Musings of the Technical Bard

The federal Finance Minister, Jim Flaherty, today released revised rules for mortgages to try to avert a housing bubble.  His mechanism is to make it more difficult for people to buy houses without taking more equity and to make it so that borrowers need to meet a higher bar of being able to pay back the house (5 year fixed rate vs. a shorter term or variable rate).

Here is the problem – this is a band-aid solution to the housing problem that doesn’t address the fundamental problems:

• We have too much debt
• Debt is too easy to acquire
• Interest rates are too low, making debt appear less risky (it is only truly less risky if it is very short-term debt)

A simpler solution is for the Bank of Canada, and central banks everywhere, to consider changing the measures that are used to guide the setting of interest rates.  Today, there are three criteria that the BoC is using to set interest rates:

1. Inflation (CPI)
2. Economic Growth
3. The value of the Loonie

The problem with these is that the Inflation rate has been compromised by politics.  They removed “volatile” prices like food and energy, which means that the remaining prices are more greatly affected by things that are deflationary, such as electronics.   Economic growth is likewise a dangerous measure, especially if that growth is being built with a large current account deficit or increase in debt levels.  And the third is simple ridiculous.  Maintaining a low Canadian dollar protected Canadian business from having to spend money on improving efficiency and productivity – but we should have known we could not rely on that forever.  Also, the value of currencies is likely to shift significantly over the next few years as Europe, Japan and America deal with their giant fiscal problems and China grows into the largest economy on Earth.

A better method for setting interest rates would be for the central banks to use the same kinds of measures that the free market would (i.e. if we didn’t have central banks) – RISK.  If there is a rising level of debt, there is a rising level of default risk.  Lenders (i.e. bondholders) would demand a higher interest rate to counter the risk profile.  Central banks should do the same.  If the level of private and public debt is rising to quickly, interest rates should be increased to slow or cease said growth.  The painful part may be that we are so far gone that economic contraction may be necessary to unwind the debt.  Imagine for a moment that we didn’t have CMHC (or Fannie Mae or Freddie Mac in the US) insurance for mortgages – would banks be rushing to offer mortgages with zero down and low interest rates?  I don’t think so.  The risk profile for banks would be very different and the housing market would likewise be very different.

Therefore, the Bank of Canada and the Minister of Finance should sit down and decide what a reasonable debt level is for Canada – preferably by asking the banks what they would be comfortable with if they had to lend with no insurance policies from government.   Then raise interest rates until debt levels fall.