Asset price inflation may pose a greater threat

TORONTO—While much attention is now being focused on the consumer price index and what it may mean for the economy, a perhaps much more threatening form of inflation—asset price inflation—may pose a greater threat. It appears that over the past 20 years, much of our gain in national net worth has been built on a castle of sand, based on overpriced housing and unrealistic increases in stock market prices, not investment in productive assets. This has the potential for a dangerous reckoning ahead if housing and stock market prices correct to more realistic levels and poses a major challenge, both for the Bank of Canada and for Finance Minister Chrystia Freeland and her forthcoming budget. It is hard to know where the Bank of Canada stands. In its January Monetary Policy Report it was extraordinarily bullish on the economy, despite being forced to lower its earlier forecasts on growth, investment and jobs, it would have made the finance minister blush. A somewhat more sober message was contained in its Financial System Review last May. It said that while the market boom in housing prices and corresponding growth in mortgage debt, for example, had helped the economy in the short run, it had also increased the risk to the economy and financial system over the medium term. It also noted that the stronger appetite for risk and chase for yield (the result of zero interest rates) had elevated the price of a range of assets. “A change in market sentiment,” it warned, “could result in a sharp deterioration in global financial conditions” and that this repricing of risk would inevitably affect Canada negatively. Owners of homes with high mortgages, corporations that had borrowed at junk bond rates and individuals and corporations that had borrowed money to buy shares could find an increase in borrowing costs from higher interest rates and a corresponding correction in asset prices could leave them in serous difficulty, with spillover effects on the financial system and hence the overall economy. But the Bank of Canada seemed fairly relaxed on this risk. The flooding of the financial system with massive flows of new funds and with zero interest rates in response to the Great Financial Crisis of 2008 and the COVID-19 pandemic of 2020 has done more to inflate housing and stock prices than to encourage productive investment. While obviously some relief was needed, free money did not stimulate needed business investment. In fact, capital stock per worker in Canada has been declining. Instead, policy has benefited the better off at the expense of the needier population, creating wealthy winners and precarious losers, contributing to inequality. This, in turn, has exacerbated political divisions and reduced trust in our institutions. Canada, along with the U.S. and other advanced economies, have created economic, political and social fault lines that now have to be put right. Unless it is done skillfully we could face another financial crisis, with the worst-off, as usual, paying the highest price, but this time policy must work in a political environment that is much more volatile. This risk of economic crisis is the warning of the McKinney Global Institute in a special report, The Rise and Rise of the Global Balance Sheet, issued last year. It is also the theme of The Lords of Easy Money, an important new book on Thomas Hoenig, who as a member of the powerful open market policy-making committee of the Federal Reserve in Washington, D.C., questioned the massive quantitative easing of monetary policy. He feared the policy would serve the interests of Wall Street to accumulate even more wealth for the wealthy through asset price inflation and encourage more speculative risk-taking while increasing inequality since few of the benefits of these giant rescue efforts would reach those needing help the most, and do nothing to improve the productive capacity of the U.S. economy. It appears he was right. Over the past 20 years, the sharp rise in the price of housing and stock market shares has far outpaced the historic link between economic growth and increase in asset prices, according to the McKinsey study. The bulk of our increase in net worth has been based not on expansion of our capacity to produce goods and services—investment in real activities—but on paper gains from a housing price bubble and stock market prices that are far in excess of the future profits. Canada’s net worth relative the GDP increased from 3.6 times in 2008 to 5.9 times in 2020; of that increased share, 77 per cent was the result mainly of rising real estate prices and 30 per cent from the increase in share prices and other financial assets; the contribution of investment in productive assets actually declined. Between January 2001 and January 2021, the average selling price of a residence in Canada rose 300 per cent, from $172,083 to $687,804, or $515,721, which is an increase of three times the value, according to the Canadian Real Estate Association. Likewise, the growth in stock market prices, based on the S&P/TSX Composite Index, rose about 115 per cent between Jan. 4, 2000, and Dec. 31, 2020. Yet between January 2000 and December 2020 the consumer price index rose only 47 per cent while between 2000 and 2020, the gross domestic product rose 100 per cent. But, the McKinsey report asks, “is it healthy that high house prices rather than investment in productive assets are the engines of growth, and that wealth is mostly built from price increases in existing wealth?” And is it healthy that stock market prices are fuelled by share buybacks and irrational speculation, not future growth prospects? The answer must be no. “The safest and most desirable option,” the McKinsey report says, is to rebalance through faster GDP growth. “To achieve that, directing capital to more productive and sustainable uses seems to be the economic imperative of our time, not only to support growth and the environment but also to protect our wealth and financial system.” This is the essential challenge of Freeland’s next budget. David Crane can be reached at crane@interlog.com. The Hill Times