Spelling out the risks

In many ways the Bank of Canada's Financial System Review contains little that we haven't heard before. Household debt is too high, which could pose problems if interest rates start to rise or the economy stalls again. The fall in oil prices makes it hard to assess the near-term outlook for the economy. And as always, developments on the international front could have negative implications for Canada -- though somewhat surprisingly, the Bank seems to be more concerned about China than about Greece.

Interestingly, though, the Report allows us to see in clearer-than-usual terms the balancing act that the Bank is trying to perform as it sets policy.  The Report reiterates the Bank's view that Canadian housing prices may be overvalued by as much as 30 percent, primarily reflecting stratospheric price levels in Toronto and (especially) Vancouver. Household debt, much of it taken on in order to participate in the housing market, is close to all-time record levels in relation to household income, at 163.3 percent. The ratio fell marginally in April, but still poses a huge risk to the economy and the financial system.

These interrelated facts -- the surging housing market and excessive household debts -- are the direct result of the Bank of Canada's very accommodative monetary policy over the past half decade. Yet there is no sign that the Bank is anywhere close to changing course, as the growth outlook remains below par and inflation slips below the 2 percent target. Indeed, the Bank unexpectedly added further monetary stimulus by cutting rates back in January, and there is a growing opinion among Bay Street analysts that there may be one or even two further cuts this year.

This, then, is the Bank of Canada's balancing act -- or gamble, as it might be better to portray it.  It knows that at some stage there will have to be a correction in the housing market.  However,  it judges that it can't afford to raise rates -- an action that would almost certainly trigger such a correction -- because that might slow the economy so much that household debt levels would become unsustainable, which would turn the correction into a rout.  In effect, this is a gamble that the economy will grow quickly enough to start reducing the debt-to-income burden, but not so quickly that inflation starts to rise and forces the Bank's hand.

It's far from clear that this is a good bet, and it's even less clear that the Bank was right to double down with its January rate cut. Despite recent encouraging employment data, the so-called rebalancing of the economy away from dependence on oil is proceeding at a snail's pace. As I've noted here many times before, much of the manufacturing capacity that might have been expected to benefit from the lower exchange rate is gone forever. In any case, prospects for that sector depend much more on what happens in the US economy, the destination for more than 70 percent of Canada's exports, than on any stimulus the Bank can provide.

That being the case, the January rate cut, and any further cuts that the Bank may see fit to make, can arguably have very little impact on the economy, yet may add considerably to the risks in the system, by encouraging Canadians to take on more debt and push house prices even higher. It's a dubious short-term gain set against the possibility of a serious long-term pain. If the whole house of cards toppled over, for whatever reason,  it would quickly bring about a crisis for the financial system that would almost certainly tip the economy back into a full-blown recession.

There's one further factor here that doesn't seem to get much attention in the Financial System Report: fiscal policy.  For the past several years, Governor Stephen Poloz, and his predecessor Mark Carney, were faced with a Federal government pursuing an economically asinine policy of fiscal austerity. Arguably, the governors had to keep monetary policy loose in order to stop the economy going off the rails altogether.

In recent months, however, the fiscal picture has changed. With an election coming in October, the Tories have been splashing the cash all over the place, with promises of more to come if (heaven forbid) they win re-election. If fiscal policy is no longer restrictive, it stands to reason that the need for massive monetary stimulus is diminished. At this juncture, however, there's no clear sign that the Bank is taking the new fiscal reality into consideration in making its monetary policy decisions. That may all have to change once the outcome of the election is known, especially if the more left-leaning NDP comes to power.

Interestingly, in doing some research for this post, I found at least one commentator who seems equally worried that the Bank of Canada is not worried enough.  Nice photo, though!  

Cause for the pause

The standard view among climate change scientists is that people who don't buy the story are in the pay of the Koch brothers or some similar nefarious interest group. Maybe some of them are, but there are also moderate skeptics, such as yours truly, who find that the climate change scientists can be their own worst enemies. This week's report from the NOAA's National Climatic Data Center is a case in point.

The new report in essence claims to prove that the much-discussed pause or hiatus in global warming, which seems to have started in 1998 (an El Nino year), never actually happened. Now of course, the belief in a pause was itself based on data that were collected and analyzed by climate scientists, rather than by stooges of the Koch brothers. Still, if the conclusion isn't what the NOAA wanted, the data must be wrong, so they've undertaken an exercise to remove "biases" from the dataset, and hey presto, no pause!

The thing is, slightly dodgy treatment of the data is nothing new when it comes to climate change science. The most famous example is, of course, the scientists at UEA in England, who used a very long data series to demonstrate the reality of global warming -- and then destroyed the literally irreplaceable data! Or there's Dr Michael Mann''s iconic "hockey stick" graph of long-term climate change. Nobody was collecting climate data back in medieval times. so Dr Mann used tree ring data to analyze the situation back then, and right up to the 20th century. But then a funny thing happened: tree ring data in recent decades have not shown any evidence of rising global temperatures -- so Dr Mann spliced on a completely different set of data to prove the conclusion he wanted.

Problem one for the moderate skeptic then: can we really trust the data? But even assuming we can, there's another issue. Many climate change scientists tried to ignore the pause in the early years, arguing (not unreasonably) that they had never suggested that warming would be a straight-line process.  However, as the pause has moved well into its second decade, this stance has become harder to justify.  Earlier this year, even the UN's IPCC report was forced to acknowledge the reality of the pause.

After denial, then, attempts at explanation. Most climate change scientists looking to explain the pause, including the aforesaid Dr Mann, seem to have settled on the almost untestable hypothesis that the deep oceans must be somehow absorbing the heat; and if so, woe betide us when the oceans' ability to act as a heat "sink" is used up, because then the atmosphere will really start to heat up. But...if there never really was a "pause" to begin with, then these great theories, posited by scientists who are in some cases quite willing to sue you if you don't believe them (Dr Mann again) were, quite simply, wrong.

Problem two for the moderate skeptic, then: the science isn't "settled", or anything like it, so please stop insisting that it is. Shouting down people who disagree with you -- and the latest worrying theme here is that climate change deniers are "a threat to national security", which is just a step short of accusing people of being traitors -- is not big, and it's not clever.

For a much angrier analysis of the new "data", check this out.

Who ya gonna believe: Lagarde or Yellen? Poloz or Poloz?

Nice timing, Christine Lagarde!  Just a day after the IMF boss tried to bitch-slap Fed Chair Janet Yellen into keeping US interest rates on hold until next year, we get news that the US economy added 280,000 jobs in May, significantly above the market consensus.  As CNN notes here, the US economy has now added a million jobs in 2015 to date. The slower rate of job growth seen in the winter months, and the decline in GDP during Q1,  can now be safely attributed to harsh weather conditions and not to a deterioration in the underlying trend.

The May numbers were strong across the board, with the predictable exception of the energy sector.  Even the slight uptick in the unemployment rate can be seen in a favourable light: the labour force rose by almost 400,000 in the month -- call it the encouraged worker effect, as improving job prospects induce more Americans to try to secure jobs.

Janet Yellen has been clear for some time that the labour market is key to the Fed's timing in terms of rate hikes. In particular, the Fed can be expected to act as soon as it sees signs that tightening in the labour market is starting to lead to wage cost pressures. Not much sign of that yet, though the number of companies voluntarily raising their employees' wages in recent months is something the Fed must be keeping an eye on -- WalMart is not known for its philanthropy, and is presumably acting because it sees a rising risk of a higher quit rate.

That aside, however, it will surely not take many labour reports like May's to jolt the Fed into action. Ms Yellen will not want to validate the criticism leveled by some of her Republican critics that she needs to act before wage and other cost pressures appear, not wait until it is too late.

Here in Canada, of course, we do not need two grandes dames like Christine Lagarde and Janet Yellen to give us two perspectives on monetary policy. Bank of Canada Governor Stephen Poloz can do the job all by himself. The Bank of Canada's most recent pronouncements had started to convince at least a few commentators that the next policy move on this side of the border would be a further rate cut.

What, then, will the Bank make of Canada's May job data, which are in relative terms even stronger than those posted by the United States? Canada added 59,000 jobs in the month, far exceeding the market consensus for a 10,000 gain. As in the US, the unemployment rate did not decline, thanks to a significant increase in the labour force participation rate.  The job gains were well diversified across most sectors of the economy, with a gain of 22,000 in manufacturing jobs offering some hope that the weakness in the exchange rate might be starting to have a positive impact on the non-oil economy.

As in the US, there are still few signs of incipient inflation to trouble the central bank, and the overall economy is still in worse shape than its neighbour to the south: witness Canada's unemployment rate of 6.8 percent, against the US rate of 5.5 percent. As a result, there's no doubt that the Bank of Canada will hold off on raising rates until after the Fed begins its tightening cycle. Even with today's strong US data, the Fed is unlikely to act until late summer or even the fourth quarter; here in Canada, today's numbers may have weakened the already tenuous case for more easing, but no move toward tightening is likely until early 2016. At least, that's my view until we next hear from Governor Poloz.

Wall of voodoo

If this article had appeared on The Onion, you'd have chuckled at "political correctness gone mad" and moved on. But it isn't a spoof; the dear old Toronto Star is perfectly serious. "Voodoo economics" is a derogatory and racist term, apparently, and the Star is banning its use with immediate effect.

It seems that the Star's "public editor"* has received not one but two complaints about the term in recent times. One is from a group of academics who evidently have too much time on their hands, and the other is from a gentleman named M. NourbeSe Philip, whose name suggests he may be of Haitian origin. I can understand why each of these parties might wish to dissociate themselves from the economic ideas that now bear the apparently offensive name, but of course, that's not their point. They want the term itself barred, and the Star is only too happy to beat its breast in anguish and comply.

No plaint too small to salve, it would appear -- and yet the Star routinely and without apology publishes all kinds of things, by its own columnists or by its correspondents, that are deeply troubling to people of faith, especially though not exclusively Christians. Too bad for them, it seems.  It allows its female columnists to assert on a frequent basis that all straight men are misogynists and potentially abusers; nothing offensive there, apparently.

One wonders, is the term "voodoo" itself now, er, taboo?  Could make things difficult on the entertainment pages, given the word's frequent appearances in popular music, from "do do that voodoo that you do so well" to Jimi Hendrix ("Voodoo Chile") to the Stones ("Voodoo Lounge") to the largely forgotten California band whose name I've appropriated for the title of this post.

Anyway, enough about the voodoo. Let's look at the economics, because in keeping with the theme of taking umbrage, I want to register a complaint of my own with the Star. Its economics coverage is pathetic and deeply offensive to any of its readers with the least understanding of the subject. I've posted about the paper's business correspondent, David Olive, previously, but he's not the only offender. Take, for example, this recent column by national affairs correspondent Tom Walkom. It's painfully obvious that Walkom, as always with heart on sleeve but brain on leave, hasn't come close to understanding the views he so enthusiastically espouses,

On behalf of all Star readers with a grounding in economics, I demand that the Star stop covering the subject entirely -- but as there may well be a whole lot more of us in Canada than practitioners of voodoo, I'm not holding my breath.

* If you want to know how politically correct the Star is, the public editor was once known as the "Ombud", because the paper could not bring itself to use the evidently sexist term "Ombudsman".

Atrocious

Statistics Canada reported this morning that GDP shrank at an annualized rate of 0.6 percent in the first quarter of 2015, weighed down by weakness in the oil and gas sector. Remarkably, this was actually a better performance than the US economy: revised data there showed a 0.7 percent pace of decline.

Given the precipitous fall in global energy markets, and considering the extent to which Canadian public policy has bet the farm on the energy sector in recent years, the modest extent of the decline is somewhat surprising. It doesn't appear to justify the epithet "atrocious" that Bank of Canada Governor Stephen Poloz chose to wheel out back in January.

We maybe shouldn't be looking to Gov Poloz for guidance about where the economy goes from here. Since January he has variously opined that the worst of the impact of the oil price decline may already be behind us; that there may be more bad news to come; that the recent data he has seen have been "encouraging"; and that the economy will return to full capacity by the end of 2016. Waterfront fully covered, you'd have to say.

The reaction of markets to today's numbers is telling, however. The Canadian dollar promptly fell by more than half a cent against the US dollar, slipping back below the 80-cent level. Whether you think the GDP numbers are atrocious or not, that looks like a clear sign that traders think a further rate cut is back on the table.

Greek Olive

Maybe it's because of his last name, but whatever the reason may be, the Toronto Star's erratic business columnist David Olive has decided he knows enough about the Greek debt situation to offer his opinions about it.  He doesn't.

So much of the article is wrong that it's hard to know where to start.  Maybe a good place to jump in is the old and much quoted canard that Greeks don't pay their taxes.  This is simply not true.  OECD data for 2014 (which took me less than a minute to find online; you really should try this sometime, Mr Olive) show that the country's tax/GDP ratio was right on the OECD average, and significantly higher than that for several major economies, including Canada, the US and Japan.

This is not to suggest that the Greek tax system is ideal. The same OECD report shows that the country depends to a more-than-average extent, and probably more than it should, on consumption taxes and not enough on income taxes. This leaves plenty of room for the wealthy to avoid paying their share, and there's certainly evidence of that. See this swimming pool story from a few years back, for example.

The fact is,  the average Athenian-in-the-street, the one getting whacked by the austerity measures, has been paying his or her share of taxes.  On the fiscal side, as Olive at least partly acknowledges, Greece's problem is one of excessively generous social programs, rather than inadequate taxation.

Olive's analysis of how Greece and its creditors got into this mess is also wrong -- and I'm actually personally insulted by his version.  He suggests that it was an "open secret", when Greece was admitted to the Euro, that the country had been cooking the books. At the time I was working in the London dealing room of one of the Big Five Canadian banks. We weren't lending to Greece but we were following the situation closely. As the date for adoption of the euro approached,  all the candidate countries were required to comply with a set of tests collectively known as the Maastricht criteria. Each country's performance was monitored by the ECB and European Commission.  These bodies duly reported that Greece was converging towards and then meeting the criteria. It's on this basis that investors, in good faith, bought Greek bonds.

It was only several years later that investigations showed that the Greeks had systematically and repeatedly lied about their true situation in order to gain euro admission. A small number of money centre banks had helped them to do so, using derivatives transactions to conceal the real picture. (If David Olive wanted to attack the role played by the financial sector, this would have been a good place to start). The players representing Athens at the negotiating table have changed, but this pattern of past deception is surely a key reason that it's proving so hard to make a deal today.

Have you noticed that there are more external links than usual in this blog post? I'm sort of trying to make a point. Finding all of these stories and linking them into the text took me, in total, less than five minutes. Real journalists like to sneer at us mere bloggers, but at least we do our research.

Shooting his bolt

Canada's Federal Finance Minister, Joe Oliver, says that the Tories will probably find ways to continue to cut taxes if they win re-election come October. Two questions here: is that a credible promise, and is it likely to be a vote-winner for Oliver and his boss, PM Stephen Harper?

As to the credibility, it's been perfectly clear for many months that the Tories were aiming to leave the Treasury as bare as possible in advance of the election. They've done this by getting the budget into the merest of surpluses, and then making all manner of commitments that will use up all available funds over the next several years -- the income splitting plan, some oddball tax credits, the tax free savings boost and so on. The goal was and is to leave no room for the opposition parties to make spending commitments at election time, unless they are also prepared to raise taxes -- at which point the Tories will pounce.

But if the cupboard really will be bare when the next Finance Minister takes office -- and it certainly looks that way -- it will be equally bare whether that minister is a rookie from the Liberals or NDP, or if it's Joe Oliver back in his current job. In promising further tax cuts,  Oliver is betting that the Canadian electorate will have forgotten by election day that the Tories have already spent any future surpluses. So, the answer to our first question is, further tax cuts are not a credible promise.

But can it be a vote winner anyway?  Both the NDP and the Liberals are promising to roll back some of the Tory giveaways: the NDP will reverse the income-splitting plan, and the Liberals will undo the tax free savings boost. In both cases, these moves will allegedly provide room for new spending initiatives, albeit on a modest scale. There are constituencies for both income splitting and tax free savings, but both measures are seen (correctly) as favouring the better-off, and most of the people who will benefit from them would probably be voting Tory anyway. It's not likely that the desire to save either measure will bring many voters from the NDP or Liberals over to the Tory camp.

So, as regards the second question, the tax cut promise may not be a winning strategy.  Opinion polls, at this early stage, show that about 70 percent of the electorate want to see the back of the Harper government. Harper's only chance of victory lies in the fact that the opposition is quite closely split between the NDP and the Liberals.  Canada's first-past-the-post system means that the Tories could still wind up back in office, as long as neither of the opposition parties succeeds in rallying the anti-Harper vote.  Here's where it promises to get interesting: Liberal leader Justin Trudeau is charismatic but callow and inexperienced, and his family name is still poison in parts of western Canada; NDP leader Thomas Mulcair is cerebral and experienced, but Canada has never elected a socialist government at the national level.

There's still all to play for -- but can we first just enjoy the summer, please?