Is Canada’s hot residential market hiding a productivity crisis?

C.D Howe Institute experts warn Canadians 'may be getting too much of a good thing' from policies fixated on housing

Is Canada’s hot residential market hiding a productivity crisis?

While being house-rich and cash-poor else has created challenges for countless Canadian retirees, policy experts from the C.D. Howe Institute are warning that a similar problem is threatening the future of Canada’s economy.

In an open letter to business leaders across Canada who are concerned about investment, Jeremy Kronick and William Robson pointed out that the country's economy crossed an unusual milestone in the fall of 2020: residential investment outpaced non-residential constructions, machinery and equipment, and intellectual property items combined.

“As a nation, we risk ending up with nice roofs over our heads, but without the incomes we need for everything else we want,” they said. “House-rich, and everything-else-poor.”

They said that until the early 1990s recession, non-residential investment was generally above 10% of GDP. It averaged roughly 10% of GDP after that, until the mid-2010s, when it fell. In contrast, residential investment varied around 5% of GDP until the 2000s, and it has been generally increasing since then.

After the 2014 decline in non-residential investment and the rise in residential investment after 2019, Kronick said Canadians started spending more on new houses, renovations, and real-estate transactions than on everything businesses equip their employees with so they can compete internationally and, not coincidentally, earn higher wages and benefits.

While Canadians might take some solace in the fact that many investment goods are becoming more affordable – for example, modern computers provide significantly more bang for the buck than those of the 1990s – that is true all over the world. The fact that business investment is more robust in other countries, notably in the U.S., means Canada risks becoming less competitive by the year.

Because firms pay the majority of their capital expenditures with internal money, Ambler and Kronick noted, the total dollar amount of outstanding residential mortgages has always outpaced that of existing company loans. But the amount of household mortgages exceeded corporate loans by only about 50% in the early 1990s; by the early 2000s, they were twice as big, and a decade ago they were 3.5 times as large. While they've dropped a little since then, household mortgages are still 2.5 times the entire amount of outstanding company loans.

“We have nothing against housing,” the two said, recognizing the role that construction, renovation, and transactions in the housing market during the pandemic played in supporting the economy. “But other investment also matters. Without buildings, machinery, IP products and other tools, we cannot earn the incomes to buy what we need, including the public services we fund with our taxes, not to mention maintain those roofs.”

One reason for rising inflation, they said, is that the economy's productive capacity has not kept up with surging demand fueled by low interest rates and other factors. While there are many options to encourage more non-residential investment, they said the spread between the interest rate applied in small- and mid-sized business loans and the rate charged to large businesses in Canada – which is higher than almost anywhere else in the OECD, they said – is a good starting point.

“This stunts access to credit by the smaller businesses that employ the vast majority of Canadians,” they said, arguing that the unusually big spread could be attributed to government policies that divert credit toward housing.

The government’s current well-intentioned approach to backstopping mortgages, they argued, helps mitigate or prevent financial crises, but at the cost of making mortgage lending less risky than business lending across the board. To reduce the bias, they recommended charging premiums for mortgage insurance that better reflect risk.

“Housing is good, but by going all-in Canadians may be getting too much of a good thing,” they said. “To boost our productivity and generate the incomes we need for fast growth without inflation we also need non-residential investment.”