Worthwhile Canadian Initiative

The Liberals' carbon tax proposal

Stéphane Dion and the Liberals are floating the idea of a carbon tax:

Liberals say carbon tax will be revenue-neutral: [I]nternal policy discussions are still underway and a number of proposals are under consideration. One proposal under study would replace the federal fuel excise tax - which applies to gasoline and diesel used for vehicles - with a more broadly based "environmental tax" to include other fuels such as natural gas, heating oil and coal-generated electricity.

That plan, proposed by economist Jack Mintz and Nancy Olewiler of the Sustainable Prosperity Institute, would leave the existing excise tax of 10 cents per litre of gasoline and four cents per litre of diesel unchanged. The authors estimate that applying the excise tax to other fuels would increase tax revenue by between $12 billion and $15 billion annually. The revenue could be used to substantially lower personal and business taxes and to fund tax credits related to climate change technologies.

If the Liberals follow through on this, they will have the distinction of being the only major party that has a sensible position on reducing greenhouse gas emissions: the Conservatives are unable to distinguish between smart and stupid taxes, and the NDP is busy pandering to those who think that gasoline prices are already too high (h/t to Paul Wells).

But I don't see why they have to make such a big deal about it being revenue-neutral. $12b-15b is a significant chunk of change - roughly the equivalent of the two GST percentage points that the Conservatives frittered away to no apparent purpose. A carbon tax will be regressive, so a good portion of those revenues should be used to compensate lower-income households. The Liberals seem to understand this point:

[Liberal finance critic John] McCallum said the Liberals are working out a plan where tax credits or some other mechanism will be necessary to ensure pensioners and other Canadians with fixed incomes, low wages or who are otherwise in zero or low tax brackets must also receive compensation.

"You may be sure that we would be acutely aware of people who have lower incomes or more difficult times and you could be certain we will do everything to look after those people," McCallum said. "Some of the lower-income people don't pay tax, so that would be a feature of any such program if we were to have one."

I don't know how it happened, but the Liberal Party of Canada has found a way to be relevant again.

Canada's income redistribution strategy: take from the rich, give to the median

There have been any number of MSM stories based on StatsCan's recent release on earnings and income. Median earnings from market income for individuals in 2005 are pretty much the same as they were back in 1980, and market income inequality has - by any measure - increased over the past 25 years.

This isn't really news - at least, not in the sense of 'revealing previously unknown facts'. Here are plots of average and median market income for unattached individuals and for for economic families of two or more people; the data are taken from Statistics Canada's Cansim Tables 202-0202 and 202-0203:

Although median market income in 2005 was the same as it was in 1980, it hasn't remained constant: the recessions of 1983 and especially 1991 reduced real median incomes considerably, and it's taken ten years to recover. And the widening gap between the average and the median indicates increasing inequality during this time; something we knew about already (see this post, and this one, among others).

Inequality in market income doesn't bother me much in itself; what really matters is inequality in income after taxes and transfers. If policy-makers are responding to rising inequality by improving its programs for redistributing income, then the effect on inequality of disposable income will be a wash.

Unfortunately, that's not what has been happening in Canada. Here is how net transfers have changed; the data are taken from Cansim Table 202-0704:

Net transfers to the highest quintile have decreased; income growth has been concentrated at the top end of the income distribution, so their tax payments have grown in proportion. But the main beneficiaries are not those with the lowest incomes; the increase in net transfers has been concentrated on the middle income groups.

Here are how the shares of (gross) government transfers have changed over the past generation:

The share of transfers to the lowest quintile has decreased since 1980, as has - albeit to a lesser extent - that of the second quintile. The winners in this reallocation are the middle and fourth income quintiles.

It's not hard to imagine an explanation for this; the median income group is likely to include the median voter. So every political party will be happy to sacrifice the lowest income group's interests (that group is either taken for granted or written off entirely) in order to gain popularity at the centre.

Comparing central banks' responses to the credit crunch

Here's an interesting graph from the Bank of Canada's Monetary Policy Report:

Yes, yes, I know; it's almost impossible to tell the difference between the UK and Canada in that graph, but if you look at the original document and zoom in to 200% of the original size, you can (just barely) conclude that the UK series is the one that has the second-highest spread as of April 2008. Someone at the graphics department of the BoC deserves a scolding.

Anyway, here is a summary of what the the four central banks in that graph have faced since mid-July, and how they've responded:

• The US: The spread increased by 175-200 bps since July. The Federal funds rate has decreased by 300 bps.
• The euro zone: The spread increased by 125 bps. The ECB hasn't changed its interest rates.
• The UK: The spread increased by 175 bps. The Bank of England reduced interest rates by 75 bps.
• Canada: The spread increased by 125 bps. After increasing its overnight target by 25 bps on July 10, the Bank of Canada has reduced interest rates by 150 bps.

Canada and Argentina in the 20th century

Whenever I teach growth theory, I like to compare the Canadian experience with that of Argentina. Up until the 1930's, the two countries followed very similar paths: foreign investment financing the development of resource-based economies. But then the 1930's happened, and Canada and Argentina parted ways.

This is the best graphical demonstration that starting points are not destiny (the data are from Angus Maddison):

During the 65 years between 1870 and 1935, Argentina kept pace with Canada. Since then, Argentina's income per capita increased by a factor of 3, less than half that of Canada.

It's hard to see how that gap could be explained by anything other than the unhappy choices made by Argentina's political classes over the past four generations. Which makes me think that the answer to Dani Rodrick's question is a despairing 'yes'.

Update: Brad DeLong has just reposted his 1991 piece with Barry Eichengreen on the decisions Argentina took in the 1930s and afterwards.

Why the Bank of Canada should stop cutting interest rates

Today's CPI release has generated certain expectations (documented here, here, and I expect in pretty much every story covering the March inflation numbers) that a 50 bps cut in the overnight rate target is in the offing next Tuesday. Those expectations may very well be fulfilled - Mark Carney has been dropping broad hints ever since he announced his presence with authority that more interest rate cuts were on the way. But it's far from clear that another dramatic cut in interest rates could be justified. In fact, there's a much stronger argument for not cutting interest rates at all.

Let's deal with the inflation numbers first. Yes, y/y inflation is - by any measure - below the Bank's target. But this looks very much like a one-off level shift, not a change in the rate of inflation. What appears to have happened is that much of the long-delayed pass-through of the CAD appreciation happened all at once, and the trigger was the realisation that the CAD was trading at par with the USD. Even the most long-suffering, mathematically-challenged Canadian consumer was able to figure out that the price that she was paying was much higher than what her cousins to the south were, and a consumer revolt during the holiday shopping season led to a sudden drop in prices. And a very good thing, too.

But that's not the same thing as a drop in the growth rate of the price level. For the next few months, this one-off fall in prices will continue to show up as a reduction in y/y inflation, but once it's been fully incorporated - sometime towards the end of this year - y/y inflation will jump right back up again.

Now let's consider the effects of lower interest rates on aggregate demand, and in particular, its interest-rate-sensitive components:

• The housing market is doing just fine.
• So is non-residential construction.
• Fixed business investment intentions are looking good.

In the US, there's an awfully good case for trying to pump up the interest-rate-sensitive sectors of the economy. But Canada is not the United States; their problems are not ours, and we shouldn't be conducting monetary policy as if they were. These sectors are at or near capacity; they don't need further stimulus.

Moving on to the credit crunch. This is an exhaustively documented phenomenon in the US, but I'm unaware of a comparably clear-cut case for Canada. The best I've seen is from this speech by Deputy Governor David Longworth a couple of weeks ago, in which he presented this graph:

I'm not at all convinced that the lesson we should draw from this graph is that Canada is facing a credit crunch, and that the remedy is an expansionary monetary policy. These spreads have not shown up in the real economy (mortgage rates are lower than what they were before the subprime crisis hit), so the only thing I see is hard times for those who happen to work in the financial sector and whose livelihoods are directly affected by these spreads. It's probably not a coincidence that in the last two meetings of the CD Howe Monetary Policy Council, the private sector members'  recommendations have been lower that those made  by the academics. Or that bankers are anxious to put forward the notion that a 50 bps cut on Tuesday is somehow a slam-dunk.

I will not be overly distressed by a 25 bps cut. But if the Bank of Canada lowers its target for the overnight rate by 50 bps on Tuesday, it will be time to start talking about a 'Carney put'. And it will also be time for someone to make it clear to the Governor of the Bank of Canada that the instincts learned at an investment bank will not serve him well in his new job.

High taxes doesn't mean big government. And low taxes doesn't mean small government.

I've never, ever understood the assertion that high taxes = big government:

• It is possible to imagine an economy with high taxes that are used to redistribute income with only a minimal distortion of markets.
• It is possible to imagine an economy with low taxes that are used to pay the salaries of a small number (it wouldn't take very many) of functionaries whose job it is to distort markets as much as is humanly possible.

(This post is provoked/inspired by this one by Mike Moffatt.)

Canada's Goldilocks housing market and the Bank of Canada

Everyone knows that housing markets are crashing and burning all over the place: the US, the UK, Spain, and many more besides. But that's not happening here:

Although housing starts in the US are about half of what they were two years ago, they are more or less holding up in Canada. And new house prices are still rising.

That's hardly a justification for complacency, of course; a few years ago, things looked just as rosy in the US. But the IMF's survey of world housing markets (pdf) has an encouraging finding: Canada's housing prices are lower than what a model based on market fundamentals would predict:

The housing sector has been an important source of growth over the past few years in Canada and elsewhere. But the difference is that housing market activity in Canada doesn't appear to have been built on a bubble, so there's reason to hope that this sector will continue to perform well.

This is yet another reason why the Bank of Canada should be cautious in how it manages interest rates: five-year mortgage rates are now back down to what they were before the subprime crisis hit. There's not much slack on the supply side of the housing market, so the only effect of an aggressive reduction in interest rates will be to drive up prices - and perhaps start the sort of bubble market that we've been able to avoid until now.

The forex market is dumber than a sack of hammers

Or maybe it's just the people who comment on its gyrations. A Reuters piece from today is a case in point:

Loonie slips on US economic outlook: The Canadian dollar slid lower against the U.S. dollar as investors were loath to bet on the currency, given Canada's heavy dependency on the waning U.S. economy...

Huh?

Yes, the Canadian economy is exposed to the risk of a severe US downturn, so it's reasonable to expect a depreciation against currencies that are better insulated, such as the euro or the yen. But that reasoning also means that the CAD should appreciate against the currencies of economies that are less insulated from a US recession. A good example of an economy that is more exposed than Canada is to a US recession is - wait for it - the US.

Unless someone has a story in which a Canadian slowdown would be even more severe than what will hit the US - and I've yet to see anyone explain how it will - then this story from Reuters makes no sense at all.

Oil prices in currencies other than the USD revisited

Time up update my irregular series of graphs of oil price movements in currencies other than the USD:

The story of the first couple of months is pretty straightforward: oil prices fell in January and came back up in February, and there wasn't much in the way of significant exchange rate movements. By the end of February, we were pretty much where we were when the year started.

And then March hit, with important swings in both oil prices and in exchange rates. In the Euro zone, an appreciating currency attenuated much of the rise in oil prices, and oil was slightly cheaper on March 20 than it was on Jan 2. The even stronger appreciation of the yen means that oil prices in Japan are 7% lower than when the year began.

The CAD has been tracking the USD pretty closely over the past few months, but the recent drop in oil prices has been offset by a depreciating CAD. The net result is that CAD oil prices are still more than 5% higher than at the beginning of the year.

As long as forex markets peg the CAD to oil prices, the CAD value of oil exports should hold up.

Mark Carney announces his presence with authority

The Bank of Canada lowered its overnight rate target by 1/2 of a percentage point to 3 1/2 per cent:

[T]here are clear signs that the U.S. economy is likely to experience a deeper and more prolonged slowdown than had been projected in January. This stems from further weakening in the residential housing market, which is adversely affecting other sectors of the U.S. economy and contributing to further tightening in credit conditions. The deterioration in economic and financial conditions in the United States can be expected to have significant spillover effects on the global economy. These developments suggest that important downside risks to Canada's economic outlook that were identified in the MPRU are materializing and, in some respects, intensifying.

The Bank now judges that the balance of risks around its January projection for inflation has clearly shifted to the downside, and, as a result, the Bank is lowering the target for the overnight rate. Further monetary stimulus is likely to be required in the near term to keep aggregate supply and demand in balance and to achieve the 2 per cent inflation target over the medium term.

I was expecting and recommending a cut of 25 bps, but there was a decent case to be made for a reduction of 50 bps. Unfortunately, it was not the case that the Bank made.

The good case would have been based on two arguments:

• Core inflation is still way below its target.
• Credit conditions are tighter than what they were last summer. A 50 bps cut still means that effective borrowing rates are higher than they were when the Bank last had a tightening bias.

The case outlined in the interest rate announcement seems much weaker:

• Now that the current account has gone negative, the CAD is unlikely to appreciate much more in the near term. And if the CAD-USD rate stays stable while oil prices continue to rise, then exports will be somewhat cushioned from the US slowdown.
• Domestic demand has been taking up the slack from weak export growth for the last six years; it's hard to see why we should be panicking about the ability to shift output away from exports at this stage.

So while I'm not overly concerned about the Bank's decision, I am somewhat worried about the reasoning it used to arrive at it. Especially if this reasoning is used to guide future interest rate decisions.