According to a report by Bank of Nova Scotia economists Derek Holt and Karen Woods, Canadian businesses have begun to pull back on investment and accumulate inventories which may be a sign that the economy is about to head into another recession. After the surprise second quarter drop in GDP, if there is another drop, it would mean that Canada has slipped into recession ahead of most other countries.
If Canada indeed slips into recession, it could be particularly brutal given the national balance sheet information released today by Statistics Canada that shows that while national net worth is up slightly, household net worth has declined after several quarters of slowing growth. Per capita household net worth fell from $185,500 in the first quarter to $184,300 in the second quarter, marking the first decline since the second quarter of 2010. Furthermore, Canada could be slipping into recession at a time when the debt to GDP ratio for persons and unincorporated business is at an all-time high as is the debt to personal disposable income ratio. The debt to GDP ratio has risen from 60 percent in 1990 to 94 percent in 2011. The debt to personal disposable income ratio has risen from 89 to 151 percent over the same period.
In a worst-case scenario, the onset of a recession fueled by a decline in exports and business investment, if combined with a tumble in real estate values and stock markets, could have a double-barreled effect on aggregate demand via a negative wealth effect on the economy. Wealth effects have traditionally been viewed as small. However, declining income and wealth combined with large amounts of debt needing to be serviced could make this downturn much worse than the previous one for Canadians.
Estimates for the United States done by Mehra (2001)* found that a decline in wealth was likely to depress consumer spending with the effects significant but small. He concluded the long-term propensity to consume out of equity values (net worth) has remained in the range of 0.04 to 0.06. Canada is not the United States but the similarities are sufficient to warrant trying out the numbers.
Canadian market value of net worth for persons and unincorporated businesses fell by about 21.2 billion dollars in the second quarter of 2011 which would result in a drop in consumer spending using the above Mehra propensity to consume numbers of between 844 million and 1.2 billion dollars – hardly a catastrophic drop. However, what if there is a more spectacular decline in net wealth fueled by a drop in real estate values or a further drop in stock markets? What if net worth fell 5 to 15 percent? Based on the first quarter 2011 net worth numbers (about 6.4 trillion dollars), a 5 percent drop in net worth would be about 319 billion dollars while 15 percent would be about 956 billion dollars. These could translate into drops in consumer spending ranging from as low as 12.8 to as high as 57.4 billion dollars. As a share of GDP in 2010 (1,624.6 billion dollars market value) it would mean a drop of 0.8 to 3.5 percent in the value of GDP. Not as inconsequential. Of course this is just a crude estimate of the potential wealth effect and the size of the drops are extreme. However, any wealth effects would be combined with the drop in aggregate demand from the drop in business investment and exports. Could it happen? Why do you suppose the United States economy is so depressed in the wake of the collapse of their real estate market? Apparently two-thirds of Americans saw their net worth drop during the recent recession and the median drop in net worth was 18 percent.
*Mehra, Y.P. (2001) “The Wealth Effect in Empirical Life-Cycle Aggregate Consumption Equations” Federal Reserve Bank of Richmond Economic Quarterly, Volume 87/2, 45-67.
Don't worry, they'll just slash interest rates to -4% and pay people to buy houses. As long as house prices keep going up, our debt-fuelled bubble economy is *fine*.
Posted by: rp1 | September 13, 2011 at 03:54 PM
According to this report from CAAMP http://www.caamp.org/meloncms/media/Fall%20Consumer%20Report%20WEB.pdf, we can find at page 28 that 46 billions were borrowed last year as HELOC. Close to half of borrowers (45%)responded that the money would be used for debt consolidation or repayment. So today we can say that we borrow for our daily consumption and we mortgage it for 30 years.
When I was young, a fair proportion of the people were paying their car cash. 10-15 years later, they were using the value of their old paid car against a rented car. Another 10 years and the whole car was financed.
All this happen during 30 years of lowering interest rates. They cannot go very much lower (inflation could...).
We also have a stock market worth at least 5X what it was worth in 1980 when the average salary went up 2-3X. Housing is +/- 6X what it was in 1980.
How can all this be sustainable?
The net worth is based on 2 major items - housing and pension funds. Both are at historic high when compared with the average salary.
For me, this is a gigantic house of cards.
Posted by: Normand Leblanc | September 13, 2011 at 03:59 PM
I think wealth effects were traditionally viewed as small because these estimates were derived calibrating models poorly suited for this purpose, not because the wealth effects were actually small.
See, for instance, //econ.jhu.edu/people/ccarroll/papers/cosWealthEffects.pdf
"we estimate that the immediate (next-quarter) marginal propensity to consume from a $1 change in housing wealth is about 2 cents, with a final eventual effect around 9 cents, substantially larger than the effect of shocks to financial wealth."
Given that housing accounts for about 60 Trillion in assets in the U.S., a 30% drop in house prices should lead to a 1.62 Trillion loss in demand, taking into account the initial shock and follow on effects.
Moreover, the effect of wealth effects depends very heavily on the distribution of wealth and on leverage.
If you have $2 million, then a change in asset prices making that $1.7 million isn't going to change your consumption a whole lot. But if you've been counting on selling your house to fund your retirement, and your equity declines from $300,000 to 0, then that will change your consumption. In both cases, the incidence of who suffers the loss and their balance sheet state makes a big difference in the aggregate response to a change in wealth.
You can see this by comparing the 2000 stock market crash with the 2008 housing crash. Most households hold very little of their savings in equities, but much in houses, whereas the wealthy tend to hold most of their savings in equities. A hit to equities leaving housing wealth untouched will have a much smaller effect on consumption than a hit to housing wealth.
Finally, households, if they borrow without collateral, are forced to pay the credit card interest rate, not the risk free rate. So as market wealth drops to zero for marginal households, they hit up against credit constraints, whereas typical models assume no credit constraints. Moreover, if market wealth does drop to zero, then in the presence of employment risk, households will choose to not borrow, even if they could borrow at the risk free rate, unless they have some guaranteed form of income with which they can repay the loan should they not be employed in the next period.
So wealth effects play a large role in the economy if you know where to look and which model to use. Look at housing wealth, and use a lifecycle savings model that takes into account a very unequal distribution of wealth, employment risk and credit constraints.
Just prior to the crisis, net home equity lines of credit withdrawals were 10% of household disposable income. After the decline in house prices, net HELOC withdrawals swung to a negative position (meaning that households were repaying their HELOC balances).
That alone accounts for about a 10% change in private sector demand.
Posted by: rsj | September 13, 2011 at 07:47 PM
It won't just be a wealth effect if housing slows down, residential investment will plunge, along with all the other related industries (home reno, mortgage brokers, banks, etc.), not to mention the impact on the money supply if banks can't keep printing money via mortgages, plus the loss of labour mobility once people are underwater, plus banks pulling back on other types of lending to lick housing related wounds, and I'm sure I'm forgetting other impacts.
Posted by: Declan | September 13, 2011 at 09:26 PM
Net worth is often less what official statistics would suggest because banks and other financial institutions sometimes don't write down the value of their assets as much as they should (so-called extend and pretend).
Posted by: Alex Plante | September 14, 2011 at 07:18 AM