be attractive for soccer. At the same time, the commitment to provide a venue for future track and field events had to be honoured. Hence the refurbished stadium will have retractable seating that can be moved close to the field for soccer, or rolled away to reveal the running oval on the rare occasions that track and field events take place.

I'm writing about this in part because it's interesting in its own right, and in part as a warning to other cities that may be thinking of bidding on huge sporting events, and to their taxpayers who may wonder about the veracity of the claims that are being made about the "legacy" that will be left behind. And yes, Toronto, this does mean you.  Recent weeks have seen renewed talk of the city bidding for the Olympic Games, maybe in 2028, and there's also talk of a bid for the men's soccer World Cup, which would undoubtedly see Toronto heavily involved. Given that this is a city that can't stick a decal on a road, extreme caution is advised!

Friday, 19 June 2015

The Pope knows?

Is it just me, or is there something distasteful about all those scientists falling over each other to applaud Pope Francis for his encyclical, Laudato Si?  Most of these folks doubtless think that the Papacy is a midden of medieval superstitions, but hey, if the Pontiff is prepared to endorse the consensus on global warming, he's our man. Behind his back, most of them are probably thinking of him in rather the same way that Lenin supposedly referred to communism's fellow-travelers and apologists in the West: a useful idiot.

We haven't yet seen anyone resort to misusing the concept of papal infallibility to bolster the case further, but I'm sure that's only a matter of time.

Thursday, 18 June 2015

The final countdown?

Based on the statement issued after this week's FOMC meeting, it looks as if the Fed might just possibly maybe see its way to raising interest rates some time soon.  The weather-related slowdown in the US economy in the first quarter of this year has given way to growth that the Fed portrays as "moderate", which has helped to tighten the labour market slightly -- or, in Fedspeak "underutilization of labor resources diminished somewhat".

Taking no lessons from Mark Carney's ill-fated attempt at providing "forward guidance" at the Bank of England, the FOMC has explicitly tied the timing of its possible tightening to two specific factors: further improvements in the employment market, and signs that inflation is moving back towards the 2 percent goal that the Fed aims for in the medium term.  The most recent employment report, for the month of May, was very strong, and there's no reason to think that the positive trend in job growth is about to reverse itself. As for inflation, the monthly data released today show a jump in the headline rate as a result of a rebound in gasoline prices, but the "core" rate, which excludes gas and other volatile (sorry!) items, remains stable below the 2 percent target.

A survey by Bloomberg suggests that almost every Wall Street analyst now expects rates to start rising later this year; that seems about right. Even when rates do start to rise, however, the Fed believes that economic conditions may warrant keeping the Fed funds target below "normal" levels for some time. Equity markets have been reassured by this, but it's hardly a surprising statement: even if the Fed were to raise rates by 25 basis points per quarter, it would still take the better part of half a decade to get back to what we used to regard as normal levels.

What does all this mean for Canada? The Bank of Canada's Financial Stability Report last week showed that the Bank sees excessive household indebtedness, much of it related to home purchases and most of it induced by record-low borrowing rates, as a key risk to the economy. A couple of surveys over the past week have delivered conflicting data on whether households are reining in their appetite for debt, but there can be little doubt that even a fairly small rise in rates would quickly push a lot of households over the edge. Financial sections of the press are starting to fill up with advice to cut borrowing, shift to a fixed rate mortgage, and so on.

Despite its concerns over debt levels, the Bank of Canada will hold off on following the Fed for as long as it can. No matter how long it delays, however, it seems inevitable that the Canadian economy will be less able to cope with higher rates than its neighbour to the south.    

Friday, 12 June 2015

Spelling out the risks

In many ways the Bank of Canada's Financial System Review contains little that we haven't heard before. Household debt is too high, which could pose problems if interest rates start to rise or the economy stalls again. The fall in oil prices makes it hard to assess the near-term outlook for the economy. And as always, developments on the international front could have negative implications for Canada -- though somewhat surprisingly, the Bank seems to be more concerned about China than about Greece.

Interestingly, though, the Report allows us to see in clearer-than-usual terms the balancing act that the Bank is trying to perform as it sets policy.  The Report reiterates the Bank's view that Canadian housing prices may be overvalued by as much as 30 percent, primarily reflecting stratospheric price levels in Toronto and (especially) Vancouver. Household debt, much of it taken on in order to participate in the housing market, is close to all-time record levels in relation to household income, at 163.3 percent. The ratio fell marginally in April, but still poses a huge risk to the economy and the financial system.

These interrelated facts -- the surging housing market and excessive household debts -- are the direct result of the Bank of Canada's very accommodative monetary policy over the past half decade. Yet there is no sign that the Bank is anywhere close to changing course, as the growth outlook remains below par and inflation slips below the 2 percent target. Indeed, the Bank unexpectedly added further monetary stimulus by cutting rates back in January, and there is a growing opinion among Bay Street analysts that there may be one or even two further cuts this year.

This, then, is the Bank of Canada's balancing act -- or gamble, as it might be better to portray it.  It knows that at some stage there will have to be a correction in the housing market.  However,  it judges that it can't afford to raise rates -- an action that would almost certainly trigger such a correction -- because that might slow the economy so much that household debt levels would become unsustainable, which would turn the correction into a rout.  In effect, this is a gamble that the economy will grow quickly enough to start reducing the debt-to-income burden, but not so quickly that inflation starts to rise and forces the Bank's hand.

It's far from clear that this is a good bet, and it's even less clear that the Bank was right to double down with its January rate cut. Despite recent encouraging employment data, the so-called rebalancing of the economy away from dependence on oil is proceeding at a snail's pace. As I've noted here many times before, much of the manufacturing capacity that might have been expected to benefit from the lower exchange rate is gone forever. In any case, prospects for that sector depend much more on what happens in the US economy, the destination for more than 70 percent of Canada's exports, than on any stimulus the Bank can provide.

That being the case, the January rate cut, and any further cuts that the Bank may see fit to make, can arguably have very little impact on the economy, yet may add considerably to the risks in the system, by encouraging Canadians to take on more debt and push house prices even higher. It's a dubious short-term gain set against the possibility of a serious long-term pain. If the whole house of cards toppled over, for whatever reason,  it would quickly bring about a crisis for the financial system that would almost certainly tip the economy back into a full-blown recession.

There's one further factor here that doesn't seem to get much attention in the Financial System Report: fiscal policy.  For the past several years, Governor Stephen Poloz, and his predecessor Mark Carney, were faced with a Federal government pursuing an economically asinine policy of fiscal austerity. Arguably, the governors had to keep monetary policy loose in order to stop the economy going off the rails altogether.

In recent months, however, the fiscal picture has changed. With an election coming in October, the Tories have been splashing the cash all over the place, with promises of more to come if (heaven forbid) they win re-election. If fiscal policy is no longer restrictive, it stands to reason that the need for massive monetary stimulus is diminished. At this juncture, however, there's no clear sign that the Bank is taking the new fiscal reality into consideration in making its monetary policy decisions. That may all have to change once the outcome of the election is known, especially if the more left-leaning NDP comes to power.

Interestingly, in doing some research for this post, I found at least one commentator who seems equally worried that the Bank of Canada is not worried enough.  Nice photo, though!