Ultra-easy money, ultra-risky debt

It’s possible that Wednesday’s rate-hike announcement by the Bank of Canada might have finally been the beginning of the end of so much “ultra-easy” monetary policy, although nobody knows for sure. What we do know is the effect that so many years of record low interest rates have had on borrowers, and we should be seriously concerned. Canadians have been borrowing record amounts, pushing the ratio of debt to GDP to what some consider a precarious level. Overall, our debt-to-GDP ratio rose to 354.5 in 2016, up 102 percentage points in just a decade.

Canada was not always so reliant on debt. After a slight increase in the 1990-92 recession, the debt-toGDP ratio edged down from 240.7 in 1993 to 239.7 in 2005. However, indebtedness began to increase rapidly starting in 2006.

Adair Turner, who oversaw Britain’s banking system during the 2008 crisis, called the debt-to-GDP ratio the best measure of leverage in an economy. He warned that after the ratio reaches a certain point, “the more potentially fragile become both the financial system and the macroeconomy.” The dangers that excessive debt can bring were demonstrated in the U.S. in the 2008 crisis, and Americans still haven’t fully recovered. The crisis spread to the European Union in 2010 when several governments saw their debt shunned by bond markets, forcing them to renegotiate their loans, plead for bail-outs and cancel spending.

Canada, emerging relatively unscathed, has been unafraid to keep borrowing. Our ratio of debt to GDP surged 36.3 percentage points in just the last two years as all domestic sectors borrowed more and saved less to sustain spending, even as low oil prices dampened incomes.

Canada’s debt binge is linked directly to the extended period of low interest rates, which were meant to help us muddle through the economic fallout caused by other countries binging on debt. This “ultra easy” monetary policy, as economist William White coined it, has been with us since 2008. White has to distinguish this period as “ultra easy” because it followed six years that were notable for persistently low interest rates that were, by historic standards, already relatively easy.

Whatever the justification for low interest rates, they have enticed all sectors of our economy to participate roughly equally in an orgy of debt finance. Between 2006 and 2016, Canadian household debt grew by $932 billion (or 85 per cent); governments by $755 billion (or 83 per cent); non-financial corporations by $713 billion (or 98 per cent); and financial corporations by $778 billion (or 93 per cent).

The most visible impact of all this debt financing happened in the housing market. House prices in Vancouver and Toronto took off after the Bank of Canada surprised financial markets with a January 2015 cut to interest rates. Instead of triggering a cheaper-dollar export boom, the bank unintentionally sparked a housing bubble. From August 2011 to January 2015, house prices in Vancouver rose a modest 4.9 per cent, but after the bank surprised with lower interest rates, they surged 46.4 per cent. The comparable figures for Toronto were a 21.2-per-cent increase until 2015, and then a 54.6-per-cent jump.

Some defend debt financing by arguing that it is no burden if the money borrowed is invested in assets that increase wealth or income. But that’s clearly not what’s happened in Canada. Families dissipated most of their growing debt on frothy home prices — since 2006 housing increased 16.0 per cent in volume, while prices were bid up 31.7 per cent — which are unlikely to see much further gains as interest rates rise. Meanwhile, governments used up their borrowed money on lavish spending for public sector workers and transfers to households; only a small portion actually was directed at infrastructure.

In his recent book The Rise and Fall of Nations, Ruchir Sharma, Morgan Stanley’s chief global strategist, concludes that the single most reliable indicator of periods of economic weakness was “the kiss of debt rule, which shows that a major economic slowdown has always materialized when a nation’s debt has grown more than 40 percentage points faster than GDP over a five-year period.” If he’s right, we’ve got a big problem: Canada’s ratio of debt to GDP rose from 294.9 per cent in 2011 to 354.5 in 2016 — an increase of 59.6 percentage points in the last five years. That easily surpasses Sharma’s threshold. And Canada, exposed as we are to large cyclical swings in export earnings and currency effects on our debt, should be more prudent than most about leaving ourselves too vulnerable.

And yet, despite some very recent lessons about over-indebtedness from the U.S. and Europe, why have we seemingly learned nothing? The answer seems to be partly that rock-bottom interest rates are too much to resist. And partly that every generation has to learn these lessons for themselves. It is why the cycle of booms and bust in business, financial, commodity and housing markets are remain in perpetual motion.