Friday, 30 September 2011
Economists — including the OECD, the IMF and Canadian bank economists — are increasingly gloomy about the economic prospects of all of the advanced economies, including Canada. The US, the EU and Canada could slip into a technical recession — defined as six months of negative growth — very soon — and even if this was avoided we are almost certainly in for a long period of very sluggish growth and continued high unemployment.
The major underlying problem of the advanced economies is that the stimulus packages which led to a brief recovery from the Great Recession of 2008 to 2009 have now run out, and have been followed by a shift by governments to austerity and spending cuts. A big chunk of the increase in public debt in many countries — such as the US and the UK — was the result of bailing out the banking system to resolve the financial crisis of 2008 which sank or almost sank major US and European banks. In the US, the UK and some other countries, household debt is also very high and housing prices have collapsed, which means that household spending is very weak just as governments are cutting back.
While China and other developing countries are still growing quite fast, many (notably China which has an artificially low exchange rate) are running large trade surpluses. As a result, very few advanced countries are able to grow through higher exports. (Germany is the major exception.) Most of Europe as well as the US and Canada are thus experiencing little or no recovery in their hard hit manufacturing sectors.
The situation could turn even more ugly if there is another major financial crisis. Growth in Europe is already almost flat as a result of major cuts to public spending in most countries, especially the ones having to deal with high interest rates on government debt. These used to be mainly small countries — Greece, Ireland and Portugal — but Spain, Italy and even France now face much higher borrowing costs than Germany or the US. The fear now is that some countries (Greece first) will default on their debt, which would potentially sink some large European banks and the institutions which have loaded up on credit default swaps which put them on the hook if bond payments are cut. No one really knows who is most highly exposed, which has begun to mean that banks cannot borrow easily from each other.
The only real way out is for the Euro area as a whole to stand behind Euro area debt, so that interest rates fall to or near the much lower levels of Germany. But this demands major changes to the design of the European Central Bank which are strongly opposed by Germany and some smaller countries. Also, it will be very difficult for the countries of Europe with high levels of public debt to grow their way out of the problem if unemployment remains very high in the most affected countries.
The international labour movement is arguing to the G20 — the governments of the largest 20 economies in the world — that the shift to public sector austerity will not solve the public debt problem since it will shrink the economy and raise already high unemployment. Governments should, instead, introduce major public investment programs which create jobs now and also increase future economic growth. Good examples are major public infrastructure and green energy projects.
The other pressing need is to get the countries with large trade surpluses — notably China but also Germany — to allow wages to rise and to import more from countries with high unemployment and large trade deficits.
Further, the task of fundamentally reforming a destructive financial system has been endlessly put off by the G20 must be addressed. Few of the lessons of the 2008 financial crisis were learned, so hedge funds and large banks continue to speculate in financial assets and cause turmoil in the market for government bonds and other assets.
Governments have also failed to recognize the roots of the crisis in rising inequality, rising profits and soaring incomes for the very rich, combined with stagnant wages for the majority of working people. This made growth before 2008 dangerously dependent upon the growth of household debt and speculative bubbles, as opposed to real investment in a balanced economy which creates sustainable shared prosperity through real investment and rising productivity linked to rising wages. The International Labour Organization has called for major reforms of the job market and social programs to improve the bargaining power of workers, seeing this as part of the solution to the problem of very slow growth and high unemployment.
Turning to Canada, economic growth has been very slow this year. Total output and incomes (GDP) increased in the first quarter, but mainly due to a build up of inventories. GDP fell slightly (-0.1%) in the second quarter, and may continue negative in the third quarter.
While total employment in Canada has recovered to pre recession levels, the unemployment rate last month (August) was 7.3%, still well above the 6.0% low registered in 2008 before the Great Recession. The youth unemployment rate is 14.0%. The “real” unemployment rate which counts workers who have given up looking for jobs and involuntary part-time workers is about 11%.
There was virtually no job growth in July and August (1,500 new jobs created over two months.) Moreover, real wages (wages adjusted for inflation) have recently begun to fall.
The Labour Force Survey for August showed that average hourly wages were up by just 1.4% from a year earlier, the same low level of increase as was registered in July. Consumer price inflation was much higher — 2.7% in July, a bit down from 3.1% in June and 3.7% in May. Union wage settlements in the second quarter averaged just 2.0% (and were lower in the public sector).
If real wages continue to fall due to a very weak economy, it will further undermine a weak recovery, negatively impacting upon consumer spending and perhaps serving as the tipping point to a major fall in house prices.
The recession in Canada was somewhat less severe than in the US for three key reasons. The resource sector (oil and gas and mining) has benefited from high prices driven by strong growth in China. The infrastructure part of the government stimulus package — which the Conservatives were forced to adopt after the threat of a coalition government — helped construction, and a somewhat improved Employment Insurance program temporarily maintained the incomes of the unemployed to a significant degree, even though half of all unemployed workers still fell through the cracks. And low interest rates have supported house price construction and held up housing prices.
However, prospects for the Canadian economy are not very good looking forward.
Manufacturing has not recovered in a significant way since the depths of the recession, which came after a long period of job losses dating back to 2002. The key problem is the very high Canadian dollar which puts us at a severe competitive disadvantage in the already depressed US market compared to US and Asian companies. Canada is now — despite high resource prices — running a significant trade deficit with the rest of the world. The resource sector, which now accounts for about two thirds of exports, is not big enough to pay for all of the manufactured goods and services which we import.
Canada came out of the recession faster than the US because, somewhat surprisingly, very low interest rates led to a recovery and then expansion of the residential housing market.
Low interest rates are still fuelling the expansion of household debt, especially residential mortgage debt which rose by $75.4 Billion or 7.6% in the year to May, and is still rising on a month to month basis. House prices are still rising. Consumer credit debt, some of it fuelled by home equity loans based on rising house prices, is also still rising.
This continued expansion of household debt is, however, very unlikely to continue given a weak job market, falling real wages, and the fact that household debt is now at an all time record high of 150% of after tax income. Moreover, housing prices are likely to fall, perhaps sharply, in the not too distant future.
Since about 2000, house prices have been rising much, much faster than consumer price inflation and well ahead of the growth of household incomes and rental costs. The average house price is now 5.2 times greater than average household income, up from a normal ratio of 3.2 times in the 1980s and 1990s. Due to increased mortgage debt, the ratio of household debt to disposable household income is now at a record high of 150%, just a bit below the US level before the housing bubble in that country burst. TD Economics estimates that house prices are 10-15% over-valued, and that is pretty conservative.
Low interest rates have kept mortgage costs relatively low and maintained some semblance of housing affordability for a surprising long period of time. But what must come to an end will, indeed, eventually come to an end.
As and when household borrowing slows, the Canadian economy will have to be driven by either (1) an improved trade and balance of payments with the rest of the world (2) expansion of business investment or (3) increased public investment. Given that business investment in Canada is led by the export-oriented resource and manufacturing sectors, scenarios (1) and (2) are closely linked.
The most recent data show that business investment has picked up a bit in recent months, but it remains well below pre recession levels despite the fact that corporate profits are very healthy and many companies are sitting on a lot of surplus cash. And much of the investment that is taking place is in the energy and mining sectors. Cuts in corporate income tax rates will not raise investment in the resource sector but will simply boost high profits and reduce government revenues. A much more effective way to raise investment, especially in the hard-hit manufacturing sector, would be to provide investment tax credits to companies investing in new machinery and equipment, research and development, and worker training.
Meanwhile, government spending is on the point of beginning to fall as federal and provincial cuts begin to bite in terms of overall spending and in terms of jobs. Total public spending is being cut by about 1% of GDP in 2011 and in 2012, enough to tip us into a recession if growth in other parts of the economy stalls.
The odds of a Canadian recession are thus pretty high, if there is no change in government policy.
The Conservative government focus is very much on large spending cuts to quickly reduce the deficit, even though total Canadian government debt is very low. Total Canadian net government debt is just 33.7% of GDP compared to an OECD average of 62.6%. Further, interest rates are at historically low levels. The Government of Canada can borrow through 10-year bonds at less than a 2.5% rate of interest. But, despite low debt and low interest rates, Canada is cutting spending more deeply than most other advanced industrial countries.
The federal government annual fiscal deficit is already very small, standing at just 1.9% of GDP this fiscal year. The June 2011 federal budget forecasts that the federal deficit will fall from 1.9% of GDP in 2011–12 to just 1.1% next year, to zero in 2014–15. This fall in the deficit is mainly due to already-announced cuts to federal government program spending which will fall from 14.5% of GDP this year to 13.1% of GDP in 2014–15.
Spending cuts at both the federal and provincial levels will shrink the combined Canadian government deficit from 4.9% of GDP in 2011 to 3.5% in 2012, according to the OECD. This will have a negative effect on the economic recovery and job creation. According to IMF staff economists, a one per cent of GDP cut to government spending reduces the size of the economy by 0.6%.
On top of frozen operating budgets and the results of earlier strategic reviews now being implemented, the federal government plans to achieve another $4 billion in annual savings by 2014–15 through the Strategic and Operating Review. The aim of the Review is not just to cut the deficit, but also to free resources to fund the new round of income tax cuts announced by the Conservatives in the 2011 election. The proposed expansion of Tax Free Savings Accounts and the introduction of income-splitting for families with children will largely benefit affluent Canadians.
The CLC budget brief argued that the priority in the 2012 budget should be maintaining the momentum of the recovery and creating jobs, not artificially speeding the pace of deficit reduction through counter-productive spending cuts. It is already clear that these cuts are not only eliminating jobs, but are also reducing important programs and services.
We recommended that federal government program spending be maintained at the current (2011–12) level as a share of GDP, and that the Strategic and Operating Review be cancelled. There should be continuing review of the efficiency of government programs, but any savings should be directed to financing new priorities, such as an improvement in the Guaranteed Income Supplement and Employment Insurance benefits, as well as job creation programs, and a national child care and early learning program.
We have called for the federal government to launch, in partnership with the provinces and cities, a major, multi-year public investment program which would create jobs now, promote our environmental goals, stimulate new private sector investment, and boost productivity.
Such a program should include increased support for basic municipal infrastructure; mass transit and passenger rail; affordable housing; energy conservation through building retrofits; and renewable energy projects.
Federal government support for all infrastructure and environmental investments should be linked to “Made in Canada” procurement policies, so goods and services inputs are purchased in Canada. The US plans to attach Buy America requirements to its proposed new Jobs Program to make it more effective in terms of boosting jobs, and there is no good reason for us not to do the same. The recently expired Canada – US agreement on government procurement gave us access to only a tiny sliver of the first US stimulus package, at the cost of much greater US access to our market. Infrastructure investment should have a mandated training component to help deal with looming skills shortages.
The federal government should also make investments in a national, not-for-profit child care and early learning program; home care as part of the public health care system; and long-term care for the elderly. These programs would create new jobs while promoting our social goals.
Economic research shows that many major public investments are largely self-financing since the positive impacts on economic growth and on private sector productivity boost future government revenues. For example, the Toronto Board of Trade argues that major investment in mass transit would substantially reduce business costs due to traffic congestion, boosting productivity. And leading Quebec economist, Pierre Fortin, calculates that the annual cost of the Quebec child care subsidy is covered by the benefit of the increased labour force participation rate of parents of young children, and by better outcomes for children.
The initial costs of a major public investment program should be covered by raising the federal corporate tax rate from 15% in 2012 to 19.5%, which would raise $9 billion per year in additional annual revenues.
Canada has a very low level of public debt, borrowing costs for the federal government are and will remain very low, and many public investments yield a high rate of return in terms of immediate job creation, public benefits, and growth of private sector productivity. Given that the economic recovery is now in trouble, there needs to be a major shift in government policy.
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