Worthwhile Canadian Initiative

The Canadian business cycle mesa of 2008

The August 2008 GDP numbers are out, and real output continued its path sideways. As in these  posts, all variables in the graphs that follow are logged and re-scaled to zero at the peaks of the expansions: 1981:04, 1990:03, 2000:12 and (provisionally) 2007:11. They are then multiplied by 100, so that they can be interpreted as the per cent deviation from their values at the peak.

Here is employment:

And here is StatCan's composite leading indicator:

Up until now, we've been following the path set out in 2001-2002: a brief pause between strong expansions. But it's hard to see how this will happen again: what saved us in 2002 was the beginning of the oil boom. Nor does it look as though there will be an imminent US expansion to pull us up out of recession.

Since November of 2007, we've neither fallen into recession, nor have we managed to keep expanding. It's a good thing we don't have the equivalent of the NBER recession dating panel; they'd have a hard time calling a business cycle peak on the basis of these data.

So let's call it a business cycle mesa.

Life in the time of six sigma

Standard deviation of daily per cent changes in the CAD-USD exchange rate since the CAD was allowed to float in June, 1970: 0.33.

Number of days in which daily per cent changes exceeded six standard deviations since June 1970: 6.

Number of days in which daily per cent changes exceeded six standard deviations since September 15, 2008 (the day Lehman Brothers filed for bankruptcy): 5.

What if increased government spending is contractionary?

Suppose that Canada does go into recession, either this month or in the months to come. What policy instruments are in the arsenal?

• The automatic stabilisers: Taxes will fall with revenues, and expenditures will rise as unemployed workers start drawing on employment insurance benefits. (There are of course other mechanisms at work here.)
• Monetary policy: The Bank of Canada has cut its interest rate have by 250 bps since the credit crunch started last summer, and there is still space for further cuts.

Which brings us to discretionary government spending. There is of course a strong case that can be made for increasing discretionary spending in a recession, and the case is even stronger for a country that has been running surpluses for more than a decade. But that's only if you think the fiscal multiplier is positive.

Readers of a certain age who happened to be paying close attention to Ontario politics at the time [Oh come on, there must be someone out there who remembers this - ed.]  may recall Floyd Laughren's line about choosing to 'fight the recession, and not the deficit' in one of his budget speeches during the 1991-92 recession. The problem was of course that Ontario is far from being a closed economy, and whatever fiscal stimulus that the Ontario government could generate would leak outside its borders, with essentially no effect on the Ontario economy. The only thing Bob Rae's NDP government got out of the exercise was a scary deficit. (I should mention here that I don't want to be too hard on Rae or Laughren: they were dealing with a very tough situation, and both acknowledged that they had made a mistake ex post.)

Which brings us to this graphical representation of some of the results from Roberto Perotti's paper 'Estimating the effect of fiscal policy in OECD countries' (the graph comes from the IMF):

It would appear the the import leakage story for government expenditures carries over to Canada as a whole over the past 30 years: if anything, the cumulative effect on GDP of increasing government spending was negative. Curiously, the effect of tax increases has the opposite sign.

I'm not keen on tax cuts as a countercyclical move for two reasons:

1. They're hard to cancel when the need for them goes away.
2. Since low-income households don't pay much in taxes, tax cuts are rarely progressive.

(Yes, I'm aware of the point of how people may simply save the tax cut and not spend it; I'm not entirely sure why I should view that as a bad thing.)

But the case for spending doesn't look much stronger: the only people who would benefit are likely to be the best-connected special-interest groups. If a MP really wanted to help the people of her riding, she should resign and force a by-election -  government money would rain down on her constituents like so much confetti.

Here's what I'd like to see:

• No mention whatsoever of increasing government spending as a counter-cyclical measure - that sort of exercise is pretty much futile.
• Broadening and strengthening the safety net. For example, there are many workers who would not be eligible for benefits if they lose their jobs. If these measures result in a deficit, so be it.

I don't see any point in Canadian governments trying to fight a global recession. They should adopt a defensive position and do their best to protect Canadians from the worst of its effects.

Commodity prices and the Canadian economy

The story of the Canadian economy since 2002 is one of an improvement in the terms of trade created by a surge in commodity prices. As commodity prices rose, the CAD appreciated and the real buying power of Canadian incomes increased. But in the past few weeks, much of this has been reversed. The possibility of a fall in commodity prices was the thing I feared most, and it seems to have come to pass: the price of oil and other commodities have been falling over the past few weeks and months. It's useful to put these movements in context.

Here is a graph of oil prices and the CAD-USD exchange rate:

Oil isn't the only commodity that Canada exports; here is a graph of the Bank of Canada's index of commodity prices  along with the exchange rate:

As of last Wednesday (where these series end), we're back to roughly where we were a couple of years ago; I suspect we've moved back a few months since then.

This is not good news. The 2002-2008 expansion provided significant real income gains, and more than half of those gains were due to the improvement in Canada's terms of trade.

So where do we go from here? One possibility might be going back to the 1990's recipe of low exchange rates and increased manufacturing activity. But that would be more of a fuite en avant* than anything else: real wages declined during the 1990's. It's hard to see how competing with China and other low-wage exporting countries for US market shares is going to be a recipe for prosperity anytime soon.

In the short run, there's not a lot we can do to counter these trends. But there's reason for optimism in the medium term. The main driver for the rise in commodity prices has been the development of the Chinese, Indian and other developing economies. Their growth rates will no doubt be slowed by the financial crisis over the next few quarters, but their incomes have by no means plateaued. The demand for commodities will resume when the developing economies pick up again.

For all of our history, Canadian economic development has depended on the fortunes of the leading economic powers of the time: first Britain, then the United States. It now appears to be China's turn.

*I'm not aware of an equivalent English expression; babelfish translates this as 'escape ahead', but the phrase is supposed to convey the notion of a desperate choice in unfavourable circumstances.

What should Canadian governments be doing right now?

My answer would be: nothing.

Right now, the Bank of Canada is doing the grunt work of trying to keep financial markets from drying up, and there's not a lot that governments can do to help. And if the Bank were trying to provide monetary stimulus on top of all that, it could hardly do better than the 15% devaluation that the forex market has provided.

If the federal and provincial governments do nothing, there's a good chance that they'll run a deficit, either this year, next year or both. And that's okay: we've spent the better part of a generation getting our fiscal house in order - we can handle it.

If Canada does go into recession (let's all remember that available data indicates that we were not in recession as of September), then we should not exclude the possibility of fiscal measures beyond the automatic stabilisers. But we're not there yet.

Update: Gilbert Lavoie puts it well in this morning's Le Soleil:

L'opposition demande un «plan». Qu'on lui en donne un. Ça coûtera quelques heures de travail aux fonctionnaires, et le papier sur lequel il sera rédigé. Quant aux fonds publics, attendons la tempête avant de savoir s'il faut s'acheter des parapluies ou des habits de neige.

My translation:

The opposition wants a 'plan'. So give them one. It'll cost a couple of hours of a bureaucrat's time and the paper on which it's written. But when it comes to public money, let's wait for the storm to hit before deciding whether we need to buy umbrellas or snowsuits.

Automatic monetary stabilisers and destabilisers

Since the Lehman Brothers bankruptcy on September 15, the Canadian dollar has depreciated by 12.5% against the USD, and the US trade-weighted exchange rate has appreciated by 6.7%.

This may be a partial explanation for the high priority that US policy makers are giving to a fiscal stimulus package. The forex markets are working to counter the threat of a Canadian recession, but they are reducing world demand for US goods and services.

A $10b deficit isn't what it used to be

There are several reports to the effect that the federal govt may run a deficit on the order of $10b in FY 2009-10.  When the deficit went to $10b back in 1977-78, it was 5% of GDP. Thirty years later, $10b is something like 0.6% of GDP.

Let's all not panic, shall we?

On the causes of an eventual Canadian recession

I was planning on writing this post a bit later, but since several good points have already been made in the comments over here, I'm going to start a discussion on the mechanics of how the Canadian economy might go into recession in the next few months.

The decline in exports to the US. About 25% of Canadian GDP is exported to the US, so you'd expect that a 1% decline in US aggregate demand would reduce the demand for Canadian output by about one-quarter of a percentage point. Clearly, this story is not enough, since it doesn't generate the sort of reduction consistent with what we'd call a recession. Moreover, exports to the US actually increased during the 1982 and 1991 recessions, and have been increasing during 2008.

Financial contagion. One way that the US financial markets could affect the Canadian real economy is financial contagion: falling prices for US assets held by Canadian banks would reduce their value and lead to tightening credit conditions. But again, this doesn't seem to be happening: the Asset-Backed Corporate Paper agreement has more or less dealt with the subprime toxic waste, and if there were anything else that would be hitting Canadian banks' balance sheets, we should have seen it by now.

Housing markets. There are two things to think about here. The first is the wealth effect of falling housing prices. For a variety of reasons (enumerated by Nick Rowe in the comments over here) we're not going to see the wave of foreclosures the US is going through. But to the extent that people are basing their spending decisions on the assumption that house prices will increase, then we can expect a slowdown in consumption expenditures. The other is the effect on employment in the construction sector: a reduction in the demand for housing will hit a sector that has been an important source of employment growth.

Consumer confidence. After several weeks of being bombarded with Scary Headlines Announcing Impending Doom, households may decide to cut back on spending, even if there is no objective reason to do so. For example, this is by no means good news.

I'm pretty sure that this list is not exhaustive, but I'm going to stop here anyway. I'll be pleased to add suggestions made in the comments.

Election markets are beyond silly

I'm going to indulge in a heaping helping of I Told You So:

Trader drove up price of McCain 'stock' in online market: An internal investigation by the popular online market Intrade has revealed that an investor’s purchases prompted “unusual” price swings that boosted the prediction that Sen. John McCain will become president.

Over the past several weeks, the investor has pushed hundreds of thousands of dollars into one of Intrade’s predictive markets for the presidential election, the company said.

“The trading that caused the unusual price movements and discrepancies was principally due to a single ‘institutional’ member on Intrade,” said the company’s chief executive, John Delaney, in a statement released Thursday. “We have been in contact with the firm on a number of occasions. I have spoken to those involved personally.”

In the context of a US presidential campaign, 'hundreds of thousands of dollars' is the equivalent of the loose change found while shifting furniture.

Election markets were an interesting experiment. They failed.

(h/t Paul Krugman)

So where were we?

Now that it's been decided who will form the government, it's time to look at the problems facing it and what it can and should do about them. The next few posts will be data-oriented, trying to provide some background.

Today, I'm going to look at the state of the labour market. In the US, labour market conditions alone are arguably sufficient grounds (Menzie Chinn, Jim Hamilton, Brad DeLong) for concluding that the American economy has been in recession for several months now:

The recent jump in US unemployment rates is not (yet) something we've seen here:

Now that we have a bit of a historical perspective, I'm going to focus attention on what's been happening in the last couple of years. Here's a graph for employment in Canada and the US since 2007:

US employment peaked in November of last year, but the most recent LFS release put Canadian employment at an all-time high. Indeed, the employment increase in September 2007 was the largest we've seen since Statistics Canada started recording this series in 1976.

Next up are employment rates:

Canadian employment has grown slightly faster than the working-age population since the beginning of 2007, but the US civilian employment-population ratio has fallen by more than one ppt.

Employment growth has slowed somewhat in Canada, but it is still positive.

As Nick Rowe mentioned recently, Canadians read too much US media. In the US, the story of the financial crisis is taking place in a background of an economy that was in recession even before the meltdown. But that's not the case here.