How does an appreciating Canadian dollar prevent improvements in innovation?

Dan Trefler's op-ed in Saturday's Globe and Mail had this passage:

Do we want to be an innovation-based economy? Or do we want to be a resource-based economy? Unfortunately, we can’t be both. The loonie won’t let us.

Why can't we be both?

It seems to me that Dan's point is not an argument about business cycle policy and whether or not the recovery is strong enough to cope with the deflationary effects of an exchange rate appreciation. Rather, it is an argument that the relative price movements behind the sectoral shift from manufacturing to resources will have negative long-run effects on innovation.

I don't see why this would be the case. At the micro level, the effect of an exchange rate appreciation is to increase the relative prices of domestic factors of production over imported inputs. In Canada, this means an increase in the relative price of labour (which is entirely domestic) compared to the cost of capital goods (much of which is imported). If innovation is more likely to occur in environments where firms have easier access to new equipment, then these sorts of relative price movements should be welcomed.

Indeed, if we look back on the 1990s - when the dollar was depreciating and the manufacturing sector was expanding - it was often remarked that Canadian firms were simply taking advantage of lower labour costs and not investing enough in new capital. I'm unaware of any study showing that the 1990s was a period of higher-than-average innovation among manufacturers.

Nor do I see why the examples of outsourcing on the part of Canadian firms such as Manulife, Bombardier and RIM are problems in themselves. It is presumably the case that the high-wage innovation is still being done here, and that it makes sense to have the more routine work done where wages are lower. I would be more concerned if Canada were on the other side of these exchanges.

I can see the merits of policy initiatives aimed at making sure that adjustments proceed at a measured pace: wage spikes that induce people to drop out of high school are something to be avoided. But it's still not clear to me how higher resource prices will slow innovation. If anything, a high-wage environment will oblige firms to be more inventive in finding ways to make best use of their labour forces.

Update: Go read Mike Moffatt's take, if you haven't done so already.

Comments

[Wendy Waters]

Thank you. The Trefler article puzzled me in that his argument went against most economics that I've read / been taught. And I can't find any evidence that Canada isn't offering innovation. Look at the Polar Mobile announcement today (making hundreds of new aps for Microsoft phones, in Toronto).

Also, perhaps an economist here can confirm this, but hasn't the GDP contribution of manufacturing in Ontario stayed roughly the same over the past 5 years, while the CAD has increased in value and while jobs have declined--thereby indicating a shift toward higher-end, more innovative manufacturing (pharmaceuticals rather than tractor parts)?

Once Ontario/Canada completes the shift to manufacturing higher-value, higher-innovation goods, is there not an argument that the jobs will follow?

[Patrick]

Sorta OT: As manufaturing uses more technology - especially IT and automation - it becomes really hard to tell the difference between a manufaturing job and service job. Example: is the guy who works for the firm that services the chemical manufaturers control system working in manufacturing or is it a service sector job? And the same worker could be at a chemical plant one week and an oil sands operation the next.

[Mike Moffatt]

Patrick: That's a great point. I've always liked Greg Mankiw's question of how to classify someone working at McDonald's - service or manufacturing?

I just gave my thoughts about the Trefler piece in a new blog post. I didn't wholly agree with Trefler's argument, but I'm very glad he brought up the issue in the Globe.

[Neil]

What really irked me about the Trefler column was the assumption that resource extraction doesn't involve any innovation. It's all part of the "manufacturing is special" mentality, and just doesn't make much sense.

[Just visiting from Macleans]

I can see the merits of policy initiatives aimed at making sure that adjustments proceed at a measured pace: wage spikes that induce people to drop out of high school are something to be avoided.

This is the key concern of mine as well.

Doesn't the Fed revenue spike through higher tax revenues from resource based industries risk higher Fed program spending - exceeding growth and inflation (on a per capita basis) but hidden on a pct GDP basis?

I know this is a point of disagreement between you and say Coyne as to the appropriate measure.

[Wendy Waters]

Following up on a couple points above...resource extraction in Canada is now very dependent upon high value add contributions from engineers, geologists, finance experts, and other specialists. The techniques to extract natural gas from the shale layers in the earth, such as fraccing and horizontal drilling, for example, have revolutionized the natural gas industry and now some pockets of the oil industry (horizontally drilling for oil in Sask, for example). These techniques I believe are largely Canadian innovations/inventions. (This is all not to mention the techniques for extracting usable oil from the oil sands, which also required a lot of engineering innovation, construction, mechanics, etc.)

Maybe it's Canadian innovations that are fueling the resource extraction dominance of the economy (and not resource extraction that is hurting innovation).

[Roland]

In a globalized world with maximum relative advantage, Canada unsurprisingly reverts to primary resource extraction as the basis of its economy.

The energy resources at the heart of that primary sector are non-renewable.

The skilled and specialist elements in resource industries have always been present--no more today, relatively speaking, than in the past. So it's nothing to boast about.

The resources are very unevenly distributed in a regional sense, which can be troublesome politically.

As for high exchange rates hurting us, that's one of the problems associated with "Dutch disease," the negative impact of raw material exports on other sectors in a trading economy.

I wouldn't worry about "wage spikes" until such a time as labour becomes more expensive to import. Much of the developing world has an aging demographic profile, but the impact of worldwide declining fertility won't be felt much in the Canadian labour market for at least 15-20 years.

Look at trajectory of median wages in Canada. Relax, buddy, the proles can't make much nuisance for a while yet.

Of course, with all the monetary stimulus being tossed about in vast heaps, high inflation is a possibility in the next decade, and that could cause labour unrest. However, it looks like the main inflationary impact of US and other Western monetary stimulus is being felt in double-digit inflation in mainland Asia and the Middle East, rather than in reflating their own economies.

[Determinant]

Stephen:

You forgot that Canadian firms and that includes domestically-incorporated subsidiaries of foreign corporations also book their revenues and profits in Canadian dollars. Thus an appreciating dollar really does cut into the bottom line because the revenue stream for manufacturers is usually US dollars.

This directly affects capital investment because it reduces the revenue available to reinvest directly or the profit stream used to service debt used for capital improvements.

You can say that it's a wash when you turn around and import equipment from the US, but anything complex isn't as easy as that and the friction between CAD expenses and USD revenues is significant.

[Stephen Gordon]

I don't recall claiming it was a wash.

[Determinant]

I was anticipating an expected retort to my argument.

[GA]

If Mankiw gets to ask whether someone at McDonald's works in services or manufacturing, we can also ask whether someone in oil sands production works in resource extraction or manufacturing. I don't know, just asking.