3 Years

Arthur Schopenhauer once wrote “All truth passes through three stages: First, it is ridiculed; then it is violently opposed; then it is accepted as being self-evident”.  

Suggesting that I am an economist would be worthy of such ridicule. However, I am a student of economics, and educator to my clients and friends, and only offer insight that you may choose to discard as rubbish, or choose to treat with a degree of seriousness. I have been watching the irrational exuberance of the real estate market, especially in BC in the last few years, with a similar degree of seriousness.   And I suspect something is about to change.

It has been mathematically proven in various political and economic studies that mismanagement - by manner of government intervention of the free market, and politically influenced fiscal policy - exacerbates the normal expansion and contraction of the normal economic cycle.  Indeed, as we know that bureaucratic policies that engage in the process of sovereign credit expansion are by their very nature, inflationary.  Policies that perpetuate a forced and unnaturally low interest rate environment allows companies and governments to expand credit when normal economic logic would preclude such action. For investors chasing better returns, assumed knowledge says that it requires them to unnecessarily increase the risk in their portfolio.  In short, government fiscal policy and economic action is responsible for the economic cycle.  

The economic cycle oscillates in greater fashion when the government, armed with the monetary printing press, debases its currency with the unbridled production of money. Governments also have a tendency to further instil the dramatic wave of the cycle with potential for making bad investments on the wrong side of the curve. (For example Bombardier, which recently asked for $1B in Federal funding) I’m not here to debate the legitimacy of these actions, but rather to identify what affect, if any, deferring the application of real solutions to our economic problems has, rather than dealing with it now.  

Problems - when the solutions to them are delayed, deferred, or otherwise ignored - tend to be worse in the future when we ignore dealing with them today.  This is true in any area of life including our health and mental abilities, and even in economics.  Take for example the person who, in only paying the minimum payment on their credit card, doesn't stop to calculate the total amount of interest paid over their lifetime.   And if it's true that government debt in Canada alone is more than $1.2 Trillion, then what is the interest payments over time, due to us, our children, and the multiple generations hence?

If we consider the total interest paid annually on our $1.2 Trillion dollars, even at 1% that amounts to $12Billion in interest payments every year. Consider the only four measures that these debts can be satisfied:

• increase income through higher taxation
• cutting spending with austerity measures
• make no cuts and increase the debt
• create more money (#fiatcurrency)

No one seems to want to directly increase taxes, except what is generally popular and socially acceptable to increase taxes to the wealthy, and cutting programs seems unpopular. We don’t seem to have a problem with increasing our debts, or printing more money. But the economic cycle is deeper than just simply printing money or increasing the debt.

We have been educated to think that the economic cycle of supply and demand is responsible for the cycle of booms and busts.  We believe that it's actually the free market and its evils that create economic calamities, when in all actuality it is not capitalism itself, but a perfect storm of government and central banking action, coupled with crony capitalism, that not just contributes to the ups and downs of the economy, but complicates it.  

Free markets, entrepreneurialism, free enterprise (I'm not even comfortable calling it capitalism anymore as the word has been so misaligned, twisted and misused) have always had its ups and downs. Countless writers such as Frederic Bastiat, Hayek, Hazlitt, Rothbard, Menger, Mises to name a scant few, have often lamented about the destructive nature of maligned bureaucratic economic policy. Crony capitalism is where the private sector seeks political favour, resulting in a corporate welfare state.  This collaboration between government and monopolistically minded business has had dramatic results in the modern economy. Historically, nowhere was this first more evident in the US since the passing of the Sherman Act in 1890 and the Act to Regulate Commerce in 1887 in the US.

As Thomas Di Lorenzo writes about the political climate at this time: “…the trusts "have made products cheaper, have reduced prices," admitted Congressman William Mason, who nevertheless was in favor of an anti-trust law. He was in favor of the law because he, and most of his congressional colleagues, wanted to protect less-efficient businesses in their districts from competition. Antitrust has always been a protectionist racket."

The evolution away from true capitalism towards one of “crony capitalism” – a state of government protected business interests and the political favours conferred therein. This, of course, leads to the erosion of the general entrepreneurship and the rise of the multi-national corporation, protected legislatively under the auspices of legislation.

Current evidence of this is clear. Wal-Mart, as an example, has been given deferral on tax in some communities in order for them to be encouraged to come into various communities. Over time, and based on the human nature, the mom and pop stores have struggled to maintain their profitability, and closed up shop as they lose significant market share to the box stores. This doesn’t mean that competition is evil – on the contrary, competition directly leads to improved prices and increased production that benefits the consumer. But what I object to is the use of government favour (special tax breaks) and other bureaucratic benefits in order to enforce competition rather than giving the power to the consumer. Further examples include, but are not limited to introductory tax reductions, bank bailouts, the TARP program, etc.

In the absence of crony capitalism, there are multiple examples of government control that have resulted in issues against its own people and free thought. Take the USSR for example, where millions of innocent people were sent to labour camps; or Maoist China, where millions of people died in opposition to the Cultural Revolution; or Ceau?escu in Romania; or Cambodia; or North Korea. Venezuela has in the last few weeks totally descended into chaos – no food, no medicine, the highest murder rate in the world in 2014, random and scheduled electrical black outs, and a hospital system that looks more like a morgue than a medical facility. Anyone speaking out against the state has found themselves against a wall of police in riot gear, in jail, or worse.   Anyone unwilling to cower to totalitarian rules has found themselves victims of human rights abuses. Anyone found to be unwilling to conform to political correctness has found their Section 2 Charter Rights to freedom of thought, belief, opinion and expression fall short. Rather than find the commonality with others, people are more willing to tell others they are wrong for having an opinion.

I’m not about to wade into a moral or ethical debate here, only to observe the evidence against the quasi-capitalist system we live in, and what most people refer to as its alternative. When faced with the ideological choice between socialism and crony capitalism, one will inexorably choose socialism. After all, what is there to gain from supporting a system that promotes the evolutionary survival of the fittest? This seems like the choice between rotting and festering. But what of the free market, free prices, and free choice? The third option of the free market exists which favours the individual, which tends to get lost in the shuffle between the political left and right.

I’m pretty sure crony capitalism isn’t what Richard Cantillon, Jean-Baptiste Say or Turgot had in mind in their proposals on the ideals of economic liberalism. Adam Smith in “Wealth of Nations”, vigorously attacked government restrictions, interference and the mercantilist and tariff systems, which – as he maintained – created monopolies and higher prices and market inefficiencies. John Locke, in 1689 stated “The state of nature has a law of nature to govern it, which obliges every one: and reason, which is that law, teaches all mankind, who will but consult it, that being all equal and independent, no one ought to harm another in his life, health, liberty, or possessions… (and) when his own preservation comes not in competition, ought he, as much as he can, to preserve the rest of mankind, and may not, unless it be to do justice on an offender, take away, or impair the life, or what tends to the preservation of the life, the liberty, health, limb, or goods of another.” Essentially, there can be no subordination from one man to the next, and doing so creates an abdication of responsibility and accountability from the governed and freely given to the governor. Indeed, even Joseph Schumpeter saw this eventuality in his view of capitalism eventually morphing into “corporatism” (rather than through a single, violent act of defiance or opposition as Karl Marx mused) and those corporatist values were hostile to real capitalism. Furthermore, as Schumpeter viewed, the increased aspirations for restrictions on entrepreneurship from the intellectual elite would inescapably lead to labourism.   More dangerously, as Machiavelli predicted in his 1513 work, Il Principe, that violence may be necessary for the successful stabilization of power and introduction of new legal institutions.

On the heels of these protectionist policies came the establishment of the modern central banking system. The establishment of an entity of a bank to control the economics of a country was simply a natural progression of thought. The symbiotic relationship of governmental fiscal policy and central bank monetary policy led to the establishment of control over the economic cycle. There are those who hold the opinion that the central banking experiment has failed; that the central failure of the banking system has been experienced – the credit trap, where that manipulation of interest rates has not worked to stimulate the economy. How much lower do rates have to go to “stimulate” the economy? We can regard the Eurozone as a prime example of an economic calamity that interest rate manipulation has not been able to positively affect. More than one country has instituted zero or negative interest rate policies. Injecting more and more printed capital (through the establishment of increased government indebtedness through a closed bidding process where central banks are the only possible buyers in a closed loop system) only delays the inevitable. At some point, the piper always eventually comes calling.

Government overspending in the unnaturally low interest rate environment, leads to an abundance of capital flowing through the banking system, which leads to higher consumer indebtedness, which leads to higher spending, which ultimately profits the banks and other corporations. The lure of cheap money leaves people to believe in the unsustainable affordability of houses, cars, vacations, and discretionary spending. As people keep on blindly purchasing, or blindly financing to keep up, the wheels of the economy are greased.  But it is all a game of smoke and mirrors.  If Canadians continue to spend as their governments have, we would be, as author Nelson Nash describes, "Thrown under the jail".   Having saved capital during times of economic prosperity to deploy sensibly when opportunities eventually arise is making sound and reasonable decisions with money, rather than continuing to borrow for lifestyle choices.  

It reminds me of that Saturday Night Live sketch where Steve Martin and Amy Poehler are a regular couple who learn to handle their finances by spending less than they make and having “saved” money. Simple.

But savings is in direct contradiction to the ideas presented in The General Theory of Employment, Interest and Money which was first published in February 1936. John Maynard Keynes’ magnum opus supported the already established idea of centralized economic control, and was initially a response to the lack of, in his mind, government intervention during the beginning of the Great Depression. The theories of increasing government intervention through its central role in supplying aggregate demand (capital spending) were adopted by many government systems, regardless of political affiliation. No other document would have as much lasting impact on modern economic theory as Keynes did. In Keynes’ view, government spending, and manipulation of interest rates were logical gateways to personal spending, which would further increase a tax base in order to recover the cheques the government had initially written. Lew Rockwell, Founder of the Mises Institute writes “Government officials were rather more attracted to the message Keynes was sending them: the free market can lead to depressions, and prosperity requires more government spending and intervention.”  

There have been a lot of varying perspectives offered on Keynes view, some supportive and some not. The debate on the validity of the arguments for and against Keynes is well beyond the scope of my intent here; but suffice to say, government financial intervention, started since the dawn of democracy, and emphatically supported by Keynes General Theory has been taken for granted. According to a personal source, when Keynes was questioned on the validity of his theory, he stated “we are all going to die anyway”.

So let’s mix this all together and take a scientific approach to its current effect the state of the Canadian economy.

It’s a deductive approach to suggest that the Chinese people, who save an average of 30-50% of their income, are eager to get their money out of their country before their economy collapses.  Where better to park their funds other than something beyond the long arm of the communist government than in the Canadian real estate market?  Specifically Vancouver, which since the early 1900’s became a hot bed of Asian immigration, but much more dramatically between Expo 86 and the 1999 transfer of Hong Kong back to mainland China. In fact, in the decade between 1986 and 1996, Vancouver detached housing prices soared 218% according to the Vancouver Real Estate Board. What better place to park it with low risk, high return, relatively highly demand market, other than where I see an undervalued real estate market, compared to other cosmopolitan cities around the world? We have seen $600 Billion leave China over the last several years and move into real estate markets and business purchases around the world. This has translated into a literal feeding frenzy for both foreign millionaires, and domestic buyers who still can afford to qualify for a mortgage. Housing prices in the last 12 months are up almost 40% for single detached homes, 25% for semi-detached homes, and 22% for condos.

So why this need to hide money from your own government?

China’s central bank has been literally printing tonnes of Yuan in order to maintain liquidity in their economy, and continues to express their interest of keeping the printing presses running to support it. Keynes certainly supported the idea, specifically with definition of aggregate demand as a responsibility of central action in the content of General Theory.   If you know your history on Keynes, you will know about his attraction about Leninist/Stalinist Russia, and his affinity for complete government dominance over economic affairs. Certainly, this love was based in his mutual (with Marx) hatred with the bourgeoisie class system. 

China’s government is certainly no stranger to this centralized control ideology. Chinese economic stimulus has resulted in credit growth over the last 5 years of $30 Trillion, where their GDP has only grown $5 Trillion over the same period. It seems like a very expensive way to keep the wheels going round on the bus. However, evidence of a banking and economic crisis in China is starting to bubble to the surface. According to The Economist, debt to GDP ratios have exploded to over 250%, in the last several years, and almost 20% of Chinese companies owe more in bank interest than to tax.  The world's stock markets experienced considerable volatility in January 2016, as a result of the nervousness stemming from the Shanghai index decline of 24% in a span of 30 days.   The significance of the world economy losing steam will be affect Chinese banks, currently the world’s largest banking system, controlling assets equivalent to 40% of global GDP.  Those same banks are facing a problem of (according to official data) a collective non-performing loan portfolio of $200,000,000,000 USD, corrupt official economic data, and urgent reform in order to fix systemic issues.   One source quotes a bank liquidity problem requiring $10 Trillion in new capital in order to fully recapitalize the banking system.  In order to fulfil this, are the Chinese going to raise taxes, print money, or call US Treasury Bonds?  The problem certainly becomes systemic, rather than localized to the Chinese economic experience.   

In all progressively structured tax regimes, such as Canada, arrange their corporate tax rates in order to provide the maximum balance to the needs of the country. It is typically done so in order to trap capital inside companies, take that those retained earnings and encourage them to spend on infrastructure, employees and inventory rather than pay shareholder dividends. This helps grease the wheels of the economy without implementing quantitative easing. If there is no real advantage to re-adjustment of tax rates, then printing more money is in order. China is no different and operates under these guidelines. They have printed trillions of yuan, and incurred significant sovereign debt in order to keep the economy moving. A communist system doesn’t have the ability to react to market demand, and instead keeps the production of irrelevant materials, goods and services. This has helped to inflate Chinese GDP beyond what is sustainable.  

This leaves China with, in my opinion, a few difficult choices to make. Since we already know that money is escaping China, and we know that the intention of currency printing is to stimulate their own economy, will this lead to the Chinese government intervening, closing the door and stopping the exodus of capital into the Canadian real estate market? Will the Chinese government turn a blind eye to this issue and continue to promote loose fiscal policy, continue to increase sovereign debt, and the oversupply of yuan? Or will domestic policy and interventionist measures close the door on the influx of capital? Certainly, the big banks have seen a drift of the assets move more heavily towards Canadian residential real estate, and they have been making some noise about needing interventionist policies to reduce the growth and overexposure to this class of assets. In fact, BNN last week that two bank CEOs and the Organization for Economic Cooperation and Development are calling for further government action to cool the jets on the real estate market. Regardless of any movement in this area, I think the next few weeks will be interesting to observe.

I’m not suggesting I have all the answers for this – I’m going to leave this in minds much more capable than I. But I am going to suggest that until we really understand the gravity of government economic action, nothing significant will change. Until we realize that until government-based spending systems, as influenced by Keynes, have a foundational error in economic logic, we will be doomed to rinse/repeat, rinse/repeat until we reach a point beyond repair.   There are those that believe that point has long since passed, but I remain optimistic and continue to educate my clients on a praxeological approach, and teach them about reclaiming the control of their finances back from the banking system.

So what‘s the deal with the 3 years?

As a result of the impending reform needed to stabilize the Chinese banking system, and subsequently the world markets, a significant challenge is ahead of us. Do we continue to allow national and non-national sovereign debts to escalate as quickly as they have, especially since 2008? Do we allow for the continued hidden rise of inflation coming from the expansion of the money supply? Do we allow for the government-privileged centralized banking system continue to assume more and more economic control over citizens of countries around the world? One staggering statistic offered by Jon Erlichman via Twitter, is that the last 4 years of the Toronto housing market and Toronto stock exchange, which are up 57% and 24% respectively. According to Vancouver Real Estate Board statistics, the price for single detached home in Greater Vancouver is up 64% in the last 5 years. Are we already flirting with the bubble?

I suspect that the next market correction will be significant in both the real estate and stock markets. In the 2008 mortgage crisis, we roared towards that boom as central banks and governments created stimulus in order to revitalize the economy after the tech crash backed up with 9/11 in the early part of the millennium. The flow of credit from these policies resulted in an unsustainable jump in real estate prices, backed up with a shaky derivative position for most investors of mortgage backed securities. Since 2008, governments, in splendid Keynesian fashion, starting the process of unmatched currency creation, spending programs, and diving head first into stacking “temporary” debt measures on top of already burdened budgets. Time and again, we end up in the same place as we did in the previous cycle, with an additional tidal wave of government liabilities. The next time won’t be any different. We will go through the next economic cycle and ultimately end up in the exact same place, but with ever increased government debts.

Originally as I started writing this article, I speculated that a real estate and stock market correction will happen within the next 3 years. However, the more I researched, the more the evidence suggested that it will be a lot sooner than that. Even this morning, the mayor of Vancouver is calling for government action to reign in the real estate markets. In my opinion, the real estate market will do very well on its own to reign in itself, and will experience a moderate to deep correction without any interference on the part of provincial or federal due process.

Whether foreign or domestic government policies shape the headwinds, or whether naturally occurring market trends will prevail, there naturally has to be an ebb and flow to all things which provides balance. Among the other unknowns are the length and severity of the decline, but are incalculable based on the unpredictability of human action.

As with all scientific theories and varied extrapolations, I know that a thesis and an antithesis must exist, and there are a lot of differing views.  But regardless of the perspective, I would encourage everyone to pay attention to cutting expenses, getting real with their budget, get financial mentorship, and save like crazy. The world isn’t going to pieces, but a boy scout is always prepared.

photo credit (Lucidio Studio, Inc. / Getty Images)