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US Meltdown Puts Heat on Canada

Decades of fusing the two economies exposes us to grave risk.

By Marc Lee 22 Sep 2008 | TheTyee.ca

Marc Lee is a Senior Economist with the Canadian Centre for Policy Alternatives, and chairs the Progressive Economics Forum.

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Watching the turmoil in financial markets this past week, the question is no longer whether there will be a meltdown, but how much melting is left to go. So what's next, and what does this mean for Canada?

It's worth reflecting on just how far up we climbed. The back-story is now familiar: the lowest interest rates since the 1960s that prevailed in the aftermath of 9-11 reduced the cost of holding a mortgage, and led many people to buy into the real estate market. As prices went up, others wanted to get in on the action "or get priced out forever."

Before long, bullish sentiment overwhelmed rational thinking: real estate prices went through the roof, with doubling and in some cases tripling of resale prices between 2001 and 2007 in Vancouver.

On the way up, increasing asset prices created a "wealth effect" -- those lucky enough to see the value of their home go up so much were more inclined the spend money, thereby stimulating the real economy. Moreover, rising home prices led to spectacular new residential construction, providing more jobs and more income to keep the party going.

This particular party was a real bender, and now it's hangover time. Our southern neighbours went even wilder -- everyone was invited -- and they are now feeling a world of hurt. But even though our Canadian party did not rock as hard, there was plenty of liquid refreshment, and it went well into the wee hours.

The jaw dropping events in the U.S. are the gears thrown into reverse: a vicious cycle of falling home prices, with homeowners sitting on mortgage debt that is worth more than the market value of their home. New residential construction is at half of 2005 levels, undercutting employment, and home prices are down about 25 per cent.

Integration changed equation

In Canada, we have been lagging developments in the U.S. But new investment in residential construction fell in the first half of 2008, and average home resale prices in August fell by five per cent compared to a year earlier.

Because the U.S. is so much bigger than we are, and our economies so interconnected after two decades of increasing integration, their downturn will hurt Canada, too. Their drop in residential construction, in particular, hurts wood product sales from our forestry sector, and their overall slowdown undercuts our exports across the economy.

The unwinding is complicated by actions in the U.S. financial sector, which repackaged dubious mortgages, and made out like bandits. Once the value of homes started to come back down, it exposed a lot of bad wood underneath the veneer. What is becoming clearer by the day is that this can only be solved by major write-downs of those "toxic mortgages" that are clogging up the balance sheets of big financial corporations.

Big government steps in

An irony of the current situation is to see a right-wing U.S. government engaged in massive government intervention in order to prevent a meltdown -- except they are bailing out the people who caused the problem in the first place. Brokers and dealers made millions -- worth decades of real work by real people -- en route to the current financial crisis. The next step appears to be having the U.S. government take much of this bad debt off the hands of the banking sector. Privatize gains and socialize losses is the rule.

If only governments these days were as committed to protecting the security of regular working folks. It would be far better for the government to step in and take over mortgages from families, so that they could stay in their homes with greater certainty through this period of turmoil.

In Canada, how far down is the bottom is anyone's guess. What's troubling is a federal government whose answer to every problem is a tax cut. An economic downturn has already begun in Canada, with economic growth stalling in the first half of 2008. Canada's economic fundamentals are anything but sound, despite mantras to the contrary.

That downturn is pushing the federal budget towards deficit, but having rejected deficits outright, the Harper government will have to cut spending to balance its budget, thereby making economic problems worse. This is precisely the type of thinking that turns recessions into depressions.

The Japan example

Yet, while recent developments invoke the spectre of the Great Depression, a full-blown collapse is unlikely. A better modern example is Japan, the miracle economy of the 1980s (just as the U.S. was in the 1990s and naughties). Following a collapse in its stock and real estate markets in the early 1990s, it took Japan the better part of a decade to get back on track.

The prospect of this downturn taking several years to unwind is a realistic one, given how overextended Canadians are in terms of debt. Statistics Canada recently reported that Canadian households are sitting on $1.25 in debt for every dollar they have in income. And that's going into a slowdown/recession.

The crisis may also mark an end to the notion that "investing" means guaranteed annual double-digit returns (far in excess of income growth) without having to do any real work. This is painful news if you were planning on retiring soon, and have a stock portfolio as your keystone to financial security. Ditto if you bought real estate in the last two or three years (perhaps more depending on how far things fall). Many households out there will soon understand the term "negative equity," where debts exceed the value of assets.

Canada needs a plan, too

In the meantime, we need a plan, not glib reassurances. Most good fiscal policy recommendations have started with the notion of getting money quickly into the hands of those who will spend all of it. In the short-run it would primarily work through EI, but one could also imagine souping up the GST credit, the Canada Child Tax Benefit and Old Age Pensions, not to mention provincial welfare systems.

In addition to this, a timely intervention would be to fund a major public works campaign for climate-change-related infrastructure. Huge public transit investments. Energy efficiency retrofits. Alternative power. These are all things we need to be doing anyway, given the climate challenge. As employment drops, these projects could be brought on line quickly if the pre-planning was already in place.

As John Kenneth Galbraith famously noted, bubbles do not burst in an orderly manner. This ride is far from over, and more than any time in recent decades we need an activist government to make sure that families are not wiped out.

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