Life in Canada

Overview
High levels of government’s debt is universally regarded as a bad thing for various reasons including the potential loss of sovereignty if the debt is held by other governments and the crowding out effect on private enterprise. But what is its direct impact on the average household?

UPDATE
For the Official view on Canadian Family debt
( see this report Feb 16th 2010 )

http://ca.news.finance.yahoo.com/s/16022010/2/biz-finance-average-canadian-family-debt-reaches-96-100-2009.html

The direct effect is obvious. Large government debts are financed by one of two ways: increased taxes used to service or pay down debt or reduced services so that current government revenue can be redirected towards the same goal. There are also certain indirect effects.

In a Federal Reserve study of 2003, Thomas Laubach found that every 1% increase in projected debt to GDP ratio is estimated to raise long term interest rates by 25 basis points (1 basis point = 1/100 of 1% or 100 basis points equals 1%); a 2009 update of this study was issued but it is not free to access at this point.

The Congressional Budget Office, a non-partisan arm of the U.S. government, states that the debt to GDP was 53% in 2009 and is estimated to increase to 67% by the end of 2010 . With a borrower in that much debt, there will be pressure to raise interest rates to make investing in U.S. debt more attractive; politics can only with-stand reality for so long. The eventual raising of interest rates will force other governments which compete with the U.S. on the debt market (see Canada) to also raise rates.

The implications are quite clear. Interest rates will have to go up which means several realities going forward:

* The whole “should I lock in my variable rate mortgage” debate may be convincingly answered in the affirmative if rates begin to escalate significantly.
* The mini housing boom in Canada may soon end since it relied in large part on cheap credit which begs the question whether households can afford the increased carrying costs of a mortgage (assuming it is a variable rate mortgage) and shallow the reality that newly purchased home may fall in price.
* High interest rates tends to slow down recoveries (see below).

Here’s an interesting thought. If yields on government debt begin to rise and the investors’ appetite for risk remains cautious going forward, will dividend yielding stocks have to increase dividends in order to attract investors (a situation not without precedent)?

PIMCO, the well-respected investment management firm (and my favorite source of investing information without frills or hysteria), has already predicted that it will take 5 years to see a recovery that produces jobs given the effects of heavy governmental debt and increasing interest rates. Again, this is not without precedent. The 2010’s may indeed look a lot like the 1990’s in Canada: a brutal recession followed by staggeringly large government debt and associated high interest rates leading to a jobless economic recovery. In fact, as I posted before, it took approximately 10 years for Canada’s unemployment rate to fall back to pre 1991 recession levels.

There has been a lot of ink split lately about how most retail investors missed the rally of 2009 and whether there’s any legs left for further growth. Although important, the stock market rally of 2009 shifted the focus away from households deleveraging themselves (not to mention advertisers do not want to advertise in publications advising readers to spend less as part of deleveraging ).

When interest rates increase (and the question is now focused only on when and not if), there may be a refocus on this issue. Regardless of the economic environment, it is important to ensure all households control their expenses (even if the same can’t be said for our governments).