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27 Jul

Why consumers are unprepared for the next financial crisis

General

Posted by: Steven Brouwer

Bank of Canada governor Mark Carney has been warning about the high level of consumer debt in Canada since 2011, and this advice has been largely ignored.

Canadian consumers’ debt levels today are by any measure higher than they have ever been. The irony is that we are on the cusp of the second phase of the financial crisis that began in 2008 and, this time, Canadians are more vulnerable than Americans or even the Europeans.

We knew the cause of this financial crisis when it arrived in 2008. The previous 20 years, consumers in the Western world had embarked on a spending binge financed by debt.

Consumers piled on unprecedented levels of debt to purchase their homes, investment properties, cars and anything else the banks and credit card companies would finance. Economic reality arrived in 2008, initially in the U.S., and the rest is history.

We do not need to be financial experts to understand that if we keep eating tomorrow’s lunch today, then when tomorrow arrives, there is no lunch. Consumers faced that moment in 2008. The world’s financial system almost went off the cliff. We know how we pulled back from the brink: The U.S. and other economies bailed out the banks and stimulated their economies with trillions of dollars of freshly created debt.

Of course, we never really solve a debt problem by creating more debt, although this is a good Band-Aid that kicks the can down the road. However, now, as we see in Europe (and soon in the U.S.), the governments have too much debt and are finding it difficult to borrow more without paying very high interest rates.

The question that needs to be asked is, who bails out the governments? After 19 economic summits in two years, Europe is still trying to figure this out.

‘It was debt that caused the crisis to begin with and, in Canada, we are happy to ignore the lessons’

And what of the Canadian consumer — what has he been doing while the euro Titanic struggles to stay afloat? China’s response during the economic crisis was to undertake a huge spending binge, building new cities, malls, office towers and condos. This lifted the commodity prices that had crashed and cushioned Canada’s downturn.

We should remember that oil prices had sunk to $40, and the other resources responded in a similar fashion. In a way, this has given Canadians a false sense of security. While house prices have been crashing in the U.S. and Europe, Canadians have gone on a borrowing binge, bidding up house prices to frothy levels completely oblivious of the reality.

Canadians look at the news that emerges daily from places such as Greece, Portugal and Spain as if these events are taking place in a far distant galaxy. Huge austerity measures and 25% unemployment rates in some of these countries have done little to temper the Canadian consumer’s appetite for debt.

It was debt that caused the crisis to begin with and, in Canada, we are happy to ignore the lessons. That is, of course, until the same movie arrives in Canada.

Canadian consumers should be aware that “GREECE R US” will probably arrive by 2014. This is not a prophecy, just economics.

Europe represents almost 25% of the world’s trade, and Europe is in a recession that is getting worse by the day. The U.K. is also in a recession, while the powerhouse economies of China, Brazil and India are decelerating so fast that we can see the skid marks.

Finally, look at the U.S. economy. We see it muddling through with the risks of a recession rising by the day. The International Monetary Fund has once again reduced its growth forecasts and issued the following statement: “Growth in most major economies has showed signs of slowing in recent months, partly due to Europe’s chronic debt crisis and economic malaise.”

This is stating the obvious. So what we have taking place right in front of our eyes is a synchronized global economic slowdown.

The fact this is happening at a time when interest rates are almost at zero in the U.S. and Europe, and that the Western governments are already burdened with too much debt, which limits what they can do, should be a warning sign to everyone, especially the Canadian consumer.

‘Canadians will be going into a very slow economic period, and maybe even a global recession, with unsustainable debt levels’

Here it is in plain English: Every economy we trade with is slowing down, and this will impact us more than most. Why? Because Canadians will be going into a very slow economic period, and maybe even a global recession, with unsustainable debt levels.

The high debt levels will have a magnified effect as unemployment increases during the slowdown, and house prices start to drop from their overinflated valuations.

Our federal government obviously doesn’t get it. In fact, besides tinkering with the mortgage amortization, it has done little to prepare Canadians. So Canadians would be wise to take proactive steps to anticipate and prepare for a crisis that is heading to Canada.

The best thing Canadians can do is go back to the basics of prudence and financial management. Recessions come and go; it is the weak hands that get into trouble.

Here is a checklist:

– Build up a safety nest of at least six month’s expenses.

– Don’t live within your means, live below your means. The bigger the margin, the more you save.

– Get rid of debt. If you have investment properties, consider selling them as soon as possible, as this winter may be too late.

– If you have a mortgage on your home with a floating rate, consider locking in the rate for between three to five years. Similarly, with lines of credit that you cannot pay off. Interest rates may jump without warning.

– Pay off your higher interest rate debt, such as credit cards, first.

– Look for a secondary source of income to increase your safety net, such as a part-time job or by renting out an eligible basement.

– Expect a lot of volatility in the stock markets. If you have money invested in the markets that you may need soon, you shouldn’t be in the market.

– We are entering an age of frugality, so be frugal, but not cheap.

– It would be wise to put off big-ticket purchases and make do with what you have.

– If you are considering selling your home to buy another, make sure yours is sold first or you risk being stuck with two homes and extra debt in an uncertain economy.

– Think twice about quitting your job.

– Reconsider whether you need all the cars you have. Each car has hidden costs.