Andrew Hepburn is a business commentator living in Toronto.

If adulation comes before a fall, the Canadian economy is in serious trouble.
Both at home and abroad, people are in love with Canada as an investment destination.
Yet largely ignored amidst the hoopla are clear and growing threats to the country’s economic well-being.
The common theme of these dangers is overvaluation: pricey real estate, inflated commodities and a currency too strong for the nation’s manufacturing exporters.
The most obvious issue facing the Canadian economy is its housing bubble.
Using data from the Canadian Real Estate Association, Alexandre Pestov of Three Bears Research estimated in September 2010 that average nominal national house prices increased 121% in the prior decade.
By his calculations, this equated to 76% in inflation-adjusted terms. And of course Canadian house prices have continued to rise since Pestov’s research was published.
Granted, talk about a Canadian housing bubble is everywhere. But what should be on everyone’s mind are the consequences of its inevitable bursting. The real danger exists because the bubble has been financed with credit, leaving Canadian households in record levels of debt. According to data from Statistics Canada, personal mortgage debt at the end of 2010 totaled $956 billion, more than double the level of 2000.
Financial bubbles without debt are bad (think internet stocks), but they are minor compared to those financed with credit. This was a key implication of economist Irving Fisher’s work, whose famous 1933 paper explained the toxic combination of debt and deflation. Indeed, the major economic downturns of the last hundred years, the Great Depression, the Japanese malaise, and the recent Great Recession, were all rooted in excessive private sector debt.
Because asset bubbles ultimately crash but debts don’t magically disappear, a collapsing bubble makes the debt more onerous. Bank of Canada Governor Mark Carney alluded to this predicament in recent testimony to the Senate when he reminded Canadians that, “while asset prices can rise and fall, debt endures.”
In the housing context, people can end up owning homes worth less than their mortgage. Selling the asset to raise funds simply causes everyone else’s property to decline further in value.
The risks to the Canadian economy are not confined to real estate. Many of the investors bullish on the country and its currency justify their optimism on the grounds that commodity prices will continue to increase due to growth in developing economies. This is wishful thinking.
The real impetus behind the raw material spikes of recent years is not developing world demand, but rather a previously unimaginable degree of speculation in commodity markets. This was plain to see when oil plummeted from $147 a barrel in July 2008 to just over $30 in early 2009 as speculators unloaded their futures positions.
Like housing, the commodity bubble has received attention. Once again, though, the depth of the problem isn’t often recognized.
Pre-financial crisis, speculation in commodities overwhelmingly occurred via derivatives. What may not be widely understood, though, is that in addition to a few exchange traded commodity funds, some speculators also took physical delivery of raw materials. This activity has increased post-financial crisis, perhaps due to pending U.S. regulations to limit bets in futures markets.
To use one striking example, according to a report from the Federal Reserve, JP Morgan Chase owned physical commodities as of June 31, 2011 worth just over $21 billion. To this we can add the holdings of other investment banks, commodity merchants, ETFs and hedge funds. It is not difficult to see how financial players have distorted what are primarily intended to be markets for consumption, not investment.
The final major issue facing Canada is its currency’s strength. With oil until recently above $100 and metal and grain prices very high as well, you would think that a major commodity exporter like Canada would be running significant trade surpluses. You would be mistaken. Despite historically high commodity prices, trade surpluses have morphed into deficits.
Forget its French and English heritage; Canada would seem to suffer from a serious case of “Dutch Disease”, an economic affliction whereby an appreciating currency prices a commodity country out of other export markets. The gains of Bay Street and the oil sands thus parallel the decline of export-oriented manufacturers across the country.
Nothing could have made this more evident than a Bloomberg article from December 2010, which reported that factories now employ only 10% of the Canadian workforce, the lowest level since 1976. In addition, the story noted that Canada’s exports to the U.S. as a percentage of total exports account for their smallest share since 1982. Canada’s trade surplus with its southern neighbour has plunged from $11.7 billion in October 2005 to $3.6 billion this June. This can’t be blamed solely on China, because as TD Economics pointed out in April, “Canada has fared worse than most other countries from the changing composition of the U.S. trade deficit”. This suggests our dollar also bears responsibility.
In the aftermath of the financial crisis a peculiar Canadian hubris has emerged. Its neighbour chastened, once humble Canada is seen as a rock in a turbulent economic world. The Conservatives boasted during the election campaign of the nation’s economic prowess in television commercials, and foreigners take good notes about steady, fiscally responsible (allegedly) Canada. To top it off, Toronto Councillor Doug Ford recently presented Jim Flaherty with a mock “World Finance Minister Championship” belt. If there ever was bad economic karma, this was it.
It may be tempting to believe that Canada is, in the words of more than one economist, “a bastion of stability”. But a realistic look at the Canadian economy suggests a castle at least partly built on sand, and of course financed with debt. Unless house and commodity prices continue to defy gravity, Canada’s current good fortunes will likely come to a very painful end.
Unfortunately, there is little stock market diversification to save the day: as of September 1, the energy, materials and financial sectors accounted for a staggering 78.83% of the S&P TSX Composite Index.