Canada

Home Prices Are Rising In A Recession Because Central Banks Killed Capitalism

Unless you’ve been sleeping under a rock, you’ve probably noticed something unusual this recession – high unemployment and higher home prices. Odd, right? Usually when people are at risk of losing their jobs and business, their cost of living doesn’t rise. Free markets tend to manage risk this way, choking off credit as economic risk increases. Not this time.

Instead of crafting a market-based response, central banks decided to control markets. It didn’t matter what the market did, a small group of bankers decided they knew what it was going to do. Instead of responding to what was happening, they set out to stop a doomsday vision they dreamt. Capitalism was no longer in control, but the state was. At least when it came to investing.

Interest Rates and The Cost of Borrowing 

First, let’s just run down the basics. In free markets, the cost of borrowing is tied to supply and demand. Investors scramble to lend money when risk is low, and has a high prospect of reward. This tends to make lending rates cheaper, as well as makes it easier to borrow more money.

If everyone wants to lend you money, you get them to compete by lowering the cost. This is why Zuckerberg has a mortgage – his mortgage rate was less than inflation 10-years ago. He doesn’t need a mortgage, or thinks his house is a wicked investment that’s going to beef up his portfolio. Lenders know there’s almost zero chance he won’t pay the bills. He borrows for free, when everyone else is paying 4x the rate. This is very different from when you and everyone you know can borrow at an inflation neutral cost, but we’ll circle back to that. 

When risk is higher, fewer people want to lend money. Less capital to lend, means the borrower needs to give enough incentive to lend. This results in higher rates, as well as lowers the amount of money that can be borrowed. Think subprime lenders, that will lend if you’re rejected from a bank, but they are far from cheap.

The free market manages borrowing well this way. Demand to lend money increases when there’s less risk, dropping the cost of borrowing. It also increases leverage. Demand to lend money decreases as risk rises, increasing the cost of borrowing. It also decreases leverage. It’s a simple, but efficient system.

How Central Banks Broke The Model

When the pandemic started, borrowing rates began to increase. The market basically said, “you know what? We really shouldn’t lend the maximum amount of money to people as the economy goes down the drain.” It exposes both the borrower and the lender to a problematic situation, so both parties tone down. Great success. The free market was working to contain a predatory situation. 

The free market didn’t last long though, as central bankers planned a recovery before a drop. They imagined a risk event, decided it was over, and then started the recovery. They slashed interest rates, and when investors wouldn’t accept low enough yields, the state began to compete with investors. Investors wanted a premium for risk? Not today, the state was willing to buy the debt they also guaranteed. Investors with a lot of money, still can’t compete with an organization that has a money printer.

The argument for easy money for the government is a no brainer. Of course they needed cheap debt. How much, is a more difficult argument. Mortgage rates need to be the cheapest possible? Not valid, and doesn’t make sense in basic market theory. Flooding the mortgage market with cheap and unrestricted lending at all time highs was not meant to manage the economy. It was meant to prevent home prices from falling.

This may have been the dumbest thing they possibly could have done. Throw billions at fixing a problem that hasn’t occurred, and you’re not sure will. It was the central bank equivalent of giving an adrenaline shot to someone today, because you’re pretty sure they’re going to go into cardiac arrest next month. Not only does it not fix the problem, it causes a whole other set of problems.

Cheap Money Causes Bubbles 

“I will go to my grave believing that the financial crisis happened because of bubbles created by easy money,” once said billionaire Stanley Druckenmiller. How cheap is too cheap? One of the most common things I hear is, rates are so low, you can’t lose. 

The perception from many homeowners is inflation will wipe out the debt they have. “I’m borrowing at 1.5%, and inflation is going to be at least 2%. I’m getting paid to borrow!” I hear some variation of that from investors a few times a day now, and it’s technically right. The cost of debt is inefficient compared to inflation. The real value of your mortgage debt will go down if you borrow at a rate lower than inflation. 

However, buying a home because rates are cheap is a crowded trade, especially in Canada. Yes, the inflation adjusted value of the mortgage debt will wear down. The problem is you’re probably not Zuckerberg, doing this when other people can’t. If everyone can do it, it drives home prices higher. The general market thinks they can buy a home at any price, and it will be cheaper due to inflation. Most aren’t considering the possibility they have overpaid for an asset. 

Maybe a 3-season cottage that can’t be used in the winter, without a water hook-up in rural Ontario is worth a million. Maybe it isn’t. If it isn’t, a 0.5% real decline on your mortgage doesn’t exactly compete with a 10% or greater drop on the total value of that beauty. Back to killing capitalism though.

Capitalism Doesn’t Exist When The State Determines Risk Levels

Monetary stimulus is needed in a downturn, and no one here is saying otherwise. A temporary injection of liquidity goes a long way in stopping a crisis. However, it needs to be a market based response. A small group of bankers creating a doomsday scenario in their mind, and crafting a response to something that hasn’t happened, isn’t market based. It’s something that happens in a non-market, planned economy – typical of communist countries.  

Capitalism doesn’t exist without competition and risk. If central banks eliminate competition and risk, they set a dangerous precedent. Participants think free markets no longer apply, and downsides don’t exist. If they’ll send home prices up double digits during a recession, surely they’ll always prevent prices from falling.

After all, they already said they would keep rates low for a predetermined amount of time. They also said they would work to suppress the yield curve, and future borrowing costs. None of these messages from the central bank indicate they plan on listening to the market for the foreseeable future. The rules of capitalism no longer apply. Risk off. Mortgage on.

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22 Comments

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  • V 6 months ago

    Honestly, I don’t even feel like buying a property because this all just seems like a ponzi scheme now. The bankers at the top and boc are basically inflating these house prices which will relate to more land tranfer tax, more borrowing cost because of elevated house prices and not to mention when you sell you have to pay ridiculous 5% fee to these RIP off artist people call realtors. Enough is enough!

    • Trader Jim 6 months ago

      It’s important to understand what low inventory means, and why people pay higher prices for it.

      When inventory is low, you’re paying to jump the line. It’s not a fundamental, it’s an emotional premium. If the inventory situation corrects, prices flatten out, and the squeeze resolves.

      Sometimes there’s no reason to think inventory will resolve. Places like Monaco and Switzerland hand down homes with multi-generational mortgages.

      Sometimes there’s reason to think inventory a squeeze will resolve. A pandemic restricting peoples ability to move would rank pretty high.

      • Derek 6 months ago

        It isn’t low inventory so you pay to skip the line. That’s utter nonsense. This is a result of, first of all, rampant speculation in the real estate market and interest rates like the article says that the government won’t allow to operate in a free market way. Why is the government guaranteeing mortgages? Why are they buying so much debt? Why are interest rates so low and for so long and constant reassurance that they won’t increase? We aren’t talking about Switzerland here and in places like Switzerland renting is quite affordable compared to salaries. Why did the government give so much financial aid to people? I’m for helping out but the cash the government threw at people equalled more that their initial incomes to begin with. How does that makes sense? You are glossing over a tremendous amount here to chalk it up to simply restricted demand.

        • Ian Brown 6 months ago

          Abrupt and rapid price acceleration is literally called an inventory squeeze, and the result of order flow competition in too short of period, instead of queued.

          I get that there’s a lot of people learning on a sites like these, but please don’t act like an expert if you are one of those people.

          • Nice logic 6 months ago

            You did an excellent job at considering the completely valid points raised by Derek.

            This isn’t a free market. Sure there was less inventory on the market, creating conditions for a squeeze, but let’s not forget things like govt support and mortgage deferrals which prevented said inventory in the first place (or enabled people to have the funds to buy).

      • Nathan Horton 6 months ago

        Yes. The rate combined with a supply crunch. I feel property owners (boomers) are the least likely to want people in their homes at the moment since they are most vulnerable.

    • Rand Passmore 6 months ago

      Thanks fo the refresher lecture Stephen. I remember an economics professor saying that it would be a mistake to assume that good theory and practice will sometimes not apply in the real world. There are vested interests and lobbyists and emotions etc. And shocks that rock our realities

      • Rand Passmore 6 months ago

        To clarify the above I mean that good practices or pure ideological systems like capitalism, democratic socialism or communism often don’t happen the way intended in the real world. Humans and other forces will often screw up the best plans.

  • David Leham 6 months ago

    When even people with $450k downpayments can’t find a home in the suburbs, with $200k in income, you’re definitely a bubble

    https://www.theglobeandmail.com/investing/personal-finance/young-money/article-shut-out-a-well-qualified-millennial-home-seeker-throws-up-his-hands/

  • Arif 6 months ago

    As a tax payer. I’m tired of inflating home prices which I can’t afford.

  • WE 6 months ago

    Can you talk about the relationship between low property taxes and prices?

    I know you talk about it a lot on Twitter, but it would be great to have a piece when I try to explain how income taxes subsidize low property taxes, meaning the whole country has to pay for Toronto’s bubble.

  • Parag Agarwal 6 months ago

    That is why BoC and other officials are not elected but appointed by governments in power. They are “SUPPOSED” to be unbiased and independent (with extra emphasis on “supposed”). Unfortunately, political leaders are the ones who are running the economies. The situation was bad enough before with these Economists with their degrees and fancy models thought that they knew what they should do as their models predicted some outcomes. Now, not only these lunatic, narcissistic ‘Lords of Finance’ have control of the economies but are puppets to these political leaders who look only 4 years ahead. We need not go far to understand. COVID crisis and vaccine distribution has been managed pathetically by all political parties. If things were so dire, these politicians would not go on vacations. But because if the economy is not closed down there will be undue pressure on hospital system which will reign havoc on the constituents and in turn raise questions for these politicians. Easiest solution – close the economy, pump money into the economy, and kick the can into the future. Unfortunately, these decisions are everyone’s business but no-one’s business. All these people have way too much power now to decide the present and futures of not only our generation but generations to come. And they can easily get away by just blaming everything on COVID.

  • Sam 6 months ago

    Fantastic article. Great summary of the current situation. So many great quotes.

    The adrenaline analogy is spot on……type of stupid strategies countries like Venezuela did…..

    Not respecting market principles and steering the helm circumspectly in reference to prevailing economic headwinds…but thinking that the economy is something that can be outright controlled. So much a Trudeau-mentality thing….father & son.

    Suppressing the yield curve….wow….all that does is allow the pressure to build up and augment the explosive disaster that will take place. Need to take measures to release the pressure to soften the correction…..

    Finally, 10-12 years after the last big recession, we’re due for another downturn. Why can’t the people in charge simply manage economic cycles wisely to capitalize on the good times and minimize the down-turns….just be an even, steady hand at the till.

    • Alberto 6 months ago

      This is my issue, a million times over. When things were good, why were we loading up government and households with record debt growth?

      We knew there would be an emergency, and it would result in a situation like this. Now we’re stuck trying to control every aspect of the economy because the government can’t handle its debt.

    • Concerned Canadian 6 months ago

      This article forgot to mention Trudeau’s wild card…..immigration. Flooding the mkt when this pandemic is over will be his next step. This will offset any increase is home supply keeping demand for home product high thus maintaining high home prices. Lenders will also have access to more blood viens and keep people donating their hard earned money for years to come.
      There is no such thing as capitalism folks. Its all smoke and mirrors especially in Canada driven by Fidel Castro’s real son….Justin Trudeau.

      Care ti know the future???? Young talent will be leaving this once great country because home ownership is out of reach for them. What will be left is a wasteland of indebted immigrants with low skills but a pulse and a vein to draw blood from.

  • Jimmy 6 months ago

    “Capitalism doesn’t exist without competition and risk.”

    Without failure the system doesn’t work. The logic is we can’t let house prices go down or business fail because of the pandemic. It wouldn’t be fair.

    Then too I guess the people that have made money in business or house price inflation because of good fortune will be happy to hand over the profits.

    I am not aware of case in human history where the state allocating resources has not resulted in complete collapse.

    What we are doing is both ignorant and arrogant. We purchased 25% of the economy in debt and added it the balance sheet. We spent another 20% of the economy more then we brought in.

    I hope I am missing something.

    Bulls and real estate agents please provide a logical argument to put my mind at ease.

    Save you some time…

    There is no fundamental evidence of a housing shortage. (Check CMHC housing completion and compare to stats can population growth)

    Housing prices have gone up. Completely illogical

    • Sam 6 months ago

      Housing supply vs populations may be even. Housing supply vs demand….that’s the kicker.

      Why this insatiable demand for so many years in Canadian housing? What’s is government’s complicity in stoking this demand? Why?

      Unpacking all this ends up with the realization that we hosers have been hosed by the very government that should have been protecting us.

      • Jimmy 6 months ago

        I am really missing something. Please help me. I am already betting against the housing market. Please tell me i have this wrong.

        How can population and demand for housing not be related?

        Is the shortage of housing psychology and narrative correct?

        • Sam 6 months ago

          A year ago I was thinking like M. Burry in the Big Short….that the housing market had been stoked well beyond what the fundamentals could support. For multiple reasons….not the least of which was criminally low interest rates. (also foreign ownership, speculation, the domestic & foreign mentality that Canadian Housing is a safe, protected (CMHC), lucrative investment etc)

          It just seemed as if the demand side has been far more insatiable than could be explained by a growing population, causing a bubble situation.

          Now, after all this government and BOC intervention, I’m not sure how this is going to play out. The Harper Cons aren’t free from guilt, but these Trudeau liberals seem to be taking stupidity to unworldly levels. I’m aghast at what’s happening.

          Frankly, I think we’re beyond being able to predict anything at this point, we’re so off script. The only thing for sure is that none of this will end well. I can only imagine that the ultimate fall-out will be far worse than if the government had of just pulled out and let the darned market correct itself.

  • Ashley 6 months ago

    Canada does have a track record of turning good business into bad, real estate would be no different: Nortel, Blackberry, Bombardier, there is a pattern to become complacent and similar with real estate, it can go only one way that is UP.

  • Alex 6 months ago

    Nice People of Canada allowed this to happen.
    They elected and keep supporting a social media star because he was nice. He remains nice and he sees his existential goal as to be a nice guy for any foreseeable future. Now Stat Canada is told to be “nice” too and was tasked to change its formula of inflation because they wanted to hide inflation. Now the Bank of Canada is given a nice political goal too (equality of growth), so BoC is now saying they are going to burn the house because there is a cold corner in the basement and they cannot warm it up by any other means than burning its roof . Nice.
    Nothing is going to change here in Canada before people , voters, would change. But people would not change easily unless they are devastated and have to fight for food in order to feed their crying children.

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