On the form of the Canadian recovery

There's a certain amount of speculation about the form of the US recovery, based on scenarios of how its economy will work its way out of a balance sheet recession. As I understand it, the main candidates are (in alphabetical order):

• U: The US economy grinds along as households deleverage themselves, and the economy picks up when consumers have paid off a sufficient amount of their accumulated debt.
• V: The various stimulus measures manage to provide a bridge to the point where the US economy can expand on its own.
• W: The various stimulus measures succeed only in providing a temporary boost, and the US economy goes back to grinding its way back out of the recession.

If Canada had fallen into recession for the same reasons that the US did, then a discussion of what its recovery will look like would follow similar lines. But Canada's recession occurred for very different reasons, and our recovery won't look the same as that of the US.

As was explained at great length over here (do take the time to go and read it: it's one of my favourite posts), the driving force of the last Canadian expansion was the increase in our terms of trade (the ratio of export prices and import prices) generated in large part by the increase in commodity prices. So long as they held up, Canada's economy was able to continue to grow even after the US fell into recession in December 2007. (This is also why we aren't condemned to have a slow recovery even if the US economy stays in low gear.) But when credit markets seized up in the wake of the Lehman Bros collapse, commodity prices crashed and brought our terms of trade down with them.

As credit markets and trade picked up again, so did commodity prices and our terms of trade.

It was noted in the beer-and-pizza post that there are two mains ways of seeing an increase in Gross Domestic Income:

• produce more (that is, increase GDP), and/or
• being able to trade what you make at a more advantageous rate

This is essentially the same thing as saying that workers can increase their purchasing power by either working more hours, or by getting an increase in their hourly wage.

The fall in the terms of trade accounted for more than 2/3 of the reduction in GDI between 2008Q3 and 2009Q1, but their contribution was positive in 2009Q2. And to the extent that we can be cautiously optimistic about the prospects of sustained growth in Asia and elsewhere, commodity prices should continue to be a source of GDI growth.

On to GDP. Here, it's instructive to compare the recent cycle with cycles past.

The following graphs show the shares of changes of the components of aggregate demand as a percentage of cumulative changes to GDP over the business cycle phase, so the sum of the changes of consumption, investment, government spending and net exports all add up too 100 for each expansion, and -100 for each recession.

First up is how the three previous expansions have played out:

Once again, it's important to note that during the last expansion, net exports were a drag on GDP growth. This was due to the improvement in our terms of trade: we were able to exchange the same level of exports for increasing amounts of imports. The increase in GDP was driven by increased spending on consumption and investment goods.

Here is the same graph for recessions. Since the 2000-2001 episode hardly qualifies as a recession, it has been omitted:

In the US, people are being warned that this recession is different from the other ones they've seen in the last generation or so. Previous recessions were largely due to a tightening of monetary policy, so when the Fed moved the raison d'être of the recession, the economy bounced right back up. This time is different. As was the case for Canada in the first half of the 1990's, the US economy is going to have to undergo some structural adjustments before sustained growth can occur.

But this narrative doesn't fit the current Canadian context. Our recession was caused by a temporary fall in commodity prices and the credit crunch. Both have since corrected themselves, and they both look to continue correcting themselves in the near and medium term.

Another point to note is that the reduction in GDP in this recession has been almost entirely due to a fall in investment spending (which includes construction spending). And since investment spending is the element of aggregate demand that is more sensitive to interest rates, there's reason to hope that today's ultra-low interest rates - and the prospect that they will persist until well into 2010 - will provide a boost there. Indeed, there are already signs that the construction sector has started to rebound.

To sum up:

• The reasons for the recession (falling commodity prices, the credit crunch) have been removed.
• Interest rates are very low.
• Fiscal policy is moderately expansionary.

It looks to me as though the recession will be a milder version of the V-shaped 1981-82 recession.

Comments

[Curmudgeon]

The US fell into meltdown because the consequences of spending strangling real wage growth for 30 years finally caught up with them. They're not going to avoid an L-shaped scenario unless the elite consensus shifts far enough to recognize that allowing real wage growth for the bottom 99% is neither inflationary or 'anti-American.' Consumer deleveraging alone is not adequate if wages simply do not support consumption above bare essential levels.

The shape of a Canadian recovery will depend very heavily on non-American demand for commodities and how easily we can re-target our exports away from the (sinking) US market. Notably, on this front, China's push towards green tech does not bode all that well for the value of our oil resources.

L for the US. W for Canada.

[Andrew F]

Curmudgeon, China's shift away from oil will be a long term story, not something that happens in the next few years. It's too large a ship to turn quickly.

Stephen, thanks. This post was really helpful in clarifying how the Canadian story seems to differ from the US. The other message I'm getting from you, which you and Nick have said before, is that fiscal policy isn't what we needed, and that monetary policy will do the heavy lifting to get us out of this recession (beyond rebounding demand for commodities). Do you think it might be wise to curtail expansionary fiscal policy?

Is there anything to quality of investment spending? Does investing in housing make sense if it means Canadians will just burden themselves with mortgages that will be a whole lot less affordable when rates rise in a few years?

[Stephen Gordon]

That's a good question; it'll be interesting to break down that investment series. Soon.

[jg]

This is another great post Stephen; it really helps put things in perspective and you never this kind of well-thought analysis in major media outlets. 1 point, however;

If Canada's hopes for climbing out of the recession are so intertwined with our Toft, it seems to me like we are very, very dependent on highly volatile commodity prices. I probably buy the argument that oil at $70 and gold at $1000 is sustainable in light of EM and Chinese demand, but are we sure? What if oil goes back down to $30 or $40 if the US double-dips into recession and credit markets seize up again? We're screwed? It's only 10 years ago that oil was at $10. Global demand structure might be different now, but surely we should not assume that current prices are necessarily here to stay.

[Stephen Gordon]

Yes, the volatility of commodity prices is a worry. But I think that there are good reasons to think that the trend will continue upwards for the medium term.

[Kosta]

A lovely post, I really like your arguments, and certainly hope they accurately predict a quick recovery for Canada. But I wonder if there will be some regionality to Canada's recovery. Will provinces more dependant on manufacturing have a harder time recovering? Ontario in particular seems to be more dependent upon US markets, do you foresee them deviating from the national path to recovery?

[jg]

Stephen, I also think that there are good reasons to think the trend (for commodity prices) will continue upwards, but it is not very hard to find very worrying signals in the short term. For example:

Baltic index hits 4-month low on slow China demand (Reuters); or

Oil traders are paying the most ever in the options market to protect against a drop in crude prices. (from FT alphaville)

All in all, I think it is worrying that Canada is so dependant on commodity prices. And as Kosta says, this does have massive implications for the distribution of income across the country.

[learning james]

Care to speculate a little not just on income by region, but for people in different rungs in the ladder ? I read it here that aggregate data may not tell us as much as we would like to know.

[Too Much Fed]

I believe that learning james is asking a good question about wealth/income inequality.

[Stephen Gordon]

Indeed. Sadly, I don't have an answer. My guess would be that if we revert to the path of the last expansion, previous trends will continue.