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October 26, 2018

Canada is Ripe for an Excruciating Deleveraging Cycle

Credit growth in Canada is growing at the slowest pace in 35 years (see chart below).

Sounds great on paper. With an average debt-to-income ratio of about 170%, the average Canadian is up to their eyeballs in debt. The last thing they need is more.

So slowing credit growth should be good for the economy, right?



Unfortunately, a deleveraging cycle is painful as fuck. Look what happened to the US during their latest deleveraging cycle that caused the Great Recession (chart below). Without massive intervention, that deleveraging cycle would have easily looked like the Great Depression of the 1930s.

Although the US economy is probably stronger coming out the other end of their latest deleveraging cycle, the process was excruciating because it triggered a negative feedback loop that was very difficult to break.

Essentially, in a debt deleveraging cycle credit conditions tighten and over-indebted people and businesses borrow less. Less borrowing means less capital investment and consumption. Economic activity and asset prices weaken, causing profits to drop. Declining asset prices can lead to forced selling and further debt liquidation, and businesses and individuals begin hoarding cash creating a liquidity trap. While this is happening, rising bankruptcies and unemployment lead to even weaker economic activity and faster deleveraging. And the cycle continues...that is, until massive intervention is made to support asset prices, guarantee debts and/or spark inflation.

Canadians are deeply indebted so the conditions certainly are ripe for a protracted debt deleveraging cycle. When will this happen? Who knows.

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