Stephen S Poloz: Returning to natural economic growth
Remarks by Mr Stephen S Poloz, Governor of the Bank of Canada, to the Vancouver Board
of Trade, Vancouver, British Columbia, 18 September 2013.
* * *
Introduction
Thank you for that kind introduction and to all of you for coming this morning. It's my pleasure
to be here with the members and guests of the Vancouver Board of Trade.
My focus this morning is the Canadian economy and, in particular, how it will return to natural
growth. The story has three parts: Where are we now? Where are we going to end up? And
how will we know we are on the right path?
Where we are now
I probably don't need to tell anyone here that the recent global recession was the worst
downturn since the Great Depression. In very short order, global GDP fell more than 3 per
cent and millions of jobs were lost. In Canada, almost a half million jobs were lost and GDP
fell by more than 4 per cent.
The recession in Canada is now history, of course, thanks in large part to timely fiscal and
monetary policy measures. We were the first of the G-7 to recover our recessionary decline
in output and start expanding anew. We have regained all the jobs lost in the crisis and
added almost 600,000 more.
But everyone knows, we are not yet back to normal. Interest rates are at extraordinarily low
levels. With unemployment above 7 per cent, there is still slack in the labour market. The
export sector, close to 7 per cent below its pre-recession peak, still has a lot of ground to
make up.
Firm creation has been lagging...
There's something else. A characteristic of a naturally growing economy is a steady increase
in the population of companies. However, for five years after the start of the crisis, we saw
virtually no increase in the population of Canadian companies.
This matters, a lot. Large, established companies certainly provide the foundation of
economic growth. As they grow, or become more productive, or generate new ideas,
everyone benefits. However, it is the creation of new companies that serves as a natural
engine for growth. New ideas, new products and new ways of producing them are often the
seeds of new companies. As they grow from one employee, to five, to 20 or more, they
generate an outsized proportion of employment - in every economy, not just ours.
New companies create new jobs, which create new incomes, which get spent, creating a
virtuous circle of self-sustaining growth. That's what makes it natural.
Although the data on the population of firms are choppy, in the period from 2008 to 2012,
there was almost no net creation of companies in Canada. Particularly hard hit have been
Canada's exporters, which were exposed to the full brunt of the global crisis. Their numbers
out-and-out declined in the recession and, based on their ongoing weak output, have likely
remained flat since then. The group most profoundly affected has been manufacturing
exporters.
... as is broader business investment
Meanwhile, many existing businesses also seem hesitant to make major investments - and
no wonder.
Yes, there has been significant capacity added in the mining, oil and gas sectors. We have
seen important, long-term investment in such projects as the oil sands, shale gas extraction
here in British Columbia, and some mining projects. Indeed, during the recovery, this activity
accounted for three-quarters of the contribution to growth made by investment. It helped
return the share of overall business investment in GDP to close to historical levels.
However, companies in other sectors have told us that they have held off on creating new
capacity until they see more concrete signs of stronger demand. In the meantime, they have
focused on small, targeted or niche projects - in other words, getting the most out of their
existing capital. Such investments are important. But a more normal, post-recession
evolution would show greater investment in the capital stock of firms across most sectors -
not just mining, oil and gas.
Confidence in short supply
In our summer Business Outlook Survey, companies told us that uncertainty about the nature
and timing of improving growth prospects is weighing on their investment decisions. Much
uncertainty centres around U.S. fiscal and monetary policy, the future of Europe's economy,
and the sustainability of growth in China. But other factors also affect business confidence,
including concerns about Canadian domestic demand, access to credit, and uncertainty
about regulatory costs or government approvals. Together, these various elements of
uncertainty create a sort of wedge, blocking companies from making optimal investment
decisions.
Understandably, Canadian firms have been reluctant to add new capacity until the U.S.
economic recovery gains traction and is more certain. Given what firms have been through, it
naturally would take a lot of confidence to expand. However, once there is a shift in
sentiment, research shows that business decision-makers tend to react and move forward
very quickly with their investment plans. Economists call this "animal spirits" because it is
very hard to predict.
Encouraging signs
But some new data suggest we may be turning the corner.
Recently published private surveys of business sentiment show some improvement. Further,
financial market uncertainty has declined, according to Canadian and global indicators. Such
measures of financial volatility may well be serving as proxies for actual world events or
developments. We will be watching these closely to see if this improving trend continues.
The Bank's interviews with Canadian business leaders for our autumn Business Outlook
Survey are being conducted right now. I am looking forward to learning about their views and
perspectives - and if, and how, they may be changing.
But perhaps the most exciting sign is that the population of Canadian companies is growing
again. Today, there are some 40,000 more firms with at least one employee than there were
last year at this time. This pace is considerably stronger than we would expect in normal,
non-recessionary times and suggests that we may be replacing some of the firms that were
lost in the recession with new ones. This is excellent news.
We also know that most of the jobs created since the recession are in occupations requiring
relatively high skill levels and are mostly in industries with above-average wages. What this
will do is help contribute to the virtuous circle of higher incomes, more spending, and more
jobs that is associated with natural growth.
All of these signs are hopeful. They are signalling that we are on our way home.
Where we are going: natural economic growth
Let's talk about that right now. What does home look like? This is a discussion about the
future, so there are many unpredictable variables.
However, I anticipate that the Canadian economy will normalize and growth will become
natural, in contrast to the economic activity of the past six years, which has been fuelled by
policy, including record-low interest rates. Natural growth will be self-generating and
selfsustaining, and the economy will be growing at its potential, as its productive capacity
expands. Inflation will be back to our target of 2 per cent. As I have said before, policy rates
in Canada will be higher than they are today. We can expect that short-term interest rates, as
is normal, will be above inflation. Long-term rates will settle into place along a natural,
upward-sloping yield curve.
We can anticipate a better balance in Canada between domestic and foreign demand. All
components of GDP will contribute to growth, again, as normal.
The unemployment rate in Canada can also be expected to come down to a more natural
level. Consumer and government debt loads will be on a sustainable path. Firms will be
generating self-sustained growth.
In addition to these familiar elements, some things will look significantly different when we
get home.
We may be trading with new customers in new markets. Emerging markets are becoming
more important to our exporters. Canadian companies have done a lot during this cycle to
diversify into emerging markets, which are a growing - although still small - piece of our total
trade.
The nature of trade is also changing. More and more exporters are part of global value
chains. Today, an exported good to the United States can ultimately end up being
reexported to more than 100 other countries in a global value chain. Research shows that
companies that are part of a global value chain, because they have specialized, have higher
productivity, which means better-paying jobs.
The mix of what we trade externally and what we sell here in Canada has already begun to
evolve and undoubtedly will be different when we get home. The future will likely include a
shift in the shares of manufacturing and services in the economy. Commodities may
constitute a larger share than they do today. The sectors with the greatest anticipated job
growth are both traditional and new: on the one hand, mining, oil and gas, and on the other,
computer system design services. Employment is also expected to grow steadily in health
care and transportation.
We also have to be ready for surprises, when we get home, especially among the new
emerging businesses. For example, in 1971 when the first microprocessor was invented, we
didn't even have microcomputers.
Just as new technologies and industries emerged from previous recessions, this return to
natural growth will include the development of new technologies, new firms and new jobs.
Whole new sectors will take off; descriptions of new classes of jobs will be written; and
people will be hired under brand-new, yet-to-be-defined job titles. For instance, until recently,
who would have thought of a social media expert or a professional blogger as careers that
our kids might aspire to?
I'm not going to try to predict what new product, service or technology will deliver the next big
boost to our economy and the labour force. But there are sectors that have the potential for
ground-breaking innovations: 3-D printing, artificial intelligence and synthetic biology, among
others.
The path home
Let me shift gears and talk about how we get home. How do we get to natural growth? What
is the path? And how will we know we are on it? I have suggested before that there is a
sequence of events we can anticipate: foreign demand will build; our exports will strengthen
further; confidence will improve; existing companies will expand their production; companies
will invest to increase capacity; and, new companies will be created.
Evidence suggests we are now close to the tipping point from improving confidence into
expanding capacity.
We are seeing improvements in foreign demand. The Bank expects that strong increases in
U.S. business and residential investment will particularly benefit the sectors of Canada's
export market that have lagged thus far, notably machinery and equipment and wood
products.
Long-term interest rates have recently begun to return to more normal levels, consistent with
the strengthening U.S. economy and the anticipation that the U.S. Federal Reserve will begin
to exit from its unconventional monetary policy. But it's important to make the distinction
between policy tightening and a slowing of the rate at which additional stimulus is being
provided. Talk about "tapering" refers to the latter.
I sometimes use a spaghetti-sauce model to help explain this. When the bubble burst in
2008, we were left with a crater, which is where we now find ourselves. If you look carefully
at a pot of simmering spaghetti sauce, under every bubble there is a crater that's equal in
size. So, a 7-year bubble, a 7-year crater. Central banks have been filling that crater with
liquidity, so we can row our boats across it. We need to make sure we're getting to shore and
not just hitting a rock. But when we get to the other side, when we get home and can climb
out of the crater, central banks can gradually reduce the rate at which they add liquidity.
That's not policy tightening. Rather, it is another welcome sign that things are getting back to
natural growth. It indicates that the underlying momentum of the U.S. economy is expected
to hold.
Further, the efforts of Canadian businesses to diversify into faster-growing emerging markets
will pay off and will also help Canada's export performance. Exports more than doubled over
the past decade to countries that are not members of the Organisation for Economic
Cooperation and Development and now account for 13 per cent of total exports. This growth
has added roughly $38 billion to our exports, which is equivalent to adding a market bigger
than the province of Nova Scotia to our economy in just a decade.
Indeed, the Bank projects a solid pace of further improvement for our exports. This gathering
momentum should help lift the confidence of Canada's exporters and lead to more, and more
broadly based, capacity-building investment. It should provide additional incentives for new
start-up businesses. Historically, the lag between an improvement in exports and a pickup in
investments has been about six months.
Certainly, the preconditions are in place: the balance sheets of corporate Canada are
healthy; the cost of capital is low; and credit appears to be accessible. The corporate
environment is favourable: depending on which international consultant you believe, Canada
is one of the top five, or the top three, or even the top two places in the world in which to
launch a business.
Stronger investment means more new jobs will be created. It means more capital and better
tools for workers, which will increase labour productivity. It means more efficient ways of
working and producing products and services. It means a resumption of the natural growth in
the number of firms being created and more innovation and more creativity. This is the
virtuous circle at work. This is what the Bank wants to see. It is what we expect to see.
New demand creates new supply
As firms gain confidence in the pickup of demand, they will invest more, which, by definition,
adds to supply. In short, new demand will create new supply. As global demand improves
and investment growth strengthens, we should see higher potential output growth - that is,
an increase in the speed at which the Canadian economy can grow without causing
inflationary pressures.
With potential output higher and growing faster in response to stronger investment, the
output gap - the gap between what the economy is capable of producing and what it is
producing - could close later than if investment (and, ultimately, potential) did not respond to
demand.
The message here is that the economy should be able to support stronger activity without
stoking inflation, as investment ticks upward. Such an endogenous response of potential to
stronger demand would be natural, given the slack that we see in our labour market.
The Bank will monitor closely the various indicators, including investment, productivity, labour
participation and inflation, to determine the strength of potential output growth and the size of
the output gap and the labour market gap. Rest assured, we will conduct monetary policy
that is appropriate and consistent with achieving our target of 2 per cent inflation.
Conclusion
Many of the conditions needed to support a return to natural growth are already in place in
Canada. These include a sound macroeconomic framework, a stable financial system, a
well-educated workforce, and abundant natural resources.
We are optimistic that the gathering momentum in foreign demand, especially in the United
States, should help lift the confidence of Canada's business leaders and exporters. We can
expect the emergence of new products, new processes, new structures and new industries -
in short, a resurgence of the creation side of the creative-destruction process we attribute to
Joseph Schumpeter. It may be slow in coming, but it will emerge, and it will serve as a
driving force of economic growth.
The Bank is absolutely committed to keeping inflation predictable, stable and on target. This
is sacrosanct. Our flexible inflation-targeting framework is the best contribution monetary
policy can make so that Canadian households and businesses can make decisions about
their financial future with confidence.
In short, this is what we can do to help nurture a return to natural economic growth in
Canada.