Tiff Macklem: Regearing our economic growth
Text of the W Edmund Clark Distinguished Lecture by Mr Tiff Macklem, Senior Deputy
Governor of the Bank of Canada, at Queen's University, Kingston, Ontario, 10 January 2013.
* * *
Introduction
It is a pleasure to be here at Queen's. I discovered my passion for economics and its
potential to inform public policy as a Queen's student. I also developed a passion for a smart
and attractive Queen's Commerce student when I was here and we have been married now
for more than 25 years. Our oldest son is currently a fourth-year Queen's student - soon to
be a graduate, I trust. And before all of us, my father went to Queen's. So Queen's has long
played a big role in our family and I always like coming back.
It is a particular honour to be here to deliver the W. Edmund Clark Distinguished Lecture. Ed
Clark had an illustrious career with Canada's federal public service before becoming a leader
in the financial services industry. His success in both the public and private sectors, and
particularly his contributions to building a stronger Canadian economy, is an inspiration to us
all. So it is fitting that I will talk today about building on our economic strengths.
As you know well, how you meet academic challenges depends a great deal on your
preparation, determination and confidence. The same can be said of economic challenges.
In my remarks today, I will review how these very qualities helped Canada outpace other
major advanced economies through the recent global recession and recovery. I will also
suggest that to maintain our leading position we need to build on our strengths, with
determination and confidence, and rotate our growth so it is less reliant on credit-financed
household spending and more geared to exports, investment and innovation.
I will do this in two parts. I will begin with an 8-minute version - the short story, if you will.
Then I will use the luxury of time afforded by this lecture to develop the short story in more
detail and provide supporting facts and analysis along the way.
The short story
When you read the international economic and financial news, it is easy to feel queasy. The
U.S. economy is experiencing its weakest recovery since the Great Depression and must
now confront its fiscal realities. The euro area has fallen back into recession and must
refound itself. The Japanese economy is floundering.
By comparison, Canada has done well. We had the shortest recession and the strongest
recovery among major advanced economies. Indeed, Canada is unique among this group to
have regained its pre-recession level of both real GDP and employment (Charts 1 and 2).
Canada is by itself in an expansion.
Why have we done so well?
It would be a conceit to think it is because we're smarter, better educated, more inventive or
harder working. The truth is more humbling.
We had our crises earlier.
In the 1970s, we lost our monetary anchor, and suffered the harmful consequences of high
and variable inflation.
In the mid-1980s, two Canadian banks failed and two more were saved only by merging with
larger institutions.
In the mid-1990s, contagion from the Mexican peso crisis caused foreign investors to wake
up to Canada's precarious fiscal situation, and we suffered our own sovereign debt crisis.
Where we can take credit is that we learned from our mistakes. In the aftermath of each of
these crises, we put in place sound policy frameworks.
In 1991, Canada was the second country in the world to adopt an inflation target. The
subsequent change in the behaviour of inflation was unequivocal. Since the adoption of the
2 per cent target, inflation has averaged very close to 2 per cent, and its variability, as
measured by its standard deviation, has been cut by two-thirds (Chart 3).
Following the bank failures of the 1980s, the government created a new prudential agency,
the Office of the Superintendent of Financial Institutions (OSFI), with a clear mandate and
the authority to take necessary corrective measures expeditiously. Financial regulatory
standards were raised above international minimums, and supervision and oversight were
strengthened.
The fiscal transformation that followed our sovereign debt crisis was no less dramatic. After
allowing government debt relative to GDP to rise almost without interruption from 1975 to
1995, successive governments ran 10 years of surpluses, cutting the government
debt-to-GDP ratio from almost 70 per cent in 1995 to 22 per cent in 2008 (Chart 4). As a
result, Canada's net debt relative to GDP went from being the second-highest ratio among
the G-7 countries in 1995 - second only to Italy - to the lowest today (Chart 5).
Just as important, we have stuck with the discipline of these foundational policy frameworks
while continuing to strengthen them, even as our crises have faded into history. These policy
frameworks have served Canada well into the new millennium, underpinning almost two
decades of solid and stable growth. But their full value was revealed through the recent
global financial crisis.
In Canada, no banks failed or had to be rescued, and our financial system continued to
provide credit to households and businesses. So when the Bank of Canada, guided by its
inflation target, lowered the policy interest rate to near zero and took the unconventional step
of making a conditional commitment to hold the rate there for more than a year, the
stimulative effects of monetary policy worked powerfully.1
This monetary response was
buttressed by a large fiscal stimulus package, including infrastructure spending, tax cuts and
measures to enhance employment insurance, skills development and training. The
combination of a financial sector that continued to work and extraordinary monetary and
fiscal stimulus resulted in the smallest decline and by far the most rapid recovery in final
domestic demand among major advanced economies (Chart 6).
Thorough preparation combined with determined action and confident execution worked.
With the recession behind us, the extraordinary fiscal stimulus has now been unwound. The
Bank of Canada has moved off its exceptional policy, dropping its conditional commitment
and raising the policy rate to 1 per cent. But with foreign headwinds in the form of a weak
global recovery and elevated uncertainty, and a persistently strong Canadian dollar, the
policy rate has remained at 1 per cent even as global financial conditions have improved and
domestic lending rates have eased to near historic lows. This has provided ongoing support
to household spending.
As successful as it has been, this growth model is now reaching its limits.
Today, the balance sheets of households are stretched. After 11 consecutive years with
household outlays exceeding disposable income, household debt burdens have increased
substantially. Household debt as a percentage of disposable income has risen by almost
60 percentage points to 165 per cent today,2 and Canadians are now more indebted than the
Americans or the British (Chart 7).3 Housing activity in Canada is at a near record share of
GDP, and there are indications of overbuilding and overvaluation in some segments of the
housing market. Reflecting the strength in spending relative to income, Canada's current
account has been in deficit for the past four years.
These trends are not sustainable.
The good news is that there are now signs a gradual correction of these imbalances may be
under way. It is too early to tell whether it will continue, and there are risks on both sides. The
correction could turn out to be short lived and the unsustainable trends could continue for a
time. Or it could accelerate, risking too much adjustment too quickly. A gradual correction is
desirable to reduce vulnerability and avoid a larger, more abrupt and disruptive correction in
the future.
But as desirable as a gradual correction is, something needs to take the place of increasingly
leveraged household spending or economic growth in Canada will slow. The component of
demand that has underperformed the most is exports (Chart 8). Indeed, exports are the only
component of GDP that remain below their pre-recession peak. They have also
underperformed when compared with most other advanced economies To pick up
(Chart 9).
the slack in exports will require investment, which has been the next weakest component of
GDP.
What to do?
First, learn from the mistakes of others to ensure we are prepared for the risks ahead.
Second, confront our weaknesses with clarity and determination. And third, have the
confidence to build on our strengths.
We are fortunate to have many:
•
a well-educated and increasingly efficient labour force;
•
privileged global access to capital;
•
abundant commodities;
•
a resilient financial system; and
•
sound fiscal and monetary policy.
If we build on these strengths, there is no reason why we can't regear our growth and retain
our pole position among advanced countries.
That's the short version. I will now use the rest of this lecture to make this somewhat abstract
prescription more concrete.
Two challenges
Stretched consumers
Allow me to review the financial situation of consumers in a bit more depth. Household
indebtedness is elevated and a range of indicators suggest that some segments of the
housing market exhibit stretched valuations and overbuilding.4
In the last 10 years, the pace of household debt accumulation has been unusually rapid.
Household debt relative to disposable income increased about three times faster in the last
10 years than in the previous decade (Chart 10). The bulk of this rise in debt - 66 per cent,
or $636 billion - has been in the form of mortgage debt, putting Canadians in an
uncomfortable neighbourhood - between Spain and the United States - in the ranking of
household mortgage debt across countries (Chart 11).
Rising mortgage debt has fuelled housing activity, including resales, renovation and new
home building. Housing activity has been elevated relative to historical norms for close to a
decade now (Chart 12). After a sharp but brief decline when consumers froze in the darkest
days of the financial crisis, housing activity rebounded quickly, rising to a near record level in
2012. The total number of housing units under construction is now well above its average
relative to population (Chart 13). This is entirely accounted for by multiple-unit dwellings
(which include condominium units). While this may to a degree reflect fundamental factors
such as a shortage of land for single-family house development in some large metropolitan
areas, there is also abundant anecdotal evidence that building has been spurred by investor
demand, and is therefore more susceptible to changes in buyer sentiment.
The strength in housing activity has also been reflected in rising house prices. Over the past
decade, the price of the average home has risen from 3.5 times disposable income to more
than 5 times (Chart 14), and the house price-to-rent ratio has increased from 1.3 to
2.3 (Chart 15). Both of these measures are now well above their historical averages.
Restoring sustainable levels of borrowing and housing activity is a shared responsibility.
First, households need to assess their ability to pay year after year, factoring in the reality
that borrowing rates will eventually return to more normal levels. Many households are
prudently responding by locking into fixed mortgage rates. The share of new fixed-rate
mortgages increased from 50 per cent in 2011 to almost 90 per cent last year - a reflection
of both attractively priced fixed rates and the Bank of Canada's tightening bias.
Second, banks and other lenders need to carefully consider risks when they extend loans to
households.
Third, the federal government has on four occasions between 2008 and 2012 taken prudent
and timely measures to support the long-term stability of the housing market by tightening
the minimum standards for government-backed insured mortgages. These measures have
been complemented by OSFI's new tougher underwriting standards for home-equity loans,
enhanced supervisory scrutiny, and requirement that banks meet the more demanding
Basel III capital standards as of January 2013, well ahead of the internationally-agreed
maximum phase-in deadline of 2019.
The cumulative effect of these measures, together with increased consumer awareness, is
having an impact. In the past six months, the growth of household credit has continued to
moderate, with total household credit growth slowing to slightly below 4 per cent in recent
months (Chart 16). If this is sustained, the ratio of household debt to disposable income can
be expected to stabilize later this year.
Housing activity has also moderated recently. Sales of existing houses have softened, falling
below their 10-year average in the third quarter. More recently, housing starts have also
fallen from very high levels, declining from 225,000 units through much of 2012 to about
200,000 units in November and December. Even with this decline, housing construction
remains above demographic demand, which is estimated to be about 185,000 units. Further
slowing is expected to bring a convergence of housing starts and demographic demand this
year.
The growth in house prices has also slowed, although prices are still close to 18 per cent
higher than the previous peak in August 2008 (Chart 17).
These are encouraging signs of a stabilization of household imbalances and a more
sustainable housing market. But after a decade of buildup, it is too early to be sure.
Lacklustre exports
Even though desirable, eliminating the household sector's net financial deficit would leave a
noticeable gap in the economy. The reduction of about $50 billion in annual household
spending could be compensated by an additional 4 percentage points of annual export
growth. Today, relative to the average recovery path for exports, we are losing $123 billion
annually (Chart 18). In other words, in order to replace $50 billion in credit-financed
household spending, exports need to close just two-fifths of the gap between the current
recovery in exports and the average recovery. This should be doable.
The underperformance of our exports is due in part to weakness in foreign demand. With the
United States - our major trading partner - experiencing its worst recession and weakest
recovery since the Great Depression, our exports fell sharply in 2008 and have recovered
only slowly.
But a longer view reveals that the global recession only exacerbated an already existing
trend.
In the last decade, Canada's share of the world export market has slipped from about 4.5 per
cent to about 2.5 per cent and our share of the export market for manufactured goods has
been cut in half. Even more revealing, our export performance has been the second worst in
the G-20
(Chart 19).
Why have we done so badly?
There are two reinforcing factors - structure and competitiveness.
Two-thirds of this underperformance reflects who we trade with.5 Almost 85 per cent of our
exports go to slow growing advanced economies - 74 per cent to the United States alone -
and only 9 per cent to fast growing emerging-market economies (EMEs) (Chart 20).
Compared with our peers, Canada's exposure to emerging markets is low when measured
as a share of exports (Chart 21).
The other third reflects declining competitiveness. This is manifest in our most important
trading relationship, where we have lost considerable market share. From 2000 to 2011,
China increased its share of U.S. imports from 8 to 18 per cent, surpassing Canada as the
largest exporter to the United States (Chart 22). Over the same period, Canada's share of
U.S. imports fell from almost 20 per cent to less than 15 per cent. Moreover, while the large
increase in China's share is affecting other countries, a number of countries, notably Mexico
and Germany, have fared much better than Canada.
A comparison of the evolution of unit labour costs in Canada and the United States is telling.
Between 2000 and 2011, the labour cost of producing a unit of output in Canada compared
with the United States, adjusted for the exchange rate, increased 75 per cent (Chart 23). The
majority of this loss of competitiveness reflects the appreciation of the Canadian dollar, but
weak productivity growth in Canada relative to the United States played a significant role.
Business sector labour productivity in Canada has grown at an average annual rate of just
0.8 per cent since the start of 2000, compared with 2.3 per cent in the United States. This
accounts for about one-third of our lost competitiveness.
What should Canadian businesses do?
First, don't count on a weaker Canadian dollar. Hoping for a weaker Canadian dollar is not a
business plan. A sustainable export strategy cannot rely on expectations of a more
favourable exchange rate, since Canada is likely to remain an attractive investment
destination.
Second, businesses should intensify their efforts to develop new markets for their products in
fast-growing EMEs. This is being facilitated by a federal trade strategy that is increasingly
EME focused. The Canadian government is currently negotiating a new trade agreement
with India, has struck terms for a new investment agreement with China (the Canada-China
Foreign Investment Promotion and Protection Agreement) and is participating in the
multilateral negotiations of the Trans-Pacific Partnership. These are important initiatives - not
just for our trade with EMEs, which now account for one-half of all global import growth - but
also because they are essential to secure our positions in global supply chains.
Third, improve productivity. To do that, we need to build on our strengths.
Building on our strengths
While our current growth model is reaching its limits, Canada has far from exhausted its
opportunities. Quite the reverse - our strengths are many. Regearing requires building on
them with determination, and harnessing their complementarity with confidence. I will start
with our factors of production (labour, capital and commodities), before moving to critical
enablers (our financial system and policy frameworks).
A well-educated and flexible labour force
The most important factor of production and our biggest strength is our labour force.
Canadian workers are well educated, and our labour market is increasingly flexible.
High-school completion in Canada is near universal, and Canadian students perform well
relative to their peers, based on results of international assessments. Among the members of
the Organisation for Economic Co-operation and Development (OECD), we have the highest
level of tertiary education (including universities, colleges and polytechnics). Canada ranks
well in the sciences, technology, engineering and maths, fields where the proportion of
tertiary graduates exceeds the OECD average. We have strong research capacity centred on
our universities, as measured by per capita academic of publications, which are well above
the OECD average. And our spending on research and development (R&D) by institutions of
higher education in proportion to GDP is the fifth highest in the OECD.6
Over the past several decades, the efficiency of our labour market in matching workers and
jobs has also improved dramatically. The Beveridge curve measures how well labour
markets match workers looking for jobs with job vacancies (Chart 24). The closer the
Beveridge curve is to its origin (zero vacancies and unemployment), the more efficient the
labour market. As shown, the curve in the 1980s (blue line) has a higher level of
unemployment for a given level of vacancies than the curve in the 1990s and early 2000s
(red line).7
Part of that improvement in efficiency is due to the increasing mobility of Canadian workers.
Interprovincial migration has long been an important adjustment mechanism for the
Canadian economy. Recent Bank research suggests that long travel distances across
Canada may not be as great a barrier to labour mobility as they once were. Over the past
decade and a half, people have moved from regions with excess labour to those with the
tightest labour markets, leading to the convergence of unemployment, participation and
employment rates. By 2011, the gap, or disparity in employment rates across the
10 provinces, was at its lowest level and was not very different from the dispersion of
employment rates across the United States (Chart 25).8
In a geographically large, knowledge-based economy, these are important advantages. To
regear, we need to build on them.
While we are leading the world in tertiary educational attainment, we lag in the attainment of
more advanced degrees and business degrees. Among OECD countries, we have the
highest attainment of college degrees. For university degrees, we are only slightly above
average, and for master's and PhD degrees, we are in the bottom third.9 In the field of
business education, our proportion of graduates is slightly below the OECD average and
25 per cent below the United States.
These trends in educational attainment are significant for at least two reasons.
First, they show up in our work force. Compared with U.S. firms, Canadian firms lag in the
employment of workers with advanced degrees and in the educational attainment of their
managers. Canadian firms hire fewer employees with PhDs and other postgraduate degrees,
especially in the sciences. Only one-third of managers in Canada have a university degree,
compared with almost half of American managers.10
Second, a significant body of research suggests that education improves the quality of
management, and the quality of management influences investment in new technologies, in
the introduction of new processes, and in the development of new markets. Highly educated
individuals are much more likely to be owners of high-growth innovative firms.
This all points to a need for more Canadian students to invest further in their education and
for Canadian firms to put more emphasis on skills.
There is also scope to further improve the matching of workers and jobs. There is some
evidence of a mismatch between the supply of graduates in certain fields and the needs of
employers. In particular, Canada has a disproportionately large share of university graduates
in the bottom-earning quartile relative to other OECD countries. In addition, Canada's
employment rate for university graduates is below the OECD average. This underscores the
importance of the dialogue between industry, labour and educational institutions to ensure
that workers have the skills employers are seeking. It also points to the need to continue to
eliminate differences in occupational licensing and other barriers to inter-provincial migration.
Privileged global access to capital
Access to capital has rarely, if ever, been better in Canada, both on an absolute scale and
relative to our competitors.
Corporate bond yields in Canada are at record lows (Chart 26). Our surveys of banks and
businesses suggest that business-lending conditions have continued to ease almost without
interruption since late 2009 (Chart 27).
Our economic advantages have made Canada an attractive investment destination and a
rare safe haven in a risky world. This status is reflected in the behaviour of Canadian 10-year
yields, which tend to decline at the same time as risky assets such as global equity prices.
The correlation suggests that money flows into Canadian bonds in response to increases in
perceived risk. Indeed, by this measure, Canada is viewed as among the safest of havens
(Chart 28).
This privileged global access to capital is a critical advantage. We need to use it wisely to
invest in productive capital and research and development (R&D) rather than in houses.
There is a large empirical literature that finds two of the best predictors of productivity growth
are investment in machinery and equipment (M&E), particularly information and
communication technology (ICT), and investment in R&D. Canada is lagging in both.
Between 1987 and 2010, Canadian investment per worker in M&E and ICT averaged
74 per cent and 57 per cent, respectively, of that invested in the United States. By 2010, on
average, Canadian workers had only about half as much M&E and ICT capital stock to work
with as their U.S. counterparts.
While public support for R&D in Canada is strong, business investment in R&D is below the
OECD average and half the rate in the United States.
Investment in Canada in recent years has been solid, but not spectacular. Despite record-low
interest rates, historically low corporate leverage and a strong Canadian dollar, the recovery
in investment remains below the average cycle (Chart 29). We need to invest more in M&E,
and we need to get more out of these investments with greater spending on organizational
capital and process improvement. To regear, we must do better than solid.
Abundant commodities
Abundant commodities have long played a critical role in our economic development but
dramatic changes underway in the structure of the global economy have made commodities
an even greater advantage.
While commodity prices have fallen 19 per cent since their peak in April of last year, they
remain about 20 per cent above their longer-term averages in real terms (Chart 30). In fact,
real prices for energy and metals have been well above their long-term averages for more
than eight years and real food prices are now at their highest level in 36 years. While
commodity prices will continue to be volatile, this trend strength can be expected to persist.
Underpinning this commodity super cycle is a sustained increase in demand from rapidly
growing emerging markets, particularly China and India. Together, they account for most of
the increase in global demand for commodities in the last five years. For example, increases
in Chinese demand have played an important role in the rise of oil prices seen since 2002
(Chart 31). With convergence to Western levels of consumption still a long way off, the
demand for commodities can be expected to remain robust and prices elevated for some
time.
In Canada, the impact of rising commodity prices has been reinforced by strong growth in the
supply of some commodities. Oil is now our most important commodity by value, with its
share of total Canadian commodity production rising over the past 15 years from 18 per cent
to 46 per cent (Chart 32).
Our challenge is to develop our commodities intelligently and sustainably and to ensure that
the whole country benefits. Infrastructure investments in pipelines and refineries to get
Western heavy oil, which is trading $40 below the world price, to Central Canada and to
foreign markets would bring more of the benefits of the commodity boom to more of the
country. Increased interprovincial trade in goods and services provides another channel to
capture more of the value added from energy, mining and agriculture for all of Canada. This
is already happening. For most provinces, trade inside Canada has continued to grow from
2007 to 2011, offsetting all or some of the weakness in international trade over the same
period (Chart 33).
Resilient financial system
The financial system is a critical enabler, channelling savings to productive investments and
helping firms and households to manage risks.
Our banks withstood the 2008 financial crisis and are considerably stronger today than they
were then. They have substantially lengthened liquidity horizons. They have increased their
common equity capital by 77 per cent, or $72 billion, since the end of 2007. And, as of
10 days ago, Canadian banks met the new Basel III capital requirements, well ahead of the
maximum phase-in period that extends to 2019. Businesses can be confident that bank
funding will remain available.
Core funding markets are also being strengthened so that market-based finance is a resilient
source of diversification and innovation in funding markets, not instability. Last February, the
Canadian Derivatives Clearing Corporation launched a new central counterparty service for
repo transactions. Canada is on track to meet the G-20 commitments regarding the clearing
of over-the-counter derivatives. In this regard, in October, Canadian authorities announced
that market participants will be able to clear standardized over-the-counter derivatives using
any central counterparty recognized by Canadian authorities, including global central
counterparties.
Our priority is to be among the leaders in adopting new, stronger global standards and to
encourage others to do the same to maintain an open and competitive global financial
system.
Sound fiscal and monetary policy
Thanks to our sound fiscal policy, Canada is among a select and dwindling group of
countries with a risk-free rate. This is underpinning our privileged access to global capital.
Canada's competitive position is improving as other countries must increase taxes to
address fiscal imperatives. And while returning to budget balance in Canada will require a
determined effort, it pales in comparison to the scale and duration of the adjustment needed
in the United States. There are very real benefits to Canada's record of sound fiscal
management.
Finally, monetary policy. What can it do?
Canadians can remain confident that inflation will remain low, stable and predictable. After
more than 20 years of low inflation, the consequences of high and variable inflation are
fading in the collective memory of Canadians, making it easy to discount the value of this
commitment. That would be a mistake.
Low and stable inflation has allowed consumers and businesses to manage their finances
with greater certainty about the future purchasing power of their savings and income. Interest
rates have also been lower and less variable in both nominal and real terms across a range
of maturities. By working to stabilize inflation, monetary policy has helped to encourage more
stable economic growth, lower and less variable unemployment, and greater efficiency in
financial markets.11
Maintaining low and stable inflation is the primary focus of monetary policy, but it is not the
singular focus. Consistent with our mandate to "promote the economic and financial welfare
of Canadians," our flexible inflation-targeting framework requires that we consider the
consequences for volatility in output, employment and financial markets when determining
the optimal path and horizon over which to return inflation to target. In practice, the variation
in that optimal path has resulted in an inflation-target horizon as short as two quarters and as
long as 11 quarters since the Bank began publishing its projections in 1998.12
This flexibility is enhanced by the credibility of Canada's monetary policy. Inflation
expectations are well anchored at the 2 per cent target. But this flexibility is also an asset that
must be used with care. Credibility is hard to earn and easy to lose.
While the crisis of 2008 re-affirmed the value of our flexible inflation-targeting framework, it
was also a powerful reminder that price and financial stability are inextricably linked, and
pursuing the first without due regard to the second risks achieving neither. The primary tools
to deal with financial stability are micro- and macroprudential regulation and supervision.
However, it may be appropriate in some circumstances for monetary policy to complement
macroprudential policy and contribute to financial stability directly.
There can be tension between price and financial stability over the typical monetary policy
time frame because the consequences of financial excesses may be felt over a longer
horizon than other economic disturbances. In current circumstances, the Bank may want to
set interest rates higher than would otherwise be warranted to bring inflation back to target
within the typical six- to eight-quarter time frame. In particular, the Bank has indicated that
the evolution of household imbalances may be a factor affecting the timing and degree of any
withdrawal of monetary stimulus. If the Bank were to lean against such imbalances, we
would clearly say we are doing so, and indicate how much longer we expect it would take for
inflation to return to the 2 per cent target.
For now, signs indicate that the pace of household-debt accumulation is moderating, but, as I
have stressed already, it is too early to tell if this will be sustained.
Conclusion
It is time to wrap up.
I will conclude with a brief comment on current economic developments. As I mentioned
earlier, housing activity is beginning to decline broadly in line with our expectations.
Canadian exports are expected to add to GDP growth, but continue to be restrained by weak
foreign demand and ongoing competitiveness cha