activity. Houses will be the target of widespread speculative activity since almost everyone is interested, has a view on what the proper values are, and has a lot at stake given the size of the investment.
Shiller on the definition of a bubble, from the transcript of an NPR interview with Shiller and fellow 2013 Nobel Prize–winner Eugene Fama, hosted by David Kestenbaum.
“It’s like a mental illness.” He goes on to say: “Symptom one: Rapidly increasing prices. Symptom two: People tell each other stories that purport to justify the bubble. Symptom three: People feel envy and regret they haven’t participated. Oh, I would add one more — the news media are involved.”[6]
Canada’s house price increase since the late 1990s fits well with all four categories. Of course, there is no bubble if it doesn’t come to an end at some point, with a large decline in prices. And there is no bubble if prices don’t rise above the long-term sustainable fundamental or intrinsic value. Both of these requirements are difficult to prove in advance of the post-bubble price collapse so there is always room for debate until after the deflation period. And no one can predict when a bubble will end, making people look foolish for months and years before they are eventually proven correct. The Economist was early also in its prediction of a collapse in U.S. housing prices, but turned out to be prescient. So far Canada’s nationwide home prices defy all predictions of a collapse, as shown in Figure 1.1.[7]
If we take Grantham’s assertion at face value, Canada’s bubble (and Australia’s) could be even greater than the one in the United States, which he calculated to be 3.5standard deviations from the mean. Reversion all the way back to the original trend line in Canada means a devastating real estate crisis.
According to Shiller, while real estate cycles are as old as private ownership of land, the development of cycle peaks and valleys in several countries simultaneously is a recent development, only becoming widespread during the last two or three decades. In the 1980s, 1990s, and especially in the 2000s, bubbles formed in real estate and housing in many countries. Canada took its place front and centre with this new trend, along with Australia, which experienced even more extreme levels of elevated prices that rendered housing unaffordable.
The United States, and several other developed countries caught up in a synchronized cycle of real estate speculation, suffered a sudden collapse in housing prices. This collapse required a recapitalization of the banks in those countries that continues to this day. The bank bailouts that government authorities decided to fund in the United States, Ireland, Spain, the United Kingdom, and elsewhere created enormous debts for governments and significant political tensions that will continue for years. People resent the fact that, while people lost their homes and jobs, most bank executives were protected and continued to award themselves huge bonuses after the bailouts.
Canada’s bubble surpasses most others
We don’t fully understand why Canada escaped (so far) from the housing sector collapse that hit these other countries. We know that Canadians, and some foreign investors, continue to buy and speculate on houses and condos with borrowed money, and the housing bubble continues to grow bigger, making the situation even more dangerous than what prevailed immediately prior to the U.S. crisis that started more than eight years ago.
How did Canada get into this state of heated housing markets, excessive real estate investment, and speculative euphoria? In normal times, the primary determinants of the price level and value of residential real estate are household income (including the jobs market) and household formation, mostly young people getting married, starting a family, and buying into housing for the first time. In Canada the working population has enjoyed superior gains in income relative to other countries mostly due to the Canadian economy’s exposure to the commodity super cycle that started around 1998. As well, the good fortune of being in close proximity to the largest consumer market in the world — the United States — made wealth and incomes grow more rapidly than many other developed countries. Especially in the last twenty years, Canadians have seen large gains in income related to mineral exploitation, conventional oil and gas production, and increasing oil output from the oil sands. In fact, according to BCA Research,[8] commodity prices have doubled on average since 1998 (crude oil is up seven fold) and Canadian exports of commodities (mostly to the United States) had grown to about 40 percent of total exports in 2012, up from just 17 percent in the late nineties.
Canada enjoyed outsized gains in income compared to the United States, with unit labour costs soaring by 80 percent versus the U.S. since 2000. Hourly compensation in Canada doubled compared to only a 50 percent increase in the U.S. Unfortunately Canadian productivity lagged far behind our southern neighbour, according to the BCA report.
In the 1980s and 1990s, the North American Free Trade Agreement (NAFTA), signed by Prime Minister Brian Mulroney and President H.W. Bush in 1992, and its predecessor, the Canada–United States Automotive Products Agreement (1965), allowed southern Ontario — actually all of Canada — access to the United States for many exports, including autos and auto parts. Hydroelectric power exports from Quebec and British Columbia —fuelled income gains. Up until 2005, the housing-construction boom in the United States heightened demand for lumber and other wood products. In the last ten years the Canadian dollar appreciated from a low of about 63 cents to a peak of about five cents above par against the greenback. In late 2014, the Canadian dollar stood around 90 cents U.S., making Canadians feel much wealthier than they had in 2002. Happy days returned for snowbirds and other travelers with Canadian dollars. Canada enjoys unique good fortune compared to other G7 countries (United States, France, Germany, Italy, Great Britain, and Japan) when it comes to resources and commodities. According to the Department of Finance and recounted in a 2008 speech by the late Finance Minister Jim Flaherty, Canada has the second-largest known reserves of petroleum resources in the world (mostly oil sands) and is the largest exporter of oil to the United States. Canada is first in the world in hydroelectric power generation. It is the largest producer of potash and high-grade uranium in the world, the third largest producer of nickel and aluminum, and the world’s largest producer of forest products. None of the other countries (Brazil, Australia, Indonesia, Russia) that are large producers of these minerals or resources are located next to the United States, except for Mexico, a country that has managed its resources poorly compared to Canada (although that is changing).[9]
A major side effect of these unusual gains in wealth due to resource revenue and commodity pricing is the effect on house prices. Canadians, with their improving incomes have found the cash and the borrowing power to bid up the cost of housing.
Severely or Seriously Unaffordable
While Canadian incomes were rising more rapidly than elsewhere, housing prices grew even faster. According to an eleven-city index of single-family homes, called the Teranet-National Bank National Composite House Price IndexTM, between 2000 and August 2014 prices surged from an index level of 68 to 167 — a gain of 2.45 times.[10] This increase means that house prices grew much faster than household incomes.
One of the best measures of housing affordability is the ratio of median house prices to median household income — and this ratio indicates that a bubble has formed that is even more extended than the one that preceded the housing collapse in the United States. Median household income means that half of the households have lower incomes and half have higher incomes.
According to Demographia, in their annual report, Canada’s six major markets — Toronto, Montreal, Vancouver, Edmonton, Calgary, and Ottawa — are all moderately unaffordable, seriously unaffordable, or severely unaffordable.[11] The report showed that the ratio of median house prices to median household income in Canada’s six major markets was 4.5, or seriously unaffordable. The cut off for what is deemed affordable, according to their methodology, is 3.0. The major
