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Sooner or later, our economy will have to 'reset' Add to ...

George Athanassakos is a professor of finance and holds the Ben Graham Chair in Value Investing at the Richard Ivey School of Business, University of Western Ontario 

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Do you know what keeps me awake at night? It is the fact that the Canadian economy did not "reset" during the 2008-09 recession.

Recessions occur because economic or financial activities get out of touch with fundamentals. Inflation, wages, inventories, business investment or stock prices get out of touch with the underlying fundamentals of demand and supply, and a recession results that is supposed to correct the imbalances.

Market participants delude themselves if they think that economic and financial events are "different this time," believing that the relationship of these events to fundamentals has been altered either by technology, financial innovation, government intervention or the rise of emerging economies and so on. They are actually never different.

Markets and the economy gyrate from one extreme position to the next, driven by the cycle of overoptimism and overpessimism to which consumers, investors, corporate managers and other market participants are susceptible. Asset prices and the economy always revert to intrinsic value - a value that is driven by fundamentals.

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A recession is supposed to reset economic and financial activities, make them consistent with fundamentals and bring them to a level from which recovery starts all over again. This has always been the case - but not this time.

The massive stimulus that the Canadian federal and provincial governments have injected into the economy may have prevented the economy from resetting. And we may have overspent to make that happen.

Toronto-Dominion Bank recently reported that Canada ranked first among G7 countries in the amount of fiscal stimulus as a percentage of gross domestic product flowing in 2009 and 2010. Could a large part of the stimulus package been unnecessary?

Even with all the fiscal and monetary stimulus, the "resetting" of the Canadian economy may have merely been delayed for a few more years. The stimulus package has made the Canadian government run a bulging budget deficit, which may prevent the government from coming to the rescue of the economy if serious problems arise in the future, when the stimulus runs out.

A recent report by economists Carmen Reinhart from the University of Maryland and Kenneth Rogoff from Harvard University clearly demonstrated that the only way governments can prevent economic meltdowns is by running budget surpluses. Canada is far from budget surpluses for years to come.

If Canada's 2008-09 recession was triggered because the economy and financial markets were out of touch with fundamentals, then the economy is back to where it started, as many economic statistics have fully recovered to 2007-08 levels. During the last two serious recessions in Canada, the economy reached prerecession levels within a year or year and a half from the end of the recession. This time, the recovery has almost taken place instantaneously.

Overconfidence among consumers and business is rampant, as gains in Canadian home sales and prices are boosting sentiment across Canada and pointing to ever-higher levels of spending. Consumers are taking advantage of record-low lending rates with little consideration to the long-term carrying costs, and pushing Canadian house sales and prices to record highs.

The volume of retail trade in Canada is back where it was in October, 2008. Consumer spending and auto sales are driving gains in GDP. Luxury car sales are booming to levels that have dealers running out of stock.

Even in the midst of the "great recession," some of the cultural signs of a reset were not present. Long strikes took place in many Canadian cities, not something you see when people are truly worried about losing their jobs.

At the same time, on a global level, goods inflation is running at the fastest pace in 16 years; banks have become bigger than ever - the 10 biggest banks in the world control 70 per cent of bank assets, up from 59 per cent three years ago; and credit and other exotic derivatives are back in fashion and as opaque and unregulated as ever.

Canadians entered the 2008-09 recession with extremely low savings rates and record levels of household debt. About 60 per cent of Canadian households were in a net debt position at the outset of the recession, according to a report by the Canadian Centre for Policy Alternatives.

Since then, the debt-to-income ratio in Canada has hit an all-time high as Canadians are borrowing and piling up a record amount of mortgage debt. This leaves them more vulnerable to additional economic shocks with government unable to help, owing to excessive budget deficits.

Clearly, there has been no "resetting" of the Canadian economy. It may have been simply delayed for a few more years. And this is what keeps me up at nights.

 

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