The OECD Has it All Wrong About Canada

The OECD came out with its Economic Survey of Canada last week and like so many other institutions and commentators before it, has got it all wrong. The report lauded Canada for its fiscal performance but gave it a failing grade for productivity growth. The report, amongst other things, criticizes Canada for its declining multifactor productivity, a measure of output denominated by an assortment of production inputs. The report asserts that multi factor productivity (MFP) has been declining since 2002 and seriously lagging that of the United States. The report adds that Canada’s factors of production mix is skewed heavily towards engineering structures to the detriment of machinery and equipement.

While MFP has been dropping in Canada since 2002, many would argue that looking at labour productivity is more important. Productivity per hour worked in Canada has grown from $156 to $183 from 1997 to 2011 an increase of 17% over the period, far from the alarming trend the OECD reports. Noteworthy however is the slowing growth of productivity growth during this period from a high of 2.61% in 1999 to the present growth of 0.75% in 2011

The error of the OECD report however is one of not looking into the underlying trends and the break down of productivity change by industry. If one breaks down the numbers to find out which industries contributed to the change in the overall economy a few truths become apparent. The slowing growth is mostly attributable to one sector: mining and oil & gas extraction. This sector registered the steepest loss in productivity since 1997 contributing -8.17% to overall per worker productivity in Canada. Virtually all other sectors contributed positively to productivity growth (with the exception of the public sector and its tangents). And since mining and oil & gas extraction is the fastest growing sector in Canada the loss in productivity weights down heavily on the numbers reported by the OECD.

MFP is weighted down even more heavily by the this sector, as much of new fixed capital formation originates from Alberta’s energy industry. So why isn’t this trend worrying? the answer lies in the basics of economics. Productivity in tangible assets tends to lagg investment by tangible assets. Basic macroeconomic models tend to assume a lagg of one year between investment in fixed assets and new production from those assets. But the oil sands development in Alberta is bucking that trend as the magnitude of those  investments is larger than ever before, and the huge oil sands mines of the Athabasca region are unparalleled in history.

Most of the mines under construction take between 5 and 10 years to reach capacity and since the oil sands developments are still relatively new, few if any of the largest mines are near capacity. Production in the oil sands is estimated to double within the next decade while employment will drop as temporary construction jobs in the sector are slated to be replaced by fewer permanent operating jobs.

These trends will lead to a complete reversal of the national productivity contribution of the sector, from the most negative to what will be the most positive contribution. Canada’s over investment in Engineering structures isn’t a fluke accident on the part of Canadian businesses. It is rather a sign that business leaders in the nation understand where Canada’s growth will come from in the future.

What is strange is that these developments are widely known, as the Canadian Association of Petroleum Producers widely communicates them. That the OECD and the Bank of Canada before it, have not picked up on these trends is testament to the short term vision of macroeconomic study at some of the most important economic institutions. One hopes that policy makers don’t get wound up in the noise from these economist and continue to provide policy changes geared towards letting Canada shift economic activity to where the nation has a comparative advantage.

Here’s a Suggestion Mr Carney

The governor of the Bank of Canada Mark Carney has again continued to scold and give lessons to Canadians. He does this in his Monetary Policy Report of April 2012 where he reiterates some of the comments this blog criticized in a previous post. Those comments were that Canadian exporters needed to retool and refocus and that Canadian consumers needed to slow their pace of debt accumulation. The focus of the ‘retool, refocus and retrain’ mantra is largely advocated so as to increase Canadian firm’s ability to compete internationally and export. While this blog has already stated its objection to paternalistic economic communication from government institutions towards the private sector, this blog does accept Carney’s view that Canadian prosperity is underpinned by healthy trade numbers and international competitiveness. There is one criticism the Governor could have levelled that balances private sector independence and improved competitiveness, that critic should be less debt supply and it should be levelled at governments.

Talk of trade competitiveness unfortunately always boils down to currencies. In Canada manufacturers and commentators are always complain about the high Canadian dollar and how many jobs it kills. Leaving aside the fact that a high currency has as many benefits for a country as it has costs, a currency artificially above its equilibrium (or below it for that matter) is however  a concern. Let’s assume that the Canadian dollar is artificially overvalue, who might the culprit be for this imbalance? The Loonie isn’t a reserve currency so that can’t be it. Contrarily to McGuinty’s opinion oil isn’t to blame either. As the Central Bank report notes, Canadian oil is sold at a steep discount to certain international oil benchmarks, meaning that eastern Canada imports at high prices while the west exports at cheap prices, so the impact of higher oil prices only marginally affects the Canadian currency. In any case studies have refuted the claim of the Loonie being a petro-dollar. So who exactly is contributing to the Canadian dollar remaining above par with the US dollar?

To answer that question the certain economic facts need to be reviewed. Commentaries on trade and currencies often emphasize a restricted number of causes for currency fluctuations. Currency movements need to be understood in terms of foreign exchange market equilibrium. Every currency trade impacts the prevailing exchange rate but every trade does not just involve a quick speculation or an oil contract purchase. Much purchasing and selling of currencies involves savings diversification by institutional money managers. To give some colour to this point in 2007 before the crisis hit, foreigners shed roughly ~10 Billion of government paper while exporters sold just over 460 Billion dollars of exports. Since the beginning of the crisis over 400 Billion of Canadian government financial papers have been sold to foreigners. What does all this mean? Government budget surplus reduces the supply of government debt available to foreigners for purchase, a government deficit increases the supply. Since foreigners must buy Canadian dollars to purchase both export goods and government debt, Canadian governments’ profligacies are partially to blame for the high Canadian dollar. Part of their issuance of debt has been sold to foreigners increasing the demand for the Loonie and crowding out exports of goods and services.

Some might be tempted to point to Europe to refute these assertions. They would note Europe’s deficits have widened since 08 while the Euro has generally fallen. This is easily explained by sovereign risk. Canadian government debt is perceived to be a safe investment while much of the Euro area’s debts are considered very risky. Investors the World over generally prefer to buy Canadian debts than those from the PIIGS as they could be described as better quality products. Essentially Canada’s two most popular exports have now become oil and debt, small wonder manufacturing in Ontario can’t keep up. So if Mark Carney is so considered with the twin problem of profligacy and competitive weakness why isn’t he calling for Government austerity?

Bretton Woods Stress Disorder Again?

Did you hear? China is manipulating its currency to enrich itself on America’s back. Were you not aware that the Euro was actually German machinations so that it could out-compete the area’s periphery for its own gain?

There is a lot of talk out there of currencies being used as a form of weapon in the 21st century’s new form of favourite international warfare; economic warfare. Everybody seems to be guilty of partaking in this ‘non-violent’ form of confrontation. China has an undervalued currency pegged on the US dollar. To be fair, over a dozen other countries do too. Half of western African countries have pegged to the Euro as well as a few notable others. Accusations have been leveled against Germany for unduly profiting from the competitive weakness of its monetary partners since the 1992 Maastricht Treaty (and especially since the Euro crisis of 2011). Various central bankers and government officials around the World have called quantitative easing intentional currency manipulation, essentially accusing the US of cheating (the Bank of England and European Central Bank would also be guilty of this in such a framework). Essentially there has been a lot of posturing and indignation flying around focused on this one issue of currencies. I think remembering what a currency really does for an economy could help cool the air.

Some people like to say that currencies function as market mechanisms. Now nothing could be further from the truth. Just because there is a semi-unregulated currency market does not mean currencies are free market instruments. Just like a carbon market is not a liberal concept because trading is free. The collapse of the Bretton Woods system occurred because nations couldn’t compete in a relatively free trade environment. Certain nations were more competitive and the others did not have the political will to increase national competitiveness. A new system arose quite naturally whereby a floating currency did all the work of correcting competitive imbalances. As a nation comparatively slid into economic incompetitiveness its currency would be reevaluated downwards by a free currency market to insure a semblance of equilibrium of balance in trade terms. Essentially governments outsourced the responsibility of putting into place national competitiveness to the markets to avoid labour disputes and imposing fiscal rectitude to national budgets.

So when China pegs its currency to the US’s it is in fact just returning to a Bretton Woods type formula. If a trade balance exists between the two countries it is because the two governments do not share the same appreciation for macroeconomic rectitude. While the US splurges as a nation China saves. While in the US labour movements have the legal upper hand on business (see GM, Chrysler bankruptcies and Boing labour conflicts) in China pro business policies abound (sort of). In essence, the Chinese government does not shy away from imposing strict macro prudential policies on its economy, America elects Democrats instead. So the US’s complaint really resides in its political dithering with regards to economic policy. China’s currency policy is just one of limiting the risk to business of currency volatility. A policy US corporations should be in total agreement with if unclouded by nationalistic sentiment. To sum up a free floating currency is just a political tool to avoid hard decisions domestically.

Let’s remind ourselves of the cost of a free floating currency when a country is profoundly uncompetitive like Greece and even the US. When a country runs successive and deep current account deficits it means the country is chronically living above its means. A free floating currency would drop to correct this phenomenon. Increasing the price of foreign goods to impose a contraction in national living standards. So a country would in theory spend less on imported goods (food, clothing, cars and other discretionary items) to afford overspending in other goods (typically healthcare, education and other entitlements). So next time you see your native currency drop, odds are good that to afford government social programs you and all other individuals will need to buy cheaper food, flimsier cars and smaller houses. I wonder if electors aware of these dynamics would so liberally demand government services if they understood it meant less beer Friday night and less outings to the restaurant. Now some social democrats might argue it’s the price to pay for equity. Remind the next one you see that poor people are disproportionately affected by increased inflation on consumption goods. If they think value added retail taxes are regressive tell them government services induced current account deficits are more so (lost jobs, lost buying power).

So if one believes the Chinese won’t give up the peg and the Euro will survive (both highly likely outcomes) another solution is necessary. The US to take as an example, are doubly guilty of digging there own grave. The US worker remains the most productive of the World by any metric, so why does does the Chinese worker out-compete him (as demonstrated by the gaping trade deficit between the two countries). The reason is because the Americans are doubly competitive. How so? One of the US’s greatest exports with which virtually no country can compete is its government debts! No other financial instrument is more prized than the US’s Treasury Bonds. While the merchandise and trade balances can be negative the balance of payments always equals zero.

So all countries are faced with a straightforward choice; export goods and services or export financial paper (of which government is generally the largest component). Since the US issue so much debt that everybody buys the money cannot be spent on goods! If Barack Obama really wants to double exports in 5 years he can do it in a heartbeat by refusing to sign the next debt level increase legislation to hit his office. Obviously this implies hard political choices which I don’t mean to discount so caricaturally. China’s peg works by purchasing US financial assets, stop issuing them and China will not be able to buy them. The peg will then collapse without outright adoptions of the US dollar. Since China is so hell bent on controlling its internal economy, sacrificing the totality of its monetary policy sovereignty to another country is probably not in the cards.

The lesson while somewhat different for the PIIGS is essentially the same. Get competitive or get punished “à la Grecque”. Stop living above your means. Whether in a monetary union or even in a free floating currency regime, free lunches don’t exists, you’ve got to pay the piper someday. So Brazil and Canada pipe down will you, stop blaming your woes on currencies that refuse to act conveniently to your politics. To the US, ”Buy-American”, quantitative easing et al. are really cheap tricks. To any and all thinking of tariffs and quotas, please look at what happened last time that was tried. So to all China haters in the US or Germanophobes in Greece and the like, blame yourself for being ungovernable first, everybody else is just trying to do their jobs, time you started doing yours.

Cius