Good or Bad Boom

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The aging boom in real estate has been fabulous for sellers unloading risky and depreciating assets. A recent study of "good and bad booms" (abstract below) suggests that as productivity declines over an aging boom, the risk of insufficient collateral becomes evident. The U.S. productivity chart has momentum relative to Canada's.

Abstract: ​Good Booms, Bad Booms
​​by Gary Gorton and Guillermo Ordoñez, February 2016
NBER Working Paper No. 22008 

Credit booms are not rare and usually precede financial crises. However, some end in a crisis (bad booms) while others do not (good booms). We document that credit booms start with an increase in productivity, which subsequently falls much faster during bad booms.

We develop a model in which crises happen when credit markets change to an information regime with careful examination of collateral.

As this examination is more valuable when collateral backs projects with low productivity, crises become more likely during booms that display large productivity declines. As productivity decays over a boom as an endogenous result of more economic activity, a crisis may be the result of an exhausted boom and not necessarily of a negative productivity shock. We test the main predictions of the model and identify the component of productivity behind crises.

Canada has a population total similar to California's and yet California's GDP is +/- 1.3 times that of all of Canada's (Wikipedia). Canadians don't produce as much stuff as Californians do and with the energy and resource sectors deflating, I suspect Canada's "information regime" is going to change abruptly if it has not not already. Loans officers are going to be actually looking at the collateral underlying the loan instead of green lighting every manic bid this rising market proposes.

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HAT TIP to Jason Kirby, Macleans.ca for his "The most important charts for the Canadian economy in 2016" and the following two charts that underscore the risks of the "bad boom".

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​Canada needs stronger business investment
Glen Hodgson, Conference Board of Canada
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“2015 was another mediocre year for the Canadian economy, growing by only 1 per cent in 2015 after a technical recession in the first half of the year. The weakest aspect of Canada’s economy this year was the feeble performance of private investment, projected by the Conference Board of Canada to contract by nearly 8 per cent compared to 2014 levels. Much of this contraction is due to the sharp pullback in investment in the oil patch, now expected to decline by 40 per cent over the course of the year. That result for 2015 is depressing enough—but as the chart shows, Canada’s poor private investment performance in 2015 was not a one-time thing.
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There’s more to this story than just low oil prices as Canadian firms continue to sit on mountains of cash embedded in their balance sheets. As a result, it is no surprise that we are in the midst of a multi-year period where growth in private investment is weak—the lagging edge of our economy—with little sign of a significant turnaround in 2016. A prolonged period of little or no real growth in private investment is bad news for productivity growth, since it suggests we are missing opportunities to invest in new technology, build our productive base and boost the competitiveness of the Canadian economy. What could prompt stronger investment growth? The growing U.S. recovery should boost demand for Canadian exports and eventually cause firms to invest in order to expand their productive capacity and seize the available export opportunities. But until there is evidence that Canadian firms are responding to a stronger order book, private investment will remain the lagging edge of our economy.”

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​Global GDP is slumping
Bob Hoye, Institutional Advisors
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“The graph of global nominal GDP runs from 1981 to date and covers another “new era” of financial manias. Our era has been fabulous as reckless adventurers have dominated financial markets as well as central banks. As with previous examples, the action has been mainly in financial assets with real estate prices soaring in the financial centres. Although the experiment in ambitious policy has seemed without limit, there was a severe setback in 2009.

​The alert to the “Great Recession” was classic. Credit spreads reversed to widening in June 2007 and commodities reversed to weakening in June 2008. The rest as the saying went, was history. At -5 per cent, the current slump in global GDP is almost as severe as the one in 2009. This was preceded by the reversal in credit spreads and weakening commodities that began in June 2014. Central bankers have been charged with preventing contractions. This diminishes perceptions of risk and accounts get leveraged. Throughout history margin clerks have always trumped central bankers. This time around, central banks are highly leveraged.”
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Bob Dylan - Things Have Changed