Worthwhile Canadian Initiative

The Quebec budget: Will good economics be good politics?

The media are reporting that economists are singing the praises of the Quebec budget, and if asked, I'd add my voice to that chorus. This is the work of adults who take their responsibilities seriously, and the Charest government is to be congratulated for finally paying attention to what economists have been telling successive governments - PLQ and PQ - over the past generation.

The optimal size of government is a partisan issue. The optimal tax mix isn't.

There are so many misconceptions about tax policy and the size of government that it's almost impossible to sort through them all. But I'm going to do the best I can.

My weekend with Liberals and Thinkers

I don't have much in the way of a comprehensive narrative for how the Canada 150 conference went, or what its implications are. My live blogging post is here, and my general impressions are below the fold.

The supply and demand for bubbles (in pictures)

I have drawn a picture of the supply and demand for bubbles. I think this picture might make it easier to understand what I was saying in my previous post on the need for a bubble.

If the natural rate of interest, in an economy without a bubble, is below the growth rate of the economy, then the economy "needs" a bubble. There will be both a demand for bubbles, and a supply of bubbles, at any interest rate between that natural rate and the growth rate.

A Lucas Critique of monetary policy as interest rates

"The statistical relation between inflation and unemployment will not be invariant to the monetary policy regime". Economists will recognise that statement as an example of the Lucas Critique. They know it has implications for any policy that uses inflation to target unemployment.

"The statistical relation between interest rates and inflation will not be invariant to the monetary policy regime". I want economists to recognise that statement as another example of the Lucas Critique. I want them to recognise that it has implications for any policy that uses interest rates to target inflation. Or any other target variable, like nominal GDP.

Productivity, the Canadian Dollar and Small Business - A Case Study

Based on a true story one of my clients had to deal with (besides teaching at Ivey, I am a consultant to the chemical industry). The following case explains why there could be, at least in theory, a relationship between productivity levels and fluctuations in the Canadian dollar.

Consider a small company in Brampton that manufactures and fills aerosol containers for chemical companies. A few relevant facts:

1. The market is quite competitive, so the company's pricing power is extremely limited.


2. Americans are as likely to buy the company's products as Canadians. Since the U.S. market is approximately 10 times the size of the Canadian one, 90% of the firm's sales are to the U.S. (and denominated in U.S. dollars) and only 10% are in Canada.


3. Roughly 90% of the firm's competitors are in the U.S. and only 10% are in Canada.

The firm is trying to decide whether or not to buy a new piece of equipment for $1 000 000 Canadian (including financing costs). This equipment would make the company more productive in some way. Perhaps it could either fill cans faster (say 150 cans a minute instead of 100) or perhaps the equipment is a new technology that allows the company to do something it could not do before. (e.g.bag on valve) The money would be borrowed and paid back over 10 years.

Human capital: literal truth, fairy tale or myth?

This is from my Carleton colleague Frances Woolley:

Part I: Education

Every undergraduate student in labour economics gets told the story of human capital. Education and experience make people more productive. The skills so acquired are called “human capital.” This explains why some people earn more than others, and why some countries are richer than others.

Is human capital theory the literal truth? There is an element of truth in it. The typing skills learnt from Mr. Darby in grade 9 make me more productive than my hunt-and-pecking colleagues.  Educating girls reduces fertility rates (pdf), promotes female autonomy, and has a host of other productivity-enhancing benefits. But there are many things that human capital cannot explain.

Do we need a bubble?

There is something economists have known since 1958 that we don't talk about much, except in private, like in economics journals that nobody else reads. It's a bit too weird.

There are two sorts of world. In a normal world, the equilibrium rate of interest is above the growth rate of the economy. In a weird world, the equilibrium rate of interest is below the growth rate of the economy. What's weird about a weird world is that it needs a bubble, a Ponzi scheme, a chain-letter swindle, for the economy to work well.

Maybe the world we live in is a weird world. And it needs a bubble to work well. And the economy keeps trying to create a bubble. And when it succeeds the economy does work well. But bubbles are unstable and eventually burst. Then it works badly again. Until the next bubble.

Live-blogging the Liberals' "Canada at 150" conference

Never underestimate the power of twitter. A few weeks ago, Canwest journalist David Akin tweeted that in addition to regular media, Canada 150 would be accrediting some bloggers as well. It turned out that the deadline had past, but I sent in my information anyway. The other day, I received an e-mail to the effect that a slot had opened up, and was I still interested?

So off I go. I have to teach tomorrow (Friday) morning, but I should make it for the innovation session at 3:45 if all goes well.

It should be fun. My greatest concern at this point is that there are *far* too many business types on the program, and that I may spend the weekend listening to management jargon.

I'll update this post as the weekend goes on. I may post separately on specific topics if they seem likely to generate an interesting discussion.

I'm in. Comments below the fold.

Final update Sunday, 4:00.

In which I say something nice about the NDP

It occurs to me that I am often critical of the NDP. This is due to a combination of factors:

1. They comment frequently on economic issues, and
2. They get things wrong.

Other parties avoid these scoldings not so much by getting things right as by not commenting on economic issues.

So I should congratulate the NDP on pursuing an important issue that isn't receiving the attention it should: pensions.

Why the LM curve is (usually) vertical, and the AD curve (usually) horizontal

Short version: because the Bank of Canada (or any inflation-targeting central bank) makes the LM curve vertical and the AD curve horizontal.

Long version below the fold:

A bad argument against lower corporate income tax rates

Here it is:

The case for corporate tax cuts is that they supposedly prompt businesses to invest more in Canada. Critics have countered that an unconditional gift to those corporations which are already profitable will not necessarily increase investment. A third possibility that has received little attention helps explain why corporate tax cuts are so ineffective.    

Much of the revenue forgone by Canadian governments will flow not to enterprises operating in Canada but to foreign governments. In particular, the U.S. government taxes its corporations on a worldwide basis and President Obama has proposed tougher enforcement of this policy. American corporations account for nearly one-third of all profits subject to Canada’s general corporate tax rate.

When an American company repatriates profits from Canada to the U.S., it pays the 35% American federal corporate tax rate minus a credit for taxes already paid in Canada. If our federal plus provincial rate is at least 35%, these corporations do not owe American tax on their Canadian profits.

Emphasis added, because it is that particular word that betrays a misunderstanding of the case for lower corporate tax rates.

If the only way that foreign savings could transform themselves into Canadian productive capacity was by way of foreign-registered corporations, then this would be a powerful point. As far as foreign investors are concerned, the relevant corporate tax rate would be that which prevails in their home country. Canadian investors might see the benefits from lower Canadian corporate tax rates, but international investors wouldn't. The gains from such a policy would be somewhat problematic.

Happily, that is not the case. Foreign investors are not obliged to invest in companies registered in their own countries. They are free to invest in Canadian corporations directly and to take advantage of the higher returns generated by lower Canadian corporate income taxes.

The case for lower corporate income taxes is not based on providing opportunities for foreign businesses to invest in Canada, it is based on providing incentives for foreign lenders invest in Canada. The former are bound by their domestic corporate income tax rates; the latter are not.

The Bank of Canada and the exchange rate: the facts have changed, and so has its views

You will remember that the dollar went from 0.86 USD to 0.97 between July and October of last year, and that the question of what to do about the appreciating CAD took up a lot of our attention in the fall. (Sadly, much of my attention was diverted to how badly the issue was covered in the media: [1], [2], [3].) Back then, the Bank of Canada greeted this development with concern, and warned forex markets several times that it was prepared to intervene to slow the appreciation of the Canadian dollar.

After receding back to 0.93-0.94 USD level for a few months, the CAD is now trading in the 0.98-0.99 range, and people are talking of reaching parity and beyond within the upcoming weeks and months. But this time, the Bank isn't saying anything. Why not?

Putting the foreign-ownership cart ahead of the innovation horse

David Olive gets things wrong in his column today.

• Foreign ownership is not to blame for low levels of productivity and innovation in Canada. A 2005 StatsCan study (pdf) found that "foreign-controlled plants are more productive than domestic-controlled plants" and "are also more innovative, more R&D intensive and use more advanced technologies."
• Protecting domestic managers from the threat of foreign takeover removes incentives to innovate.
• The 'branch plant' mentality is a direct effect of generations of protecting Canadian industries from global markets.

(See also this post.)

And I cannot resist reproducing this line (h/t John Palmer):

"Protecting failing industries is like peeing in your pants. It feels warm and nice at first, but it stays cold for a long time"

Taxation in Canada - Part II: Constraints Faced When Designing a Tax System

In Part I we saw that the goals of taxation were two-fold: to collect revenue for the government and to discourage certain activities. However, the government hoarding Jacques Plante as an Edmonton Oiler hockey cards in an attempt to reduce the after-tax income of rich-people is not aligned with our goals.

If there were no other considerations when creating tax policy, then designing a tax system would to meet our two goals is relatively easy- we identify a number of negative externalities and set tax rates on those activities as to eliminate the externality. If any additional revenue is needed, we identify a number of other activities ('sins') we would like to discourage and tax those. I use the qualifier relatively because a number of complications exist:

The Division of Labour between interest rate and exchange rate

Stephen's graphs show quite clearly that Canadian monetary policy must tighten before US monetary policy. I'm convinced. But what does monetary policy mean? In this context, I'm going to ignore other interpretations, and just focus on interest rates and exchange rates. What is the division of labour between increasing interest rates and appreciating exchange rates? Which one will do the tightening? Or will it be a bit of both?

Or, to put it another way, should exchange rates or interest rates move first, and why?

Or, given that the exchange rate is appreciating already, will the Bank of Canada need to raise interest rates before the Fed does?

International reserves and involuntary borrowing

Borrowing is nearly always voluntary. Somebody might want to lend to me, but they can't force me to borrow from them if I don't want to. But there's an exception. A country that issues the reserve currency can be forced to borrow from other countries, if those other countries want to lend to it. This point helps us understand the relation between China and the US.

A question for Canadian housing bubble theorists

I suppose that this really should be entitled "A question for Vancouver housing bubble theorists", because pretty much every 'Canadian housing bubble' story I've seen uses anecdotes from Vancouver.

Here is the question: How do you get from a fall in Vancouver (or Canadian) house prices to a Canada-wide economic crisis?

And no, you cannot cut-and-paste old articles from Nouriel Roubini; Canada's financial markets are very different from those of the US. I want you to explain to me how a fall in (Vancouver) housing prices will generate a made-in-Canada recession.

Taxation in Canada - Part I: What Are the Purposes of Taxation?

This is the first in a series of posts that will examine the tax system in Canada, from an economist's point of view. If we better understand how the tax system works, we can find ways to improve it. It turns out that there are a number of ways the Canadian tax system can be improved.

Net Import Quotas and Tariffs: China and Paul Krugman

Here's another way to think about what Paul Krugman is saying: it is as if China has a quota on net imports. An ordinary import quota means that the government places a ceiling on the value of imports. In this case, it's not a ceiling on gross imports, but on net imports (imports minus exports). And that ceiling happens to be negative. Since net imports are the same as minus net exports, another way of saying the same thing is that China has placed a floor on net exports. And that floor is positive.