On the sources of Canada's recession and recovery

The good news from the latest National Accounts release is that real GDP has recovered its pre-recession peak. In this post, I'm going to review how the Canadian fell into recession, and how it recovered.

As downturns go, this latest episode wasn't all that bad:

I've gone over how the Canadian economy fell into recession a couple of times already; the main exposition is here. The most important mechanism by which the world recession was transmitted to Canada involved the collapse of commodity prices and the resulting deterioration of our terms of trade reduced Canadians' buying power. It was this - more than the fall in output - that made the recession worse than what people were forecasting going into the recession.

Although GDP and employment have more or less returned to their pre-recession levels, GDI is still almost 3% lower than it was in 2008Q3. Worse, it appears that commodity prices and our terms of trade have leveled off.

Here is a chart of how the various components of aggregate demand have contributed to the downturn and the recovery (growth rates are annualised):

In the first two quarters of the recession, the terms of trade shock reduced GDI by 8%, and this had the effect of reducing private domestic demand across the board: consumption, all categories of investment and imports fell in 2008Q4 and 2009Q1. It should be noted that the recession would have been catastrophic if it weren't for the fact that net exports were contributing some 6 percentage points to total GDP growth. Happily, thanks to our independent currency, we were able to avoid this eventuality by means of a sharp depreciation of our exchange rate. (This also explains why I was less than patient with this suggestion that Canada would do well to enter into a currency union with the US.)

Canada's terms of trade improved during the last three quarter of 2009, and so did consumer spending: spending on consumption goods and residential construction - fueled by low interest rates - were the driving force for the recovery in aggregate demand. (It should be noted that government spending has been contributing to growth throughout the expansion.)

Investment spending was disappointing through 2009, notwithstanding the low cost of capital. The most recent news is somewhat encouraging: nonresidential construction was a positive contribution to GDP for the first time, and spending on machinery and equipment - the sort of investment that of most closely linked to innovation and technical progress - was an important part of 2010Q2 GDP growth. There is still a long way to go, though: M&E spending is still 15% below pre-recession levels.

Which brings us to where we are now. GDP is back to what it was, but since potential has increased, the output gap still has not closed. Employment is pretty much where it was, but since the labour force has grown, unemployment is still high. And GDI still has yet to regain its previous levels.

I keep wondering when I should change the category title from 'The current recession' to 'The recent recession'. Not for a while, it seems.

Comments

[Nick Rowe]

"I keep wondering when I should change the category title from 'The current recession' to 'The recent recession'. Not for a while, it seems."
No! That would be tempting fate! Plus, things don't look so rosy in the ROW (aka USA).

The terms of trade were exceptionally favourable to Canada on 08:03, IIRC. Haven't we just returned to normal?

[Mike Moffatt]

I hope a 96 cent dollar isn't *normal*, but I fear Nick might be right.

[Stephen Gordon]

Yeah, I should have mentioned that the fall in the terms of trade was from an abnormally high peak. We're going to have to get that remaining 3% of GDI by increasing output.

[Geoff NoNick]

Ha-ha! That backlink to your delicious smackdown of NAMU "theory" more than makes up for your last few weeks of census obsession. I'm back onboard!

[Paul Friesen]

I still think we need to worry about where this recession is headed. I am afraid that we are going to see some extremely wrong-headed policy south of the border if the Republicans gain more power, as seems all too likely. They could still create a nasty depression there, and that can't be good for Canada.

As far as I am concerned, we should still be applying more stimulus, and it sure is no time for the Bank of Canada to let up on the accelerator.

[Patrick]

"we should still be applying more stimulus"

I'm OK with what we've done. Better to keep some ammo in reserve in case the US decides to self self-immolate.

[Nick Rowe]

Patrick: the ammo metaphor is tricky. For fiscal policy, it has some applicability. If there's a limit on the debt, then there's a limit on how big a deficit you can run for how long. The faster you are shooting, the short the time you can continue to shoot. For monetary policy it doesn't work at all. If you think of monetary stimulus as low interest rates, you can keep interest rates low forever, if you need to. The only limit is it will cause inflation if you keep them too low for too long, but that inflation is a sign you didn't need to. And if you think of monetary policy as printing money, as long as you don't run out of paper or ink...

Plus, as in my old post, bears get bigger as they grow. If you need to shoot a bear, don't save ammo for later. The longer you let it grow, the more ammo you will need to kill it. http://worthwhile.typepad.com/worthwhile_canadian_initi/2008/11/shooting-bears-ammunition-and-central-banks.html

[Patrick]

Nick: I was thinking about fiscal policy in the event that we too end-up in a US style trap... but let's hope it doesn't happen and if it does that the BoC does a better job than the Fed.

[Paul Friesen]

I would argue that we are in such a trap. We have a sizeable output gap even with interest rates at essentially zero. That, to me, is the definition of a liquidity trap. And it seems likely that our economy will get another big negative shock if U.S. policy goes nuts and triggers a further downturn there.

There is no need to "run out of ammo". The government should just issue bonds and the Bank of Canada should buy them up as fast as it issues them.

If it works and the economy takes off, only then will it be time to think about how to get all that extra money back out of the system to prevent inflation, but that is really no problem. Just raise taxes to pay off the debt caused by the stimulus.

How about a GST cut now, coupled with a commitment to raise GST in the future to recoup the loss?

[Nick Rowe]

Paul: I'm more optimistic than you. 18 months ago I would have been a lot more favourable to your proposals. But, if the US gets worse, (and if Europe gets worse), it might spillover into Canada. I can't figure out the likelihoods of those things though.