Separated, but living in the same house

Oh, I do love a good theory. Especially when it’s clearly spelled out in a way that makes it easy to poke holes in. So thanks to BMO Nesbitt Burns’ Doug Porter for his irresistible musings on decoupling:

Despite the tight linkages, there are four reasons to believe domestic growth will fare better than the U.S. economy in 2008: 1) significant tax cuts are arriving in January, 2) housing is still holding up very well nationally, 3) strong commodity prices are supporting corporate earnings and personal incomes, and 4) credit conditions are much less restrictive in Canada than for U.S. borrowers.

All true, to be sure. But likely to hold true through 2008?

1) Tax cuts. As we all know, the cut in personal taxes is no cut at all but a restoration of the 2005 rates; the additional cut in GST, simply an irritation for retailers who must reprogram cash registers. The cut in business taxes, which TD Economics called “the boldest move” in the Fiscal and Econonic Update, are “back-end loaded”, with the most powerful effects coming in 3-5 years. The corporate income tax rate, for example, is going from 22.1% to 15%, but in 2008 will be 21%. Is this the kind of “significant tax cut” that will inspire, at last, overdue corporate investment? Riiiighht.

2) The fact that housing is the second item at the list should ring alarm bells for readers who will know the housing bubble is deflating not only in the US, but around the world. Is it mere coincidence that Canadian housing prices rose more quickly than inflation during the very time the asset bubble grew in Europe in the US? Really?

3) Commodity prices come, commodity prices go. Commodity prices are not determined solely by the demand of the US consumer for goods, but that plays a big part (see post below). How economists and analysts can continually point to rising commodity prices without examining where the end demand is coming from is one of life’s eternal mysteries.

4) Ah yes, credit conditions. A month ago I mentioned that Canadian banks were paying more to borrow money but not passing it along to the consumer. Now, as it turns out, they are:

…all of the major banks have quietly moved to cut the discount they provide on mortgages because their profits have dwindled as their borrowing costs have gone up. Canadians now negotiating a variable rate mortgage can get .60 percentage points off of prime. Less than a month ago they were getting .90 percentage points off.

And if that doesn’t sound like much of a change, and you think a cut in interest rates is on its way anyway, keep this in mind — mortgage rates move with bond yields rather than the Bank of Canada overnight rate, and:

The spread between mortgage and five-year government bond yields now stands at 316 basis points, up from 260 in July and “ominously” the widest spread since July, 1990,[Merrill Lynch economist David Wolf said.]

All things being equal, that could be expected to affect consumer behaviour at some point. Some point, perhaps, in 2008.

But, in any case, BMO’s Porter gives himself an out anyway:

Of course, the great equalizer is the lofty loonie, which will keep overall Canadian growth close to U.S. trends.

So, let me try to recap. If Canada existed in a vacuum, but was still able to sell goods to the rest of the world, US consumer demand had no effect on demand for commodities worldwide, and our currency was fixed to… something, domestic growth would be just dandy in 2008. Got it?