Worthwhile Canadian Initiative

Canada: A net creditor for the first time in its history

The balance of payments data were revised with the release of the 2008Q1 numbers, and something very important happened back in 2006 - estimates for Canada's net international investment position went positive:

The sharp appreciation of the Canadian dollar during 2007 reduced the value (in CAD terms) of foreign holdings, but the precedent has finally been set.

This is a very big deal indeed. Foreign investment has played an important role in the development of the Canadian economy since long before the term 'Canadian economy' had any meaning. But in the past few decades, foreign ownership has become an obsession for Canadian nationalists, and - to the chagrin of sentient observers - they've been occasionally successful in making it difficult for foreigners to invest in Canada.

But now that Canada's holdings abroad are at the levels of foreign holdings in Canada, it is to be hoped that it will be harder to make the case for slowing the flow of capital into Canada.

When will the Canadian dollar start to appreciate again?

Since 2002, we've been seeing a pattern in which periods of CAD appreciation alternate with periods where the trade balance increases:

The cycle goes something like this:

1. When the trade balance is high, the CAD appreciates. The appreciation brings the trade balance down, and the CAD hits a plateau.
2. While the CAD is plateaued, the trade balance increases.
3. Go to 1.

Right now, we're at step 2: the CAD has been trading in a narrow range around parity with the USD since November, and during this time, the price of oil and other commodities that Canada exports have risen sharply - and so has the trade balance.

"Canada's managers are under-achievers"

Dan Trefler gave the Innis Lecture at the meetings of the Canadian Economics Association in Vancouver a couple of weeks ago. The title of his talk was "Policies for Canadian Prosperity"; inevitably, one of the points he spent a lot of time on was the problem of Canada's slow rate of productivity growth.

One possible explanation might take the form of a cultural antipathy to innovation: Canadians don't innovate because it's considered to be bad manners or some such. But it's hard to reconcile that theory with the available evidence: opinion polling data suggest that attitudes towards entrepreneurship in Canada and the US are pretty much the same.

But there was one question where there was a significant difference. When asked what sort of education was required to do well in business, Canadian managers were far more likely than their US counterparts to say that a university degree wasn't necessary. Of course, that might be because 70% of Canadian managers don't have a degree, while that's the case for only 50% of US managers. As Trefler put it, "Canadian managers are under-achievers."

This is not the sort of explanation that is easy for an economist to get one's head around, but it's worth making the effort. Not only would it explain Canada's slow rate of productivity growth, it would also explain why

1. "[F]oreign-controlled plants are more productive than domestic-controlled plants. Foreign-controlled plants and firms are also more innovative, more R&D intensive and use more advanced technologies,"  and "that there is not much difference between foreign-controlled plants and domestic-controlled plants whose parent has an international orientation. For R&D and innovation, the results indicate that domestic producers with foreign operations ... actually have a slightly better performance." (From this post). The only occasions in which Canadian managers perform well are when they are obliged to deal directly with foreign competition.
2. "Canadian investors are selling their shares in Canadian companies and buying stocks in other countries. Since 2000, Canadian net purchases of foreign stocks were about $C 60b more than foreigners' purchases of Canadian stocks." (From this post.) Canadian investors are divesting themselves of badly-managed domestic firms.

It's time to start worrying about productivity again

There were a couple of nice papers in the Centre for the Study of Living Standards' spring 2008 issue of their International Productivity Monitor. The reason we keep coming back to this issue is summarised in this chart from Business Sector Productivity in Canada: What Do We Know? (pdf), by Paul Boothe and Richard Roy of Industry Canada (click to see a larger version):

Labour productivity growth is the basis for long-run growth in real incomes, and this chart is why Canadian economists fret about productivity.

There are other sources of income growth that can be tapped in the short run, and Canada has been doing pretty well squeezing what it can from them. Boothe and Roy decompose the sources of income growth  in the following way:

• Labour productivity: Output per worker. This is further decomposed as capital deepening (the increase in the amount of productive capital per worker) and multifactor productivity (MFP), which is the increase in output that cannot be explained by the accumulation of inputs of production. MFP is usually interpreted as 'pure' technical progress, the kind that allows us to produce more with the same level of inputs.
• Working-Age/Total Population: Everything else being held constant, an increase in the percentage of the population that is of working age will increase income.
• Employment Rate: Everything else being held constant, an increase in the percentage of the working-age population who are employed will increase average incomes.
• Hours Worked per Worker: Everything else being equal, an increase in the hours worked per worker will increase average incomes.
• Net Foreign Income. The returns generated by assets held outside Canada, less the payments made to foreign owners of assets in Canada.
• Terms of Trade: An increase in the price Canadians receive for their exports relative to the price they must pay for imports represents an increase in buying power.

Here are their estimates for how these factors contributed to income growth since 1981:

Barely half of the income growth since 1981 came from increases in labour productivity, and another fifth  came from the fact that there were simply more people working. The percentage of working-age people has increased as the baby boom entered the workforce, and employment rates - especially among women - have increased. This can't be sustained: female employment rates are starting to level off, and the Working-Age/Total Population factor will start becoming a drag on growth in a few years as the baby boom cohort starts to retire.

The past few years have been pretty good ones for income growth - does that mean productivity has finally accelerated? Well, no. The authors very kindly agreed to run the numbers for the years since 2000 and to send me the results:

The run-up of the prices of oil and other commodities - and the subsequent improvement in Canada's terms of trade - accounts for more than half of the real income growth we've seen since 2000. That can't go on forever (right?), and when you take into account the increases in the relative size of the working-age population and the employment rate, it's somewhat disquieting to note that more than 3/4 of income growth since 2000 comes from sources that could not only disappear, but could also very well change sign and become a drag on growth in the medium term.

Yikes.

Which brings us to the second article in the IPM: An Analysis of the Causes of Weak Labour Productivity Growth in Canada since 2000 (pdf), by Jean-François Arsenault and Andrew Sharpe of the CSLS. They manage to find a silver lining:

Future labour productivity in Canada should pick-up compared to its 2000-2007 rate, even though there exists significant uncertainties as to the precise rate of growth that can be expected. Our analysis suggested that labour hoarding, increased training, high corporate profits and a rise in the Canadian dollar contributed to the slowdown in Canada; these four factors should in the long run lead to more intense use of labour, increased human capital and increased investment. A return to the 1973-2000 trend rate of 1.55 per cent thus appears reasonable. Moreover, with more room for convergence with the United States, it would not be surprising for Canada to exceed its trend rate.

Of course, they could be wrong:

[T]o the extent that future labour productivity growth in Canada will rely on MFP growth, any projection of future labour productivity growth must be interpreted as an informed approximation rather than a firm estimation.

Let's hope that they're right.

The Bank of Canada stops and startles

The Bank of Canada held interest rates steady today. Going into the April 22 decision, I thought it was about time to stop the round of interest rates cuts, so I certainly agree with the decision.

But I was a bit surprised at the move. Since his arrival at the Bank in February, Mark Carney has cut rates more and faster than I would have thought prudent, and I hadn't yet seen any sign that he was going to stop. Before the announcement this morning, I was marshaling my arguments for a hissy fit on how the Bank of Canada's anti-inflation credibility was being shredded by a rookie central banker who didn't realise that his job was to control inflation, not provide cheap credit for Bay Street. I may yet throw that tantrum, but not today.

The move seems to have surprised the market as well:

Bank of Canada startles market with no rate cut:  ... Economists and market players had widely been expecting a small rate cut of a quarter of a percentage point to stimulate the economy as it deals with recessionary conditions in the United States as well as tighter credit conditions.

Economists had also said that the central bank could quite easily justify a more aggressive rate cut to confront a slowdown in Canada, or swing the other way and freeze rates in the face of rising commodity prices. But they hadn't picked up any hints from the bank that anything other than a small rate cut was in store, and they assumed the central bank under Mr. Carney would continue the pattern set by his predecessors of preparing markets for a change in direction.

While it's true that it might have been a good idea to make some sort of signal to the effect that the Bank was not going to lower its overnight target, I have to wonder about the economists who thought that the Bank could "easily justify a more aggressive rate cut". The only economists on the CD Howe Monetary Policy Council who called for a rate cut are employed by banks; of the seven academics on the panel, four called for no change, and the other three called for a rate increase.

Was last November a turning point?

Statistics Canada's March GDP release was the fourth consecutive month in which output failed to go above what it had been in November 2007. So are we going into a recession as in 1981-82 or 1990-91? Or will the Canadian economy bounce back with stronger growth as in 2001-2002?

Before answering, it might be a good idea to look at what happened towards the end of previous expansions. Since Canada doesn't have an equivalent of the NBER's business cycle dating panel, I'm going to use monthly GDP to identify the months that marked the end of the last expansions: April 1981, March 1990, December 2000, and (for the purposes of the graphs that follow) November 2007.

I'm going to use the same graphical device I used here: all variables are logged and re-scaled to zero at the peaks of the expansions (1981:04, 1990:03, 2000:12 and 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.

Let's look at GDP:

Looking at this graph, it'd be hard to dismiss out of hand the possibility that we're already in a recession: the fall in GDP is almost exactly what we saw going into the 1990-1991 recession. But then again, we're not far from what we saw early in 2001, either.

But GDP isn't the only thing we look at. Employment tells a very different story:

In previous recessions, employment continued to rise for a month or two after the peak in GDP. But employment in 2008 is not doing what we'd expect five months after a turning point. Moreover, this increase in employment is being accompanied by strong real wage growth. Real average hourly wages are 3% higher than they were a year ago, and this real wage growth is sustaining retail sales. As Statistics Canada's Philip Cross notes, "A recession does not have record-high auto sales and a very tight labour market."

Finally, here's StatsCan's composite leading indicator:

Again, the leading indicator seems to be more consistent with the 2001-2002 experience than in the two previous recessions.

I suppose I could go through more series (and I may do so in the future as more data become available), but right now, I'd assign a probability between 0.3 and 0.4 that the answer to the question in the title is "yes". Although the GDP data are worrisome (if they weren't, my assessment would be much lower), when set in context of the other data - especially data that are available in a more timely fashion than are GDP data, with its two-month lag - the most plausible scenario is still one in which the declines in GDP are due to transitory events (as discussed in the March GDP release) that do not - yet! - point to a continued decline in output.

The 2008Q1 GDP release: turning point or inflection point?

I thought that yesterday's news about the rebound in the current account was an indication that the first quarter GDP growth would be better than it was in 2007Q4. I thought wrong:

Real gross domestic product (GDP) edged down 0.1% in the first quarter of 2008, its first quarterly decline since the second quarter of 2003. The economy, which had started to lose momentum in the second half of 2007 as exports declined, stalled in the first quarter due to widespread cutbacks in manufacturing, most notably in motor vehicles. In addition, weather disruptions hampered economic activity in the quarter. Economic output contracted 0.2% in March. Final domestic demand advanced 0.6% in the quarter on the strength of consumer spending. Inventory accumulation eased considerably in the first quarter, after two quarters of large build-ups.

The release makes note of three things that appear to be one-off events: bad weather (it was a brutal winter), an auto parts strike, and a rundown in inventories. And since exports have been flat throughout this cycle, I'm not getting too exercised by the slowdown in exports. So there's reason to hope that these last two quarters are an inflection point, and that growth will resume - especially if the US manages to avoid a recession.

But the thing that makes me a bit nervous is the slowdown in domestic demand, since that's what has been driving this expansion:
 

Employment and real wage growth have been holding up pretty well over the past few months, so maybe this is just another one-off blip.

At what point does a sequence of unrelated one-time events become a trend?

Update: I just came across this passage from the Globe and Mail story:

Analysts in Canada have recently focused less on real GDP and more on nominal GDP, which doesn't adjust for rising prices. That's because even while economic output stagnates, much of Canada's prosperity is coming from the money earned from rising commodity prices. Nominal GDP rose 4.6 per cent at annualized rates in the first quarter, and personal disposable income also surged.

Huh? If someone can extract meaning from this, please explain it to me in the comments.

Canada's current account bounces back up

The roller-coaster ride continues:

The current account surplus with the rest of the world (on a seasonally adjusted basis) increased sharply to $5.6 billion in the first quarter of 2008, led by higher prices for several exported commodities combined with a lower travel deficit. The deficits on commercial services and investment income were largely unchanged.

The slow growth in 2007Q4 was largely blamed on a slowdown in net exports.

Exports recorded a significant 2.2% decline in the fourth quarter, in the wake of a rising Canadian dollar and extended holiday shutdowns in several motor vehicle manufacturing facilities. Meanwhile, strong growth in final domestic demand and an accumulation of wholesale and retail inventories drove imports up 2.6%. The drop in exports was the first decline in six quarters, as Canada's international trade balance continued to deteriorate in the fourth quarter.

Tomorrow we'll find out what the implications of this rebound are for 2008Q1 GDP.

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.

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.