OCTOBER 05, 2010
One of the big goals of this blog is to examine the relationship between Canadian house prices, consumer spending, employment, and the Canadian economy in general. If you've been reading this blog for any time at all now, you'll know that I believe that real estate in much of Canada is significantly overvalued when compared to historical measures of fundamental value.
If you have even a basic understanding of economics, nothing in this primer will be particularly earth-shattering. The point of this primer is to further examine the feedback mechanism whereby rising home prices give increase to consumer spending, employment, and the economy in general. If you understand this connection, you should also be able to grasp how this works in reverse. It's why significant real estate corrections typically cause nasty recessions characterized by stubbornly high unemployment and very sluggish growth for an extended period of time. All we have to do is look south of the border to see this in action, but we could also look to many other recent examples inculding Italy, Spain, and Japan as an extreme and slightly older example.
This is why I've been predicting a recession in Canada once the housing market corrects. I'll also go out on a limb and say that I believe that we will see +10% unemployment for several years following the onset of our real estate bust.
I've been explaining that the run-up in house prices, which have far exceeded income growth and inflation over the past decade, has led to an increase in the 'wealth effect'. This is where people tap their home equity because they feel richer. They feel that they can justify the additional debt, as they feel their assets are rising faster.
This leads them to spend more money than they normally would. This in turn buoys employment, particularly in parts of the economy that would not otherwise flourish were people not so willing to be frivolous with their money. This creates an economic 'boom' which causes consumer confidence to increase, leading to a feedback mechanism that causes real estate to increase in value and the process to repeat itself. And so, real estate booms virtually always mean good times for the economy.
The entire process is great for growth on the way up, but cuts just as deeply in reverse. It was what pulled the US out of what likely would have been a nasty recession in 2000-2003, only to be the root cause of the financial crisis of 2008-2009.
For example, in 2005 Karl Case (co-creator of the famous Case-Shiller index for house prices) reported a significant relationship between house price increase and consumer consumption. He suggested that a 10 per cent change in housing wealth is associated with a 0.3 to 0.5 per cent change in consumer consumption. This suggests that the resiliency of the housing market after stock markets tanked in 2000-2001 helped avert a recession in the developed world.
This was also what pulled our economy out of the Great Recession of 2008-2009, yet paradoxically will be what causes our economy to enter another recession by Q3 2011.
CMHC, that wretched government entity, has recently published an in-depth report highlighting the importance of real estate to the Canadian economy in general. It's a fantastic read and it nicely highlights the positive feedback mechanism between increasing real estate prices, increased consumer confidence and consumer spending, and employment. You absolutely have to understand this connection to get why a realignment of real estate prices back to long-term fundamentals will be so painful on the broader economy, as the US is currently experiencing.
Now I'm not saying we will have a real estate or economic correction identical to that in the U.S. To borrow a line from Alexandre Pestov, "Canada doesn’t need a US-style problem to have a problem. A Canadian-style issue will do just fine." I agree. We have had our own brand of irrational exuberance here in the Great White North and the subsequent fallout will be different that what our neighbours to the south are experiencing...but it will be painful, nonetheless.
So let me make some connections for you. I will borrow heavily from the report highlighted above as well as from a variety of other sources. If not otherwise specified, all facts have been taken from this CMHC report.
1) Real estate's connection with the broader Canadian economy:
"Housing plays a dynamic and crucial role in the economy. Housing-related economic activity accounted for $307 billion in 2009, over one-fifth of Canada’s total gross domestic product." (pg.1)
"One study found that the production of an additional 10,000 single-family homes in 2005—a $1.8 billion investment—would have generated a total of $3.3 billion in direct and indirect production output across all sectors." (pg. 19) "In addition to the direct $1.8 billion impacts in residential construction, there were major impacts in manufacturing ($726 million) and wholesale trade ($172 million). Within the manufacturing sector, the main beneficiaries of residential construction investment are wood products, petroleum and coal product manufacturing." (pg. 19)
Let me say that I believe that we will see housing starts fall dramatically from their highs of well over 200K annually back in 2008. Mass psychology being what it is, people tend to pile into an asset class on the way up, yet hate that very asset class as it once again becomes cheaper. This is exactly what happened in the US.
With home ownership at all-time highs in Canada (and nearing the bubble peak level in the U.S) and population growth running at only 1.6%, it begs the question of who will keep buying new houses at the rate we've experienced in the past few years. And if housing starts fall, what happens to employment?
More on this connection below.
2) Real estate's connection with consumer spending:
In a 2006 paper, Michael R. Donihue and Andriy Avramenko described the increase in consumer spending associated with residential real estate appreciation:
"Real estate wealth is shown to have a positive effect on long-run consumption; at 6 cents per dollar, the marginal propensity to consume associated with real estate wealth is larger than the 4 cents per dollar associated with liquid stock market assets."(p.16)
David Rosenberg, chief strategist at Toronto based Gluskin Sheff and Associates calculated that every dollar increase in Canadian housing wealth translates to 7 to 9 cents of incremental spending in the GDP accounts.
This is not up for debate. It is a well-studied phenomenon. Here in Canada, it is captured in graphs like the one below, borrowed from Jonathan Tonge's site showing growth in lines of credit. It's also evident in our now-record personal debt levels.
A 2006 report by HRSDC noted that, "Line of credit, at 9% of total debt, was the fastest growing type of debt, with median value increasing 56.3% between 1999 and 2005, mainly due to an increase in home equity lines of credit." Note that this was before the manic phase of our real estate bull market, which I believe began in 2006.
If I'm right and real estate is set for a significant correction, the associated fall in consumer spending will have broad implications for GDP and employment figures. CIBC recently released a report with the same conclusion.
“It’s no secret that house prices have been falling recently, but less noted is that the performance of the housing market is already approaching levels seen during the recession. Even a modest 5% additional drop in average price in 2011, on top of the 6% it already shed from its peak, will lead to a negative wealth effect of $10 bn, stripping growth in consumer spending by more than a full percentage point. The same goes for consumer credit, which has been a very important source of consumer spending.”
3) Real estate's connection with employment:
With regards to the construction of every 10,000 homes, "19,300 (jobs are) generated across all sectors. Of these, 46 per cent (8,800 jobs) are created outside the residential construction sector. Over 3,000 of these jobs are created in manufacturing, close to 800 of them in wood products and over 600 in fabricated metals. Wholesale and retail trade (over 2,100 jobs) and professional, scientific and technical services (close to 700 jobs) are also major beneficiaries" (pg. 19)
"The average annual direct and indirect employment created by the 480,000 MLS® home sales in 2008 was close to 203,000 jobs." (pg. 20)
"Residential renovation activity between 2006 and 2009 generated annually over 250,000 jobs in the construction industry and over 210,000 indirect jobs in other industries." (pg. 20)
Finally, consider this chart. What is shows is the connection between home sales and unemployment. The author took home sales data out of the US, flipped the line graph upside down, and then compared it to unemployment rates a year later.
Where home prices go, consumer confidence and consumer spending follow. Where consumer spending goes, employment follows. It's the feedback mechanism described above, only in reverse. And it will be ugly! This is the Great Connection.
As I've said many times, if you're thinking of selling your home, do it NOW and price it aggressively. If you're thinking of buying a home, lay off the drugs! Wait a year or two at least. If you are living off of credit, stop it. Now! If you're embracing a lifestyle of consumption with no savings, stop that too. This is common sense stuff, but it's amazing how screwed-up our economy gets when people forget it.
Cheers and blessings