Sunday, January 30, 2011

Household Credit Expansion in Canada

This post will look at the household credit in Canada and it's contribution to economic activity. The link between the two has been a common theme of blogs such as AmericaCanada and Financial Insights for awhile and is recently becoming mainstream. The idea boils down to this:

Point 1. Credit has been growing at an unsustainable rate
Point 2. This has artificially inflated the entire economy
Point 3. Once credit contracts this artificial activity will disappear

This has been used to explain the difference between Canada and U.S. economic trajectories; Credit is contracting in the U.S. while still expanding in Canada. I do agree that credit growth has been unsustainable but not to the same extent as others. Consider the following from Financial Insights:
Let’s not forget that line of credit growth, particularly HELOCs, have significantly boosted consumer spending. CAAMP data suggests that home equity extraction alone has added 9% to the after tax income of the average family’s budget. When this slows, consumer spending (65% of our economy) slows with it. The new mortgage rules aimed at limiting home equity withdrawals will certainly act as a catalyst to strengthen this trend.
The explanation of this 9% is in a previous post.
Let me reiterate some basic math: If 18% of all households with mortgages (~60% of total) have withdrawn equity in the past 12 months, and the average amount was $46K, that means that when averaged across all households, it would be equal to over $5,400 in additional household spending per household in the past 12 months. Given that the median after tax income of Canadian households was most recently calculated at $63,900, this equity extraction has ‘boosted’ income and spending by an additional 8.5%.
No actual payments are considered in the above calculations. While many are taking withdrawals there are also households with who have made regular or lump sump principal payments over the past year. Some HELOCs may have been taken to pay others down. I think it would have been more suitable to look at aggregate HELOC growth to determine it's impact on consumer spending. I would guess this number is less than the 9% calculated here.

Also, there is some amount of household credit growth which could be sustained. Theoretically, credit could grow at a sustainable 4% with 1% from population growth and 3% from rising wages.

So I agree with point 1 in the model is true but to a lesser degree. What does this mean for the entire economy? Lets consider point 2 that above trend credit growth has boosted the entire economy. Consider a hypothetical couple, John and Jane Smith, and their consumption without credit expansion. They can only use the income to buy goods and services.
  • Debtor Income: $50,000
  • Debtor Consumption: $50,000
Since these people are impatient, shallow and reckless with money (like most Canadians are) they take a credit line against their house to "purchase" a new vehicle. They also buy granite counter tops and a Blackberry they otherwise would not have if the funds were unavailable.
  • Debtor Income: $50,000
  • HELOC Withdrawl: $50,000
  • Debtor Consumption: $100,000
Once the bills come due income is diverted away from purchasing goods and services.
  • Debtor Income: $50,000
  • HELOC Repayment: $25,000
  • Debtor Consumption: $25,000
If this happens to the balance sheets of household on masse the implications are clear. From Financial Insights:
I suspect the true state of the economy will become evident as credit demand dwindles and home prices normalize.
This example shows credit expansion as an outside entity artificially boosting economic activity. During the austerity phase debt repayments disappear into this abyss and cause widespread pain. The missing element here is that each loan has both a debtor and a creditor. It is not like debt repayments are sent to an inferno somewhere and disappear from the economy forever. First look at the creditors and debtors consumption before a reckless loan is made.
  • Creditor Income: $300,000
  • Debtors Income: $50,000
  • Creditor Consumption: $300,000
  • Debtors Consumption: $50,000
  • Total Consumption: $350,000
With the loan the Smiths spends an amount greater than their income but this is offset by the creditor's increased savings.
  • Creditor Consumption: $250,000
  • Debtors Consumption: $100,000
  • Total Consumption: $350,000
In this case it is theoretically possible that during the repayment phase there is no drop in total demand. Instead consumption is shifted from the debtor to the creditor.
  • Creditor Consumption: $325,000
  • Debtors Consumption: $25,000
  • Total Consumption: $350,000
The Blackberry, the granite counter tops and the new car the Smiths bought are all real. The debt played no part in their actual design, production or distribution. So the economy was not operating at a level higher than it's capacity which has been implied.

While I disagree that the economy was ever above a true state there still are downside risks. If the loans are not sound then this can cause shocks which will reduce activity below capacity. Hence the high unemployment rate in the United States right now. The economy will likely have to adjust from the middle class using debt to finance their lifestyles. So the model would differ somewhat:

Point 1. Household credit has been growing at an unsustainable rate
Point 2. The transition to sustained credit growth could trigger a period of time where economic activity is below capacity

And that's good news! After the economic shock subsides, John and Jane Smith will be given the privilege of toiling well into the future to fund the consumption of their creditors.


Chris Davies said...

One thing that gets skipped in the credit discussion is the growth in net worth. This goes beyond the growth in real estate values, which is the foundation of many people's net worth, which means that there's still a lot of people making smart savings and investment decisions.

Anonymous said...


This is Ben from Financial Insights. I noticed the incoming link on my blog. Nice post. Of course we disagree on the basic premise, but you did give me some food for thought.

I've written an entry examining this very topic of debt representing someone else's asset. Perhaps you'd like to comment:

Cheers and keep up the good work.