Where to now?

In the United States, the economy in general, and real estate specifically, is about to enter a critical phase.

Over the last 18 months, America has rolled out just about every program it could think of to prop up the ailing housing market. Tax credits, mortgage modification programs, low interest rates, government-backed loans and other assistance. All of it was intended to keep values up and delinquent borrowers out of foreclosure.

The objective has been to stabilize the market until a resurgent economy created new households that demanded places to live, thus reflating the housing market.

This, btw, is not too far off the mark from the strategy that has been employed in Canada.

But the economic recovery is nowhere to be found.

And as the anemic economy sputters and the stimulus wanes, housing sales in the United States have plunged again. In July US housing sales sank 26% from July 2009 and there is a growing sense of exhaustion with government intervention.

Politicians made a bet that a rising economy would solve the housing problem. But several years into the financial crisis they are out of options and they don’t really know what to do.

Now some economists and analysts are urging a dose of shock therapy: let the housing market float on it's own. And if it crashes, so be it. When prices are lower, these experts argue, buyers will pour in, creating the elusive stability the government has spent billions upon billions trying to achieve.

In Canada, after a brief hiatus, Canadians continued on with it's housing bubble due to direct government intervention. Lured by cheap money, we have carried on buying houses we can’t really afford.

And because we have taken advantage of historic low interest rates to maintain spending our nation now has the highest consumer debt to financial asset ratio among 10 OECD countries, including the U.S.

So dire is that debt situation that, according to the Canadian Association of Accredited Mortgage Professionals, 375,000 mortgage holders in Canada are already challenged by their current payments and may not be able to handle higher rates.

Think about that for a minute... interest rates at the lowest point in history and 375,000 mortgage holders have so badly plunged themselves into debt by buying the maximum amount of house they could afford that they may not be able to handle higher rates?

The Bank of Canada is well aware of the precarious position Canadians have placed themselves in and have spent the better part of the last six months issuing warnings to Canadians to be careful - and to prepare for an end to these emergency interest rate levels.

Now... the time may have come let the Canadian housing market float on it's own.

“The need to take the Canadian consumer away from the credit punchbowl remains a pressing one,” says Bank of America Merril Lynch, which is why you will see the Bank of Canada hike the interest rate again on Wednesday (and will keep hiking rates for the time being).

Minor mortgage rule changes, the HST and two simple rate increases by the Bank of Canada have plunged housing sales downward the past three months. And still there are calls for the Bank of Canada to keep raising rates.

The C.D. Howe Institute’s monetary policy council said last week that the bank should raise its“overnight rate (the short-term rate it targets for monetary policy purposes) from 0.75% to 1% on Tuesday and keep on hiking it until it reaches 2.25% a year from now.

In its statement, the monetary council said the recommendation “reflected a view that the Bank of Canada should continue to unwind the emergency measures adopted after the 2008 financial crisis.”

Carney spent the first half of the year issuing warnings of what was coming. And now that punchbowl is going to be gradually taken away.

Is it really so hard to see how things are going to play out?

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Taking away the punch bowl

Ahh there's nothing like a flood of cheap, stimulus money to revitalize stumbling equity markets, rebuild shattered nest eggs and get investors thinking it's safe to resume the party.

Faithful readers will know we've written about the bear market trap, the final stage of which appears when everyone starts plowing back into the market.

If this truly is the bear trap, then that final sign is now showing itself.

The markets, as those of bearish bent know only too well, have been on a remarkable run for the past six months. But this isn't another post warning of the bear market trap.

Roger Bootle, a well-known British economist, author and government adviser who has a solid bubble-forecasting record, is yet another who is adding his voice to those who preach that potentially crippling bubbles can and must be prevented - with doses of bitter medicine, if necessary.

And the irrationally booming markets have him concerned to the point he believes it's time to administer that bitter medicine.

“I don’t think it’s rocket science,” Mr. Bootle said earlier last week on a visit to Toronto to drum up business for his London-based research consulting firm, Capital Economics. “All I’m suggesting is a return to the old views of central bankers, in particular William McChesney Martin’s idea that the role of a central banker is to take away the punch bowl just as the party gets going.”

And what is the prescription for yanking away the punch bowl?

He stongly advocates imposing more stringent capital requirements or lending curbs on financial institutions and jacking up interest rates, even if it trips up an economy still trying to find its footing.

[Recall last week's post about Scotiabank economists Derek Holt and Karen Cordes warning that lenders have been providing "excessively generous financing terms."]

"The optimists in today’s markets could be right about the state of things to come," said Mr. Bootle. “But eventually one of two things is going to happen: Either the economy is going to be disappointing or interest rates are going to go up.”

The problem, of course, is that if the economy doesn't revive then crushing government debt and declining tax revenues are going to trigger interest rate hikes from the bond markets anyways.

It comes across as a catch-22. Raise the rates now to stiffle unfounded gains, or trigger higher rates later when the unfounded gains bubble up to cause another crash.

Bootle joins the growing ranks of those who do not subscribe to the doctrine which says market booms are best left to collapse under their own weight, leaving the cleanup for after the party is over.

In the long run, ensuring the stability of financial structures is paramount, Mr. Bootle said. When bubbles are allowed to form, the ensuing mess is so hard to clean up “that it’s worth almost anything to prevent that.”

So the remedy, according to the likes of Bootle, is to yank the stimulus punch bowl away right now.

Hmmm... what a choice.

Yank the stimulus immediately by jacking up interest rates now (and cause considerable pain), or let the bubble run amok and deal with the catastrophe later (which will result from sky-high interest rates to fund exploding government debt and decimated tax revenue).

Regardless of the choice, the forecast is the same.

High interest rates are coming. One way or another, they're coming.

What a great time to assume massive amounts of debt on million dollar crack shacks.

How can this possibly end badly?

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Email: village_whisperer@live.ca
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