I met a guy from Ireland at a pub about four weeks ago here in Buenos Aires. Once we got a few beers into our system, I thought I would pick his brain about what happened is his country. In North America we all know that they got themselves into a bit of a debt crisis, but the how and the way are mostly lacking from media over here.

In short, it was their own fault. Banks were participating in predatory lending, and most people in Ireland were hungry for credit. Many of this guy’s friends had three of four credit cards, fancy cars, and banks were basically giving away mortgages to most people for free. All in all, what he described what essentially the sub-prime mortgage meltdown in the United States, except one that had been in the works for quite a long time.

The thing is, most asset classes and stocks historically grow at a steady rate. When they deviate from that level, you really have to ask why. In the 2000s, Internet stocks started going crazy. We saw P/E ratios of 20, then 50, then 100, and then 200. Insane by all rational measures of a business’ future prospects. And yet everyone on the news and the media said things were different, and these stocks deserved these great valuations. Very few people said it was all make believe.

And then of course, kaboom. The entire bottom fell out of the market, and most of my friends ended up jobless out in Ottawa. I worked for a company at the time that employed nearly 30,000 people world wide, many of them educated engineers. Twelve months later many of them were at the end of their unemployment benefits, looking for any job they could find to simply make ends meet.

Jump ahead to a few years ago, and housing became the next big thing. Take out a massive mortgage, toss it into a house, and wait for that cash cow to start singing falsetto. Now the dream isn’t having a roof over your head, it’s having multiple properties, each with their own granite countertops and stainless steel appliances.

In the US, the sub-prime mortgage crisis was eventually shown for what it truly was, a massive house of cards. And as the cards tumbled, so did much of the housing equity America, along with dreams of early retirement for many couples.

But Canada’s different, right? That’s what we’re led to believe. That somehow we’re different than the Irelands of the world, or the US, or any of the economies before us that have inflated bubbles and then hoped they wouldn’t eventually collapse. Houses in Vancouver and Abbotsford are valued at nearly 10x the average income in each area, and yet realtors and real estate newspapers continue to say that this is the new norm, that we shouldn’t expect housing to drop, and that now is always a great time to buy.

The truth is though that housing has actually never been a great investment. It’s only in the last ten years or so we’ve seen these huge spikes in housing prices. Prior to this last decade, the average return on a house was only slightly more than the inflation rate. That meant you wouldn’t lose money in a house, but it wasn’t really an investment, simply a store of value. And really, that’s all it should be. You don’t look at your clothes or your food as generating a return on your investment, so why does housing have this strange status where everyone wants to make money on it?

So what changed? How did we get to where we are now with these inflated bubbles? Debt happened, that’s what.

The more money people have available to bid on items, the higher the prices usually go. As an example, imagine an auction where the max price of a painting was thought to be around $100. Now imagine someone walking into the auction and giving everyone an extra $1,000 to spend. Do you think that painting would still go for $100? No, people have more money to bid on it, so it’s price will go up, probably to around $1,100. That’s generally how prices respond to increases in the money supply. Print more money – prices go up. Remove money from the system, prices go down.

That is the classical definition of inflation, an increase in the money supply, and why QE1 and QE2 in the states will lead to higher prices. It’s also why education is becoming more unaffordable (easy access to mountains of student loan debt), and why housing costs have completely skyrocketed (5% down, previously 35 year mortgages means it was trivial for most people to buy a house). It’s also why the governments are extremely hesitant to raise interest rates, because all these asset bubbles are only staying inflated due to cheap credit, and low interest rates are fueling that. But pretty soon inflation is going to rage out of control, and the only knob that will be left to turn to try and tame it will be interest rates. And they’re going to go up, way up most likely.

When that happens, the shit is going to hit the fan. Housing prices generally inversely track the interest rate – as interest rates rise, housing prices drop. It’s the same as bonds – if the yield goes up the bond price goes down and vice versa. Housing prices will drop, but the original debt that purchased it will still be alive and well. Unlike the US, Canadians generally can’t walk away from a bad mortgage which means that burden will stay with each individual for potentially a long time. Maybe it won’t happen overnight with housing, but as mortgages come up for renewal people will only be able to afford housings that are cheaper in value. So the housing market will slowly deflate. What happens to all the equity? It will disappear. It wasn’t real in the first place, simply air in an inflated bubble.

Interest rates should have one purpose – to encourage people to save, and to ultimately invest. What we have now is known as a fractional reserve system, where a bank can loan out a multiplier of the money it has on hand. So if the multiplier is 10x, then a bank only needs to have $10 in the bank in order to lend out $100. If a bank wanted to lend more money out, it would typically have to raise interest rates to encourage more people to leave their money in the bank. Once they bank accumulated more money, it could lend out more. In the absence of a fractional reserve system, the only way a bank could lend out money was to have the interest rates set such that enough money was on hand to lend out.

Unfortunately interest rates are more of a political tool now than an economic one (although clearly the misuse of interest rates has a severely detrimental affect on the ecomony). While the Federal Reserve is supposed to be independent in the US, it’s a lot easier to get re-elected when the economy is booming. And one way to encourage people to spend and for the economy to “grow” (consumption contributes to the GDP, but it’s short lived – once the spending is removed the GDP drops by the original amount) is to give everyone cheap credit. Max out the credit cards, go get another loan, we don’t care – just keep spending.

Things in Canada still aren’t that bad. Yes, the housing market is a bubble, and it’ll most likely deflate at some point. But our economy is generally based on natural resources, and those continue to do well. But I don’t believe it’s any different here, nor do I think we will be spared the same fate as Ireland or the US if we’re not careful. Changing the maximum mortgage amortization from 35 years down to 30 was a good first step, and raising interest rates slowly is another good way to unwind the bubble. But it’s a delicate line to walk. Raise rates too quick, and people will be forced out of their homes. Raise them too slow and the bubble continues to inflate.

So we’ll see what happens. Things down south are looking very scary right now. I bought some silver back in Canada in December for $29 an ounce. Today silver in Vancouver was selling for nearly $40 an ounce. So, about a 33% increase in price in just four months. Precious metal pricing usually inversely tracks faith in the currency markets. So the rapid and dramatic price increases could be a sign of a severe currency crisis about to hit the United States. My friend Duncan sent me a message on my phone earlier today alluding to the fact he thought the US dollar could collapse this year. It’s definitely possible.

Most people agree if and when it happens it will be sudden and catastrophic. China could start selling US treasuries, a few big countries could abandon the dollar for trades, or the US could lose its reserve currency status. Any one of those could start a run on the dollar that would decimate it. Unless the US cleans up its balance sheet, it’s a foregone conclusion at this point. The only question left to answer is when.

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