Worthwhile Canadian Initiative

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.

The Global Effects of U.S. Fiscal Policy

That's the title of a discussion paper (pdf) by Kimberly Flood at the Bank of Canada. This is from the conclusion:

The results of our U.S. fiscal policy simulations show that the expiration of the tax relief from the AMT and the expiration of the tax cuts enacted in 2001 and 2003 can impose short-run economic costs to the U.S. economy. However, in the long run, aggregate demand in the United States and the rest of the world benefits from the expiration of AMT relief and the 2001 and 2003 tax cuts, owing mainly to a corresponding fall in the world real interest rate. Furthermore, the simulations highlight the potentially important role that U.S. fiscal policy adjustment can play in the unwinding of global current account imbalances. In particular, the increase in taxes associated with the expiration of relief from the AMT relief and the expiration of the 2001 and 2003 tax cuts can result in an improvement in the U.S. current account deficit. Nevertheless, this improvement is small compared with the size of the adjustment required to reverse global current account imbalances: U.S. fiscal policy is only one factor behind such imbalances, and will therefore be only part of a successful adjustment package.

The results of our study suggest that the initial expiration of relief from the AMT will:

• reduce the level of U.S. real GDP by 0.1 per cent, on average, over the first five years following the expiration of AMT relief, and increase real GDP by about 0.5 per cent in the long run
• improve the U.S. current account-to-GDP ratio by about 0.2 percentage points in the long run
• increase the level of Canadian real GDP by about 0.5 per cent in the long run

The results of our study also suggest that the expiration of the 2001 and 2003 tax cuts will:

• reduce the level of U.S. real GDP by an average of 0.2 per cent over the first five years following the shock, and increase real GDP by about 1.5 per cent in the long run
• improve the U.S. current account-to-GDP ratio by 0.7 percentage points in the long run
• increase the level of Canadian real GDP by about 1.5 per cent in the long run

Memo to the US Democratic Party from the rest of the world: Please get your act together and win the election. Thank you.

Reactions to the carbon tax: the good, the bad, and the ugly

The good: In addition to being good policy, there's some reason to be optimistic that the Liberals' carbon tax proposal will be good politics. According to one poll, more than 60% of Canadians approve of the general idea of carbon taxes. And even noted environmentalist David Suzuki endorses the idea. David Suzuki can't always be counted on to support sensible policies, but at least this time he's not going to be an obstacle.

The bad: As predicted, the Conservatives are spinning the carbon tax as, well, a tax. And since the CPC is unable to distinguish between smart and stupid taxes, they're coming up with stuff like this.

The ugly: The NDP's response is a confusing jumble of faulty analysis and short-sighted pandering.

Layton raises carbon tax alarm: NDP Leader Jack Layton launched a vehement campaign against carbon taxes yesterday and was quickly accused of alarmist pandering by prominent Canadian environmentalists.

Speaking to a fundraiser for an Ottawa homeless shelter, Mr. Layton said carbon taxes would raise home heating costs and hurt Canadians living on the margins. He said big corporations should bear the lion's share of Canada's climate-change tab and a federal ombudsman should ensure those costs aren't passed on to consumers.

"With energy costs soaring in Canada, we've got to ensure that the solutions to climate change don't aggravate an already dire situation for those who struggle to make ends meet," Mr. Layton said.

He said he supports a cap-and-trade system, which imposes penalties on industrial emissions above a certain level, or cap. Liberals, meanwhile, are preparing to announce a plan built around carbon taxes, which is expected to apply to a wider range of emissions and raise money for environmental efforts.

As far as the consumer is concerned, cap-and-trade will have exactly the same effect as a carbon tax, namely, to increase prices. The only potential difference is who is on the receiving end of that extra spending: with a carbon tax, the government gets the money, and with cap-and-trade, that money is rent for those who own the permits. If the permits are auctioned off by the government, the two programs are essentially equivalent.

But there's more to the NDP's position than a second-order difference of opinion on mechanics; there's also this sentence:

He said big corporations should bear the lion's share of Canada's climate-change tab and a federal ombudsman should ensure those costs aren't passed on to consumers.

It is at this point that one begins to despair of the NDP.

Could someone please explain to Jack Layton that corporations don't pay taxes? Only people pay taxes, and corporations are not people. And the people who pay corporate taxes are not the owners of the corporation, either: the people who really pay those taxes are workers (in the form of reduced employment opportunities) and consumers (in the form of higher prices).

The Liberals and Conservatives understand this point. The CPC is targeting the people who don't want to pay those costs, and Stéphane Dion is going after those who do. The NDP's niche appears to be voters who want someone else to pay the costs of reducing greenhouse gas emissions.

And if you give food to raccoons, they won't come back

From the Toronto Star:

More money for GM despite layoffs, McGuinty says:

Premier Dalton McGuinty says Ontario will give General Motors more money for new projects, despite thousands of layoffs announced by the automaker.

GM wants the Ontario and federal governments to contribute about $140 million towards a new engine plant in St. Catharines, Ont., and a new research centre in Oshawa.

GM has received about $250 million in provincial money, and recently announced layoffs of 1,400 workers in Windsor and about 900 in Oshawa.

But McGuinty says Ontario is still competing with U.S. states to land new automotive projects and must be prepared to pony up some cash.

Why do governments still think that they can win this game?

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.