Before the financial panic in the United States the Bank of Canadaâ€™s target overnight lending rate was 3%.Â At the height of the financial crisis, by May of 2009 the Bank reduced the target to 0.25%.Â Today the target sits at exactly 1%.Â The Bank of Canada states that â€œchanges in the target for the overnight lending rate influence other interest rates, such as those for consumer loans and mortgages.â€
The Cause of the Bubble
The Bank of Canada has observed that changes in the overnight lending rate affect longer-term interest rates.Â The Bank acknowledges that the rise and fall of interest rates will cause firms to change their demand for investment goods and households to change their demand for residential housing and other big-ticket items.
When the central bank changed its target from 3% to 0.25%, it sent a signal to entrepreneurs that lengthy and time consuming projects that were previously unprofitable would now be profitable.Â At the same time households also increased their demand for housing, because their cost to carry was lower.Â At 3% the cost to borrow half a million dollars to buy a condo unit is fifteen thousand dollars per year; whereas at 0.25% the cost to borrow half a million dollars is one thousand two hundred and fifty dollars per year.Â With artificially low interest rates families will demand more housing than if interest rates were left alone, producing a bubble as households bid up the price of housing and developers build additional units.
In its 2011 annual report the Canadian Imperial Bank of Commerce said â€œa continuation of very low mortgage rates led to high levels of home building and rising house prices.Â Capital spending, particularly in the energy sector, provided a lift to growth that helped offset a softer environment for consumer spending.â€Â When a central bank artificially lowers interest rates, capital spending will increase because the cost to obtain capital is lower.Â Initially housing prices will also rise, because households will demand more housing when the cost to carry a home is discounted.Â Â As the price of housing appreciates, developers will build more and more units in order to reap abnormal profits.
Increasing the Money Supply
When entrepreneurs, developers, and households borrow money from the commercial banks the money supply increases.Â This is because commercial banks do not hold the money they loan in their vaults, but rather through fractional reserve lending the banks conjure up most of the money out of thin air.Â Commercial banks happily loan money because the more they loan, the more profits they will accumulate.
When managers and developers begin constructing their capital projects, they pay workers and suppliers with the new money that was borrowed from the commercial banks.Â The workers and suppliers will start to spend this new money, which injects it into the money supply and bids up the prices of scarce resources, resulting in an inflationary boom.Â Â This has generally been observed in Canada as the cost to purchase food, shelter, and clothing have all been steadily rising since the Bank of Canada lowered the interest rate.
The Collapse of the Bubble
The reason the housing market is bubbling is because businesses are being seduced by the low interest rates to divert resources into long term capital intensive projects, such as housing, and away from producing consumer goods.Â When the workers spend the new bank money the public directs this new money back towards current consumption and away from long term investments, for their time preferences have not changed, or will be shorter due to the unnaturally low interest rate.Â The public does not save and invest enough money to purchase the new capital goods, houses, or condominiums.
Businesses and developers acted as if there were more savings in society than actually existed. So, when the artificially stimulated capital goods projects are completed, consumers will re-establish their old proportions exposing the malinvestments in the capital goods, housing, and condominium industries.Â Businesses had over invested in lengthy and time consuming projects and underinvested in consumer products.
When credit expands at a slower pace than malinvestments are completed, there will be a downturn that exposes the systematic mistakes made by entrepreneurs that were enticed by the low interest rate.Â The commercial banks will begin to realize that they are carrying bad loans as some businesses will default when their enterprises are struck with losses.
Decreasing the Money Supply
The banks too will take on losses as entrepreneurs begin to file for bankruptcy.Â Â In order to maintain its old reserve ratio, commercial banks must reduce their loans by similar proportions that the banks increased their loans during the boom.Â This will result in commercial banks refusing to loan any additional funds and requesting that old loans are repaid to ensure that their reserve ratio does not fall below acceptable levels.
As the credit market freezes, while the commercial banks attempt to repair their balance sheet, the price of housing will plummet because banks will refuse to loan any new money.Â Further, as loans are repaid there will be a contraction in the money supply, since the repaid loans cannot be spent by the public.
As the money supply decreases there will be a decline in the price of all goods.Â However, the price of capital goods will decrease at a faster rate than the price of consumer goods, as the public desires less long term investments and more current consumption.Â Also, in a deflationary environment businesses will find it harder to fill their order books because consumers will have less money to buy their products, so firms will show signs of decline and take on losses.Â The entrepreneur will recognize that in order to survive their business must tighten, resulting in layoffs and a general reduction in the labor force.Â A steep depression will occur because banks will continue to contract the money supply as more and more losses are recorded and therefore more loans need to be recalled.
When the Canadian housing bubble pops, the money supply in Canada will contract, as the banks contract; the value of the Canadian currency will surge because demand for the currency will be unchanged, while the supply is drastically reduced.Â This was observed during the financial crisis in the United States in 2008, as the value of the U.S. dollar was rising relative to other currencies.Â The general belief was that there was a flight to safety, but this belief is incorrect, the truth is there was a reduction in the supply of U.S. dollars resulting in a rise in its relative value.
This also helps explain why we have not seen significant inflation in the United States despite the Federal Reserve sharply expanding its balance sheet.Â The Federal Reserve simply replaced the money that the commercial banks had destroyed.
The Government Card
While the Canadian commercial banks are contracting their balance sheet, it is likely that the Bank of Canada will expand its balance sheet to replace the destroyed money.Â This may result in a temporary continuation of the housing boom, or a softening of the collapse, but in either case the end result will be the same.Â The economy will divert valuable resources away from productive uses to less constructive stimulus projects, impairing the economyâ€™s ability to efficiently service the consumer.