The Bank of Canada says it believes the recession has ended. Maybe they are right; I haven't checked, but I get the impression that their forecasting has been better than most over the last year. This doesn't mean that output and employment will immediately return to normal, of course. But it does mean, if they are right, that output and employment will stop falling. Or at least, that output will stop falling, because employment normally lags output.
I don't know if the Bank of Canada is right. It might be. And I'm certainly feeling less worried than I was back in the Fall and Winter. I want to ask a different question: what are the biggest risks to recovery? Here is my list of things that might still go badly wrong:
1. The exchange rate. I always pay a lot of attention to the exchange rate, because it is one of the most important relative prices in a small(ish) open economy. But I don't normally worry about it much, because in normal times the Bank of Canada can offset an unwanted exchange rate appreciation by cutting interest rates. But it can't do that now, and I'm not sure if the Bank would be willing to pursue an aggressive enough unorthodox monetary policy to counteract an appreciation of the Loonie.
In normal times I also think I understand exchange rate determination, at least in theory. I don't think I understand it very well in these abnormal times, with interest rates stuck at the lower bound. (And I don't think anyone else does either).
In the long term the US dollar needs to and will depreciate (in real terms), as the US switches the composition of demand away from consumption and towards net exports. And it needs to do that because of the high level of net foreign debt. Net exports are the way the US repays principal and interest on its foreign debt. So I expect the US dollar to depreciate against most currencies, including the Loonie. This depreciation of the US dollar has been postponed by the initial flight towards liquidity during the financial crisis, and by the large US fiscal stimulus. But sooner or later it must depreciate, and the Loonie appreciate even more than it has currently appreciated.
There is a risk that the Loonie could appreciate more than rising demand for Canadian-produced goods could warrant, and the Bank of Canada might be unwilling/unable (I'm ducking that distinction here) to stop it.
2. House prices. Teranet says Canadian house prices fell about 9% from their peak to April 2009 (their latest data). Less reliable data suggests there has been a recovery in sales and prices since April.
There are two views on the future of Canadian house prices. An optimist could argue that there was less of a bubble in Canada; that the recent recovery is real, and will continue, driven by low real interest rates that will stay low in future, as world savings stay high. A pessimist could argue that the current recovery is local, and temporary, and that Canadian house prices were in a bubble, and must eventually follow US house prices down as the bubble bursts. If the pessimists turn out to be right, most of the financial losses would be born by CMHC (and thus the government), but there would be some colateral damage to other Canadian financial institutions, and to home building, furniture sales, consumer credit-worthiness, etc.
3. Changing composition of demand. Even if aggregate demand recovers, the composition of demand may be very different than it was before the financial crisis. If so, there could be an increase in the natural rate of unemployment as structural unemployment increases -- a mismatch between the demands and supplies for different types of labour and other resources. It's not only the AD curve that shifted left, in other words. The LRAS curve shifted left too, and it will take time for the structure of the economy to change to match the changed composition of demand. Any attempt to push AD to grow faster than the supply-side can adjust will only result in inflation rising above target.
Why might the composition of demand change? If the US changes the composition of its demand away from consumption and government spending towards net exports, that will probably affect the composition of demand in Canada too, since exports represent about 40% of Canadian demand, and the US represents around 80% of our exports.
4. The Eurozone. I don't follow the Eurozone very closely. But I get the impression that a lot of Eurozone banks are very highly leveraged, and have a lot of dodgy loans, especially in Eastern Europe. Lacking a central fiscal authority to match the central monetary authority, it will be harder for those Eurozone banks to be bailed out if a major default triggers a liquidity/solvency crisis. A Eurozone financial crisis could be about the same scale as the US financial crisis, and would be harder to fix. That's not a specifically Canadian risk, but it is a risk to world recovery, and Canada trades goods and finance with the world. It's probably the biggest risk to world recovery that I can think of.
Well that's my list of the biggest risks to Canadian recovery, ordered roughly in terms of expected damage (probability of occurrence X damage if they do occur).
What big ones have I missed? (It's the "unknown unknowns" that get you).
A general collapse in commodity prices could derail any incipient recovery in the Canadian economy. I'm not sure what would cause such a collapse, although couple of possibilities come to light. I think the most obvious possibility is if China's recovery stalls for whatever reason, commodities will drop in price.
Posted by: Kosta | July 26, 2009 at 12:59 PM
I agree that the recession may be over technically (I chickened out in my own forecast and put Q3 at about 0%), but I find the 3% growth in 2010 a little harder to stomach.
It seems to me that the BoC is too optimistic about personal consumption expenditures and residential investment leading the economy out of the recession. Isn't it possible that households are going to look to improve balance sheets by cutting consumption and increasing saving, particularly given the wealth effect from decling equity markets and home prices. Moreover, household debt in Canada is something like $1.3 trillion or around $100K per home and the unemployment rate is still increasing.
Posted by: brendon | July 26, 2009 at 03:33 PM
I would add:
a) inevitable tax increases (or the expectation of tax increases), perhaps particularly in the US, driven by mounting deficits;
b) the next big wave of debt default in the US - commercial real estate;
c) I see the changing composition of demand as inevitable and therefore a crucial aspect of the recovery, although your point that the processes first of determining to what sectors resources should be reallocated and second of reallocation itself will be time-consuming is correct, I'm sure. My concern is that government stimulus, either in the form of fiscal measures or credit allocation by the monetary authorities, will be biased in the form of preserving the status quo, thereby obscuring and slowing the ultimate path of restructuring.
d) Further to your point about the exchange rate, one cannot help but wonder whether over time the dominance of the US dollar as a reserve currency may decline as countries make bilateral arrangements involving other currencies, diversify reserve holdings over time away from US dollars, China potentially begins to move towards convertibility of their currency, high growth countries such as China and India begin to represent significantly larger parts of the world economy, etc. This could show up in the near term in the looney if in fact China is stockpiling commodities as a means of diversifying reserve holdings.
Posted by: David Stinson | July 26, 2009 at 03:36 PM
Kosta: I agree that a collapse in commodity prices could be bad for Canada. But what would be the scenario under which global growth (or China's recovery) stalls? The Eurozone banks would be my candidate.
brendon: "Moreover, household debt in Canada is something like $1.3 trillion or around $100K per home and the unemployment rate is still increasing." which must mean there's a $1.3 trillion credit somewhere else in Canada ;). If output stays constant, then income stays constant, regardless of what happens to unemployment. Changes in employment, given output, only change the distribution of income.
David:
a) I saw the inevitable US tax increases as part of the change in the composition of US demand from consumption to net export based. But I expect you could argue that, with the US being large, it would represent a contraction in world fiscal policy.
d) interesting angle. You think that China etc. may be stockpiling commodities rather than US Tbills? That makes me think back to my post about whether real interest rates could ever go very negative. I argued that households would store cans of beans. Maybe it's not households, but China!. But If you want liquid reserves, I'm not sure that commodities would fit the bill. If everyone else were trying to sell reserves at the same time, the price of beans may drop. Households, on the other hand, are born with a short position in cans of beans. They can always eat the beans.
Posted by: Nick Rowe | July 26, 2009 at 04:35 PM
Nick, I'm not so sure the dollar will fall. Nor am I at all sure that the US trade deficit will shrink, at least in the next 50 years. Doesn't it seem likely that Asian trade surpluses will get larger and larger as Asia develops? In that case why wouldn't western countries with high rates of immigration (US, Australia, Spain) run big deficits? (Yes, I know, Canada doesn't fit my theory.)
Generally I think your list a a good one. From what little I know I am more optimistic about Canada than I am regarding the US, but then the grass always looks greener . . .
Posted by: Scott Sumner | July 26, 2009 at 10:26 PM
Scott: I'm not sure either. Higher population growth rate (due to immigration or births) would mean higher investment. Roughly I would guess that a 1% point increase in the population growth rate would increase investment/GDP by about the same 1% point. But I would expect the US savings/GDP rate to increase by more than a couple of percentage points.
But even though immigration and population growth rate are higher in the US than in other countries, I don't expect them to increase. Whereas I do expect the savings rate to increase compared to the past few years.
And if US national savings rises relative to investment, net exports has to increase, which means a real depreciation of the US$.
Posted by: Nick Rowe | July 26, 2009 at 11:10 PM
I would add one more thing that Pr Gordon discussed many times, namely the impact of the long-term structural shift away from manufacturing. All these jobs that are gone and that will not be coming back could keep unemployment high for longer than usual if the labour force is not able to find work in different areas of the economy. If Canada is stuck with high structural unemployment, recovery could be depressed for some time.
Posted by: jg | July 27, 2009 at 10:27 AM
I'm curious about the age structure of the newly unemployed in this recession. I'd guess that anyone who is in their 50s and older will never regain meaningful employment and will retire much poorer than they had hoped/planned. I guess that will reduce unemployment eventually.
Posted by: ramster | July 27, 2009 at 12:06 PM
The reason I worry about Canada experiencing a Japan-style lost decade is that our demographics are starting to look more like Japan's. And that could be bad for the economy for a whole load of reasons: declining productivity; (I'm paid a lot more than I was 20 years ago, but am probably not much more productive - probably less productive); life-cycle trends in spending and saving (older people don't buy as much stuff); tax breaks to over 65s causing a decline in tax revenue; the need to care for, or pay for the care of, less healthy older people, plus to pay for pensions etc., will either create deficits or create a need to increase taxes thus suppressing growth.
My theory: Canada's young for a variety of reasons won't buy into the whole let's-care-for-over 65s-through-our-taxes theory and will opt out. As jg says, manufacturing is going/going/gone. New jobs are in small businesses, who face a high relative cost of complying with taxes etc., and a low relative cost of evasion. Eventually we'll reach a new low tax/low spending equilibrium, but it will be painful getting there. I just hope I get in a few more years sucking at the trough... have to save for the kids!
Posted by: Frances Woolley | July 28, 2009 at 08:54 AM
Nick, Why do you think the US savings rate will increase?
Posted by: Scott Sumner | July 28, 2009 at 03:27 PM
jg: my view is that slow steady structural shifts do not cause unemployment. All that happens is that fewer young workers enter the declining sectors, and they decline as workers retire. So the slow steady decline in manufacturing employment is not a problem. It's the sudden unanticipated structural shifts that cause the problem.
ramster: I don't know about the age-structure of unemployment in this recession. Normally it's the new entrants that get hit hardest. Firms stop hiring before they lay off workers. StatsCan gives separate figures for the under and over 25's, but I don't know if they break it down more finely.
Hi Frances: That's a depressing comment ;). I thought that Canada's demographics weren't as bad as many developed countries. It's not so much immigration (though that may help), as a higher birthrate (don't immigrants have more kids??). I don't see why we should save for our kids inheritances, if they won't support us in our dotage!
Scott: I think private US savings will decline (EDIT: I meant INCREASE) (compared to the last decade, not compared to now) for 3 reasons:
1. It was so abnormally low a few years back.
2. A lot of people ran up debts that they will need to repay (and unlike Canada this did mean an increase in net debt, financed by foreign borrowing).
3. Because a lot of people have been scared by recent events (house prices can fall, you can lose your job, depressions can happen, etc.)
And government savings will rise for much the same reasons (except replace 3 with:
3' governments need to build up a reserve of borrowing capacity for emergencies.
Nothing very deep or novel; just the usual stuff.
Posted by: Nick Rowe | July 28, 2009 at 09:08 PM
China, eg.
http://mpettis.com/2009/07/notes-on-a-real-estate-trip-in-china/
http://mpettis.com/2009/07/squeezing-out-the-exporters/
Posted by: Peter | July 31, 2009 at 12:15 AM