As good Canadians, we have all been taught to believe that the Canadian and American economies were “tied together at the hip”. If America does well, Canada will do well. If their economy picks up, ours will be pulled along for the ride. So now that we hear that the “good old USA” is doing better, Canadians should be happy, right? Absolutely not! In fact, the newly accelerating American economy almost surely kill the Canadian economy. ….and it will start with our housing market!

I recently had a chance to interview Mike Verge, author of the recent book, “Global Deflation, and the Next Great American Decade to Come.” (Check it out on Amazon!) He says that today, all the economies of the world are inextricably linked. What happens on one side of the world will drastically affect the other. To understand what is happening locally, you must understand what is happening globally. In his book, he develops some highly intuitive models that help make global economics easy to understand. He calls these models Economic Sunglasses. “Put them on and everything will become clear”.

In our fascinating interview, Verge talked about how the world has recently come through a decade of deflation that started in 2008 in the United States.  Most countries followed the U.S. into their own local deflation cycle, but at different speeds. Now the U.S. is about to be the first country to exit this deflationary period and enter a decade of growth and inflation. (Hence the book title   “…..And the Great American Decade to Come.”)  However, this time the surge in the U.S. economy may not be good for Canadians.  

To fully grasp what is about to happen next, you must first open your mind to some of Verge’s  “counter-intuitive” concepts. Firstly, to keep track of this global economy, he says we must all use the same global score card, the U.S. dollar. We must all look at each of our local economies only in terms of U.S. dollars and act as if all financial decisions must be made as if you were a global observer sitting in New York. The second key concept is that deflation is not the enemy. We need to embrace it and understand it to fully grasp what is going on. Each country is in their own business cycle. In Canada, we are about to enter our own deflationary period. Surprisingly, he says, the culprit for our next deflationary period will be our great Canadian banks, not because of what they are doing now, but because of what they did a decade ago!

The Simultaneous “Inflation-Deflation Paradox”

He explains our current situation by saying that in 2007, the U.S. banks were providing high-risk mortgages, including ‘sub-prime mortgages” as fast as they could process them. Then they bundled these mortgages into new financial products and sold them to outside investors so that they could get them off their books and be free to sell even more high-risk mortgages. Canadian banks did not pursue these risky avenues and stayed in more secure investments. So when the housing crisis hit in the U.S., Canadian investors were somewhat protected.  But as we would find out eventually, while we were protected from the disease, we were not protected from the cure. The cure began when the U.S. Federal Reserve tried to revive the faltering U.S. economy by lowering interest rates to effectively zero. Since so many people had lost their jobs in the U.S., these initiatives were very appropriate for the U.S. market.

However, in Canada, the actions of the U.S. Fed led to completely unintended consequences. Since the Canadian banks had not followed their U.S. counterparts into the sub-prime abyss, there was no great loss of jobs and our employment rate remained relatively strong. In spite of this, however, the Bank of Canada did follow the lead of the U.S. Fed and dropped interest rates to almost zero. And what happens when you drop interest rates to zero in a fully employed and healthy economy? House prices take off! So, in effect, by not following the U.S. banks into the mortgage debacle, but still deciding to lower interest rates, Canadian banks, in conjunction with the Bank of Canada, began the process of blowing up the biggest housing bubble in Canadian history. Simultaneously, and counterintuitively, deflation in the U.S. had created a housing bubble in Canada!

A Fizzle or a Pop?

The problem that Canadians now have is that our housing market is now priced for perfection! House prices now reflect the volatile (and artificial) economic combination of high employment generated locally, with low interest rates imported from the U.S. This has put us in a very precarious situation. What happens if a part of this perfect combination changes?

 If the U.S. economy starts to expand under Donald Trump this will send U.S. interest rates higher. The Bank of Canada will then have two choices, neither one of them very appealing. Firstly, they can keep the Canadian interest rates low and watch the Canadian dollar drop in value or secondly, they can raise Canadian interest rates and watch the housing market tumble. Either way we reach the same outcome. To an observer in New York, Canadian housing prices would either go down slowly along with the depreciation of the Canadian dollar (a fizzle), or they would implode quickly if Canadian interest rates spiked in line with U.S. interest rates (a pop). To an observer in New York, either way, Canadian  housing prices are going down. Either way, this will have a huge deflationary impact on Canada.

Alternative Facts?

In his book, Verge explains how there is a whole industry of economists, planners and even business schools, designed to explain only inflation. No one likes to talk about deflation. But he says that in order to truly understand economics, you must first embrace the concept of deflation and understand it’s role in the global economy. Inflation and deflation are neither good or bad, they are different aspects of the same phenomenon, (like freezing and thawing). Only by embracing them both will you fully be able to see what is coming next.

Now, Verge says, as the U.S economy gathers steam under Donald Trump, Canadians should be preparing themselves for a new slowdown, “The Great Canadian Housing Market Slowdown”. So when you hear Canadian politicians forecast great things for Canada because the U.S. economy is taking off, Verge says don’t believe it .… It is just “Canadian Fake News”.