Household debt could be a ticking time bomb

It hasn't been a great few weeks for economy watchers. The troubles in faraway Greece and China have rattled the nerves of investors worried about their repercussions for the global economy.

It hasn’t been a great few weeks for economy watchers. The troubles in faraway Greece and China have rattled the nerves of investors worried about their repercussions for the global economy.

Here at home we’ve known that the Canadian economy was in for a rough ride after the collapse of global oil prices. And while a small loss of 6,400 jobs in June has to be put into perspective in a country the size of ours, many analysts are saying that Canada is indeed in another recession. The International Monetary Fund has cut its predictions for the Canadian economy, reducing projected growth to a sluggish 1.5 per cent. And the price of oil is down yet again, with analysts unsure of where it will go from here.

The weak numbers have prompted speculation of yet another round of interest rate cuts from the Bank of Canada – a decision that will have been made by the time this column goes to press.

A reduction of the Bank of Canada’s trendsetting rate typically prompts other lenders to reduce their rates accordingly. The hope is that people and companies will borrow more money to spend, giving the economy a boost. Then, when the economy gets moving again, policymakers can raise rates before it becomes overheated.

It’s an elegant theory, but one that in practice has painted us into a bit of a corner in recent years.

The problem is that these “hot” economies which prompt rates to rise don’t seem to exist – at least not anymore. In textbook discussions of monetary policy they are a concern, but in the real democratic world where citizens demand economic growth policymakers rarely seem to see an economy they want to “cool down.”

For all the problems that come with economic growth on steroids – like the kind that is commonly associated with Fort McMurray, Alberta – it is rarely something that anyone actually wants to curb.

So while there are some good arguments for a rate cut, our failure to restore rates during the period of sluggish growth that followed the “great recession” of 2008 means there isn’t that much more room to cut this time around.

That failure to restore rates has created another problem: Canadians have built a way of life around the low rates that have prevailed since the “great recession” of 2008. We now have bigger mortgages and more debt, meaning that a rise in rates would be that much more difficult to cope with for many Canadian families.

And we seem to have forgotten – particularly those of my generation – that it wasn’t too long ago that we didn’t have rates like today. Our parents like to point back to the 1980s when rates were in the double digits to offer a cautionary tale about historical interest rates, but we don’t need to go back nearly that far to find cause for concern.

Shortly before I began wrapping up my university education less than a decade ago (just before the 2008 financial crisis) discounted five-year fixed mortgage rates (the rates most banks give you, not the ones they advertise) were still in excess of five per cent. Today they are less than three per cent.

At 2.75 per cent interest your biweekly payments on a $400,000 mortgage amortized over 25 years are $850.18. At five per cent those payments jump to $1,073.74 – not a catastrophic leap but enough to take a big bite out of your discretionary spending.

Manulife Bank of Canada recently released a “debt survey” which suggested that a third of Canadians would struggle to make their mortgage payments if rates increased by only a percentage point. I suspect that these self-reported numbers reflect some amount of exaggeration on the part of respondents. Most families would probably be able to do some belt tightening and avoid foreclosure if rates were to rise. The point I am trying to make isn’t that financial ruin is a rate hike away.

But there is no denying that even modest rate hikes would hurt and would be felt by many Canadian families. Rate hikes now represent such a significant hardship for Canadian families that policy makers will be that much more reluctant to restore equilibrium if and when the economy gets back on a solid footing.

Of course that is tomorrow’s problem. No one is talking about rate hikes right now. Today’s problem is a stumbling economy in need of some stimulus. But the deeper we dig the further we have to climb out. If monetary policy works the way it is intended to work, further rate cuts will only encourage further borrowing, which will make it that much harder to increase rates in the future.

And, at the risk of catastrophizing, there are nightmare scenarios that could force an increase in rates. Interest rates by definition have to exceed inflation. If they didn’t, lending would grind to a halt because lenders wouldn’t make any money. If inflation were ever to take off because of, say, crop failures or resource depletion, even the Bank of Canada would be unable to control rising rates.

Perhaps policymakers should look at ways to stimulate the economy without encouraging more debt.

Kyle Carruthers is a born-and-raised Yukoner who lives and practises law in Whitehorse.

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