Wednesday Night #1627 with Peter Berezin

With Peter Berezin – focusing on Canada
[It was reiterated several times during the discussion that Canada is not alone; other countries, notably Australia and Norway, will face the same challenges as they too have overvalued housing markets, high levels of household debt, and strong currencies. Canada may be the outlier in a scenario in which smaller economies begin to suffer the ill-effects of global financial conditions. Today’s winners may well be tomorrow’s losers.]
An SRO crowd of economists and finance mavens, including new faces: Vincent Dostie and Stephen Tapp, gathered to hear Peter and participate in the lively exchanges. Vincent is president of the Montreal LBS alumni association and has worked with the Caisse; he is a CA and CPA who has particular expertise in setting up hedge funds. Stephen, an economist who has worked with the (late and much lamented) Parliamentary Budget Officer, is now research director of the Competitiveness, Productivity and Economic Growth research program at IRPP.
Housing bubble
Once you have a bubble, it doesn`t take too much to prick the bubble.
Setting the tone, Peter confirmed his bearish view of Canada’s prospects – predicting that there is a 50% chance of recession (not depression) by the middle of 2015. Despite the current consensus on 2% acceleration of growth, Peter believes that there will be a deceleration owing to the housing market where prices have been falling for 6 months; noting that residential construction is about 7% of Canada’s GDP, he cites a toxic combination of over-priced housing (30%-40%, especially in Vancouver) and an oversupply, particularly in the condo market. This development will lead to a decline in prices of about 20% over the next three years and to lower housing construction. In Toronto, the Green Belt, established in 2005-2006, is said to have played a significant part in the cost of housing, but this element is deemed structural, rather than cyclical.
[Note: the Globe & Mail published an extensive report Ottawa’s $800-billion housing problem in late December 2012]
A related issue concerns the problems identified in the automated valuation model built into CMHC’s “emili” underwriting system that may routinely overestimate property values.
Demographics — we are essentially looking at an aging society that will be renewed through immigration; with guidelines changing to encourage economically active immigrants there will likely be a long-term effect on the housing market, but not within the next 2-3 years.
Consumption will be affected as Canadians are no longer able to leverage their houses as they are used to doing (“using their homes as ATMs”). Additionally, the profitability of Canadian banks would be affected, given that some 75% of their loans are to the household sector.
[Update 22 May: Canadian Housing Bubble ‘Set To Burst,’ The Economist Says
(Via HuffPost) Canada’s housing market is “especially vulnerable” to a major correction, The Economist says in its latest roundup of global real estate.]
Decline in capital expenditures
The economy needs to go through a recession before we will see a meaningful policy response.
Adding to the bad news is the decline in investment spending, especially in the natural resource sector where commodity prices have been falling. Pipeline bottlenecks have hampered crude oil production, forcing Canadian producers to accept a steep discount to
global prices.Two oil issues are in line to change: the ‘shut in’ effect on Canada’s access to global markets which will be resolved by Keystone, and the de facto two-oil policy of East and West, which the TCPL to Maine would solve. Both projects promise at least short-term positive injections into the economy. But Keystone will not be up and running until at least 2015, therefore the current $25 discount at which Canadian oil is selling will continue for at least two years.
If the resource boom ends, would that not address some of the problems caused by the exchange rate? Yes, but with a 3-4 year lag. Bank of Canada has no room to manoeuvre on interest rates as they are already so low.
Ottawa appears reluctant to introduce fiscal stimulus as the government’s focus remains on balancing the budget by 2015. This is unlikely to change unless unemployment spikes and there is fear for the political future of those in power.
We should remember that in contrast to a number of European countries, the Canadian economy is perceived by others as being very healthy and prices of real estate very cheap.
Canada’s terms of trade are very worrying – the gap between export and import prices has never been so huge. As commodity prices fall, cost of manufactured goods from Asia (China) will rise, causing inflation on the supply side. Meantime, Canada’s manufacturing capacity has shrunk drastically.The decline is the inevitable result of more than a decade of deteriorating competitiveness.
Our resident technical analyst has a different view (surprise!). He cited Peter Munk’s financing of condo projects in Toronto as a counter to the general consensus on the housing bubble. He also points out that the market shows no indication of concerns, but is reaching new highs. Toronto is lagging but that is typical of Toronto at this point in the cycle. The market is very extended and there is some resemblance to 1987, however the steady rise in the market may be due to investors turning from bonds to securities.
Update on the New School of Athens conference in Paris in partnership with the OECD and INSEAD, which modestly bills itself as The Business School for the World. It is now scheduled for December 3-4 and will   be the launch pad for the 5-year Reinvention Initiative”.  One program of OECD, New Approaches to Economic Challenges , takes a similar approach to that proposed by NSoA, e.g. to “examine what lessons can be learned from the crisis and what policy implications can be derived from these lessons as we address the challenges going forward. The main goal is to enrich our analytical frameworks, while identifying a renewed strategic policy agenda for inclusive growth and well-being.” Another important new player is the Institute for New Economic Thinking, founded by George Soros in partnership with Jim Balsillie and William Janeway “to broaden and accelerate the development of new economic thinking that can lead to solutions for the great challenges of the 21st century.”
Inflation
A lot of excess capacity exists in the economy today. Possibly in about 3 years, the Fed will need to act to normalize its balance sheets and then we will see an increase in inflation of 3-4%. Then what happens? Possibly the Fed would increase rates to knock back inflation, but that is not a sure bet as a number of academics and economists today think that 2% inflation is too low.  So we could well have a world where 3-4% inflation is the new norm — not a good thing for those who have invested in 30-year bonds on the assumption that inflation would remain at 2%.
There exists a dual economy with respect to inflation: on the one hand, low inflation in sectors like manufactured goods where we have over capacity; on the other hand  high inflation in luxury goods (arts, gold jewelry,etc.) and in sectors characterized by monopolies (food) rather than because of scarcity. This duality feeds into the pervasive inequality – the one versus ninety-nine percent . This inequality has become a concern for not only economists – and sociologists – but organizations that are not characteristically  concerned – IMF, World Bank, OECD.
It would have been impossible with the room packed with economists to avoid the story of Niall Ferguson’s recent remarks about John Maynard Keynes (Niall Ferguson: Keynesian Economics Flawed Because Keynes Was Gay, Childless) which created a flood of outrage combined with ridicule. Wednesday Night’s learned economists efficiently refuted Ferguson’s interpretation of “in the long run we’ll all be dead”, pointing out that the statement was made as a counter argument to a laissez-faire approach to corrections of the economy. Several points were made regarding Keynes’ obvious concern for the future, e.g. his role as the manager of the King’s College pension fund, but perhaps the most interesting was his role as one of the leaders of the British eugenics movement.

P R O L O G U E

Be prepared for a pretty gloomy outlook in the BCA Special Report [titled Canada: On the road to recession?] which argues that there is a 50% chance that the Canadian economy will fall into recession by the middle of next year, due to the bursting of its housing bubble and a decline in capex spending, especially in the natural resource sector.
Maybe, as at least one wag has suggested, Mark Carney has chosen the right moment to move to the Bank of England, leaving his successor, Stephen Poloz (an alumnus of BCA – as well as Wednesday Night) to deal with the problems.
And what of that somewhat surprising nomination?  Amidst mostly favourable coverage (the Globe & Mail weekend RoB stands out for thoroughness) especially of his knowledge and empathy for Canadian export businesses, Andrew Coyne asks Is Stephen Poloz hiring another sign Bank of Canada is losing its independence?
John Ivison appears to agree: “Bank of Canada Governors are appointed by the bank’s independent directors, subject to the approval of the Minister of Finance and the federal Cabinet. At least, that’s how the Bank of Canada puts it. Jim Flaherty would doubtless say it differently – the directors give the Finance Minister a shortlist of qualified candidates and he picks the one most likely to follow the government’s agenda.” He also quotes Finn Poschmann, of the C.D. Howe Institute who said the appointment: “may indicate that the government is thinking less about monetary policy in its traditional sense, and more about the impacts of commodity prices and exchange rate movements on trade, and hence on the economy.” New Bank of Canada Governor’s most important attribute is understanding the Harper agenda
As long as we are on the topic of the Harper government agenda, we cannot overlook the proposal in the recent Budget Bill (or as Mr. Flaherty would have it, Economic Action Plan 2013 Act, No. 1) that a government official will be able to sit at the table when Crown corporations negotiate collective agreements with their employees, and that the government must approve any offers to change employees’ terms and conditions. Harper tightening the reins on CBC, Via Rail and Canada Post Once again, this appears to be government by decree, something at which this government is disturbingly good.
Meanwhile, the threats that ICAO will succumb to the enticements of a totally underwritten move to new quarters in Doha have created an extraordinary fellowship among the federal, provincial and municipal authorities newly committed to keeping the UN agency here – ‘Team Montreal’ fighting to keep UN’s aviation agency ICAO. The recent Power & Politics panel discussion Keeping UN agency in Montreal offers some insights on possible linkages to Canadian foreign policy (though not much insight from Mr. Baird’s hapless parliamentary secretary).
While accepted wisdom suggests that ICAO will not move, one friend of Wednesday Night reminds us that If Qatar fails, it could be a close call. Fifty-odd Muslim nations give it a nice leg up on the 115 votes it needs. A lot of small nations can be bought. The US & few nations in Europe likely don’t feel very strong on this issue. And many others, like China & India, might see this as a way to open the door to shifting a few other UN agencies from their predominantly Western domiciles and from the situation created in the immediate post-war period that most of the benefits generated by the re-organization of the world were captured by the developed countries.
Montreal’s Chambre de commerce/Board of Trade has launched an unusual campaign (we cannot remember ever seeing a move like this in a municipal election), seeking a new mayor for whom the qualifications are extensive; the Gazette’s Peggy Curran has taken up the cause. It will be fascinating to watch developments and see what knight (or lady) in shining armour comes to the rescue of our poor damsel in distress.
Around the world the news is not brilliant. The situation in Syria has been exacerbated by Israeli air attacks which the Syrians conveniently have described as evidence of an alliance between Israel and Islamic extremist groups trying to overthrow President Bashar al-Assad. Certainly an original take on the issue. UN sources, meantime, say that it was the Syrian rebels and not regime forces that used sarin gas – further complicating President Obama’s decisions regarding intervention. With general elections only days away (11 May) Pakistan is not only coping with the assassination of prosecutor Chaudhry Zulfiqar Ali, but also, according to the ADB is running out of money and would need to secure loan commitments of up to $9 billion by the end of the year. Will Imran Khan be the Game-Changer? If the results of Malaysia’s vote are an indicator, the tide is turning against incumbents as Malaysia PM faces limited future after worst electoral showing.
Hungary is again in the news; this time for the demonstrations of the far-right Jobbik partyagainst the meeting of the World Jewish Congress. And, of course, there is always more.
Ending on a happier note, there is a lot going on this week in Montreal and we suggest these items for your agenda