A day of reckoning approaches.
Many people today are seizing on “low” interest rates, like five per cent for three years, and purchasing homes.
They should give their heads a shake and do some math. Such an interest rate can only be considered “low” when inflation stays at roughly three per cent or higher for the duration and the asset itself holds its value.
After all, deflation – the sustained decrease in prices as a whole – has occurred regularly in the past, and it’s knocking on our door again. Five per cent over three years is high if the price of everything, including the house, goes down by two per cent this year, and the next, and the next . . .
The implications of deflation are many, and the threat is real.
Is a general decline in prices possible? Definitely. Likely? Well, let me put it this way. Two economists I recently spoke with, (Dr. Rolf Mirus from the University of Alberta and Dr. Don Roper from Colorado University), each questions my pessimism.
But based on my interpretation of history and economics, highly leveraged folks in Canada today should clear the decks of debt as soon as possible. Unless there is hyperinflation, in which case the very opposite holds true.
Many economists seem to think Canada would be able to use monetary and fiscal stimulants to prevent potential deflation. They are wrong, as time and common sense will bear out.
There is no historical evidence to support money-supply injections in cases where they need to be large to be effective. In fact, revving up the money supply engine, when what is really needed is a stripped-down rebuild, can be dangerous.
Fiscal and monetary mechanisms have always failed when profound pressures were at play (see the 1920-30s, 1970s and Japan more recently). When central banks adjust the money supply (this can include printing money to cover debts – “monetizing debt”) or when the government incurs deficits for programs or tax cuts, small economic shocks can be averted. But the risk is that such interventionism aggravates fundamental corrections. An ideal world with steady, mild inflation will never happen. Proponents of that notion should get their heads out of their textbooks and look at the real world.
Such theorists are deceiving themselves and playing down two powerful factors – the competitive, robust (sometimes nasty) international markets and the truly substantial cost savings being realized for businesses via new technology. Besides, gentle price declines can be helpful, depending on why they happen.
It’s my belief that the declining rate of inflation that we have seen over the past 20 years is systemic, and we are not headed for a small “deflationary bump” in the road, to be smoothed over by monetary or fiscal policy. It’s easy for our central banks to miss the Grand Canyon ahead when they are worrying about the next pothole.
You don’t need a degree in economics to understand it. But the basic rule is that there is no easy way out of debt when that debt has no basis in realistic returns.
There is a bomb ticking in our closet. Handled carefully, it will hurt, but won’t do fatal damage. Our governments, and Albertans in particular, must turn this debt-induced, inevitable meltdown into an opportunity.
We last heard dire warnings about deflation four years ago, just before the telecom bubble distracted us and when Japan faced its banking crisis, but it’s rearing its ugly head again.
With the housing and auto sectors now arguably peaking, personal and business bankruptcies are reaching recessionary levels (5,000 per day in the U.S. right now).
Those of us taking on more indebtedness during this most-indebted period are risking a great deal. Reducing debt fast seems like common sense to me right now. But North Americans are still borrowing at record levels. Even the U.S. government is incurring huge deficits again. How foolish. There will be hell to pay.
Closer to home, Edmonton and Calgary have recently added to their liabilities. Mayor Dave Bronconnier, in justifying Calgary’s recent borrowing measures, referred to interest rates as “favourable” (but it’s much too soon to judge that, Mr. Mayor).
EPCOR, Edmonton’s city-owned electricity and gas retailer, has recently taken on mounds of debt to finance expansion. This is risky business. More so today than ever before.
There are plenty of signposts that suggest we could soon face a reckoning. But it’s amazing how many corporations and individuals are deluding themselves with their lack of mathematical prowess and historical perspective. No over-indebted generation has ever escaped unscathed. Today, we sit in almost exactly the same position as Japan in 1991. That year, Japan had government debt-to-GDP ratio of 58 per cent; Canada has roughly the same today. The Japanese had extremely high levels of personal debt, much of it incurred by an asset and real-estate bubble; we have record levels of household debt and the recent bubbles in telcoms/dot-bombs and houses are in no small part to blame.
Before the crises that started in 1989, Japan had the lowest government debt of all G-7 nations, and the yen was rock solid. Twelve years later, many economists are diagnosing Japan’s ills as incurable (debt-to-GDP is 135 per cent and climbing rapidly) and saying, as John H. Makin of the American Enterprise Institute for Public Policy Research did recently, that “Japan’s government is in an inescapable debt-death spiral.” Whether the Japanese economy collapses this year or next, the longer Japan waits to induce it, the worse it will be when it finally comes. Regardless, the Japanese are struggling to address growing bankruptcies and unemployment levels not seen since the Second World War. Does this sound like Argentina’s downfall? It should, except that Japan’s economy is about 40 times larger.
Canada’s problems are not as acute as Japan’s. Corruption and stagnation in the banking sector allowed many bad loans to uniquely infect Japan’s system. Japan’s population and investment community is an oppressively closed shop, unlike Canada’s.
I mention Japan’s case, instead, as an illustration of fundamental, systemic deficiencies weighing down the ship of state. No monetary stimulus in the world is able to right it. Japan has bankrupted itself trying to spend its way out of this mess (what economists call the liquidity trap).
Things would have been infinitely better if debtors and inefficient banks had taken the fall immediately after the bubbles burst a decade ago. Japanese defaults should not have been postponed for so long. So, judgment day is coming fast, and the fall of the Japanese economy will affect Canada. Are we prepared for those austerity measures here?
A shattered yen would drive prices down here. This could lead us into a deflationary trap, imperilling many of the vital sectors of our economy that are already suffering.
Japanese banks will soon have to liquidate stocks ($3 billion in the U.S. alone), putting serious downward pressure on all markets. My advice is for businesses and investors alike is to hedge against Japan’s downfall now. You have been warned.
