David Dodge: Prospering in today's global economy - challenges for open
economies such as Australia and Canada
Notes for a speech by Mr David Dodge, Governor of the Bank of Canada, to the Sydney Institute and
the Canadian Australian Chamber of Commerce, Sydney, Australia, 6 November 2006.
* * *
I'm very happy to be here in Sydney this evening to talk about our two economies, which have so
many features in common: healthy growth, low unemployment, solid prospects for the future, and
sound macroeconomic policies. But I'd also like to talk about our economies in the context of the wider
global market in which we both trade. Further, I'll discuss just how essential it is to our economic
wellbeing, and that of future generations, that we buttress the global institutions that are so vital to stable
international trade and financial systems.
As major producers of commodities, both Canada and Australia rely heavily on international trade for
our economic expansion, and we each rely extensively on global capital markets. So, what I would like
to talk about first is how we see the global and Canadian economies unfolding and what we might
expect to see in the future. Following that, I'll also talk about some of the policies that can best help
countries like ours to deal with the challenges of today's global economy, looking at this from both a
domestic and an international perspective.
Canada, Australia, and the global economy
In Canada, we're feeling pretty positive right now about our prospects, despite the fact that the
pullback we are now seeing in the U.S. economy is larger, and has come faster, than we had
expected.
That slowing has serious implications for global demand, of course, but it hits home particularly hard
for us, since the United States is, by far, Canada's largest trading partner.
After several years of strong expansion, the U.S. economy is cooling down, restrained by a pullback in
the housing sector and slowing demand for autos. After growing robustly in the first quarter of this
year, U.S. growth slowed to 2.9 per cent in the second, and the advance estimate is that growth was
just 1.6 per cent in the third quarter. The Bank of Canada now projects that U.S. economic growth will
average 2 to 2 1/2 per cent in the last half of this year and the first half of 2007. Activity should then
recover to above 3 per cent in the second half of next year and throughout 2008.
Slower U.S. growth has clearly caused Canadian GDP growth to fall short of expectations in the
second and third quarters. After expanding at a 3.6 per cent annual rate in the first three months of
this year, GDP growth slowed to only 2 per cent in the second quarter, and we expect a similar figure
for the third quarter.
But it's important to think of this as a mild, and likely very short-lived, cyclical slowdown for Canada.
With near-term weakness in the U.S. economy, net exports will likely exert a considerable drag on
Canadian growth. However, consumer spending and business investment are expected to remain
robust. Overall, we at the Bank of Canada project 2.8 per cent growth for real GDP in 2006, slowing to
2.5 per cent next year but coming back up to 2.8 per cent in 2008.
Core inflation is expected to move a bit above 2 per cent in the coming months but return to the 2 per
cent target by the middle of 2007 and remain there through 2008. Total inflation will likely average
about 1 1/2 per cent through the second quarter of 2007, before returning to the 2 per cent target and
remaining there through to the end of 2008.
The main upside risk to the Canadian economy continues to relate to the momentum in household
spending and housing prices. This momentum is linked to strong consumer credit growth. By
increasing home equity and thus expanding the availability of collateral, the recent strong increases in
house prices have contributed to robust growth in consumer credit. There is a risk that these linkages
could be stronger than assumed or that house prices could continue to grow more rapidly than
expected, resulting in higher-than-projected household spending and, hence, greater upward
pressures on inflation.
The main downside risk to the Canadian economy relates to the possibility of a sharper slowdown in
the housing sector in the United States and a broadening of the weakness in the housing sector to
consumption and investment. A larger decline in domestic demand in the United States would lead to
decreased demand for Canadian exports and broader weakness in the Canadian economy. This
development would also lead to lower inflation.
The slower growth in the U.S. economy is a sharp reminder of just how important a role its powerful
appetite plays in absorbing the exports of many countries and just how critical that strong U.S.
demand has been to global economic growth.
Of course, the United States has been far from alone in absorbing goods and resources from around
the world to feed its economic expansion. The extent of the strong worldwide demand, particularly the
demand for commodities coming from the emerging powers of China and India, has fuelled Canadian
and Australian growth and also has reminded us of just how closely intertwined countries have
become.
Canada has traditionally been known for its net exports of non-energy commodities. Minerals and
lumber continue to be important commodity exports for us. However, over the past decade, thanks to
plentiful oil and gas reserves and sharply higher prices for oil and natural gas, we are now increasingly
known for our energy riches. Similarly, Australia's reserves and exports of minerals, uranium, and coal
are among the largest in the world, and demand for those commodities helps to shape the views of
global markets about your country. As well, we're both major exporters of grains, traditionally among
the top three in the world. As such, I can certainly understand and sympathize with your farmers who
are suffering the effects of drought.
With such strong world demand and interest directed towards our commodities, it's perhaps a good
time to pause for a moment and reflect on how we might try to strengthen the global trade and
financial systems that we rely on so much. World commodity markets are subject to ups and downs.
The movements in commodity prices and our exchange rates can pose serious economic challenges
for firms and workers. In turn, central bankers and governments must design policies that allow
businesses and workers to react rapidly to changing economic circumstances. The healthy, steady
prosperity of our two economies is a testament to domestic policies that are working to encourage
flexibility, and thus facilitate adjustment.
Policies to encourage flexibility
On the domestic front, it seems that both Canada and Australia have been on the right track - and we
both have the economic record to demonstrate that! In terms of monetary policy, both the Bank of
Canada and the Reserve Bank of Australia have embraced a policy of inflation targeting backed by a
floating exchange rate. For over a decade, both the Reserve Bank of Australia and the Bank of
Canada have concentrated on maintaining low and stable inflation.
Inflation targeting helps to preserve confidence in the future value of money and, in that way, anchors
inflation expectations. This helps business in making appropriate investments, by maximizing the
clarity of the signals that are sent by prices. Controlling inflation is also crucial to maintaining the
confidence of markets at home and abroad.
Central banks pursue inflation targeting by adjusting interest rates with the goal of keeping total supply
and demand in the economy in rough balance. By aiming to keep the economy running at or near full
capacity, monetary policy can make it easier for resources to shift from sectors that are shrinking to
sectors that are expanding.
This is particularly important in times such as these, when large swings in relative prices highlight the
need for rapid adjustments in economic activity. And it's especially important for countries like Canada
and Australia - open, trading nations that rely particularly heavily on the production and sale of
commodities for their economic well-being.
Of course, a central bank that targets inflation must have a floating exchange rate. Experience has
shown that for countries such as ours, exchange rate flexibility facilitates adjustments to shocks.
Both Canada and Australia have reasonably flexible economies, by which I mean they have the ability
to quickly adjust to changing circumstances. And while we recognize that both countries have taken
steps to improve flexibility in recent years, there is still much more to be done. In my own country, for
example, we continue to grapple with the need to make labour markets more flexible and to foster
competition. We also recognize the need to make financial markets as efficient as possible.
In the past decade, both Canada and Australia have followed very good fiscal policies. In Australia,
this has been built on an earlier period of debt reduction, while in Canada, we are in the process of
reducing debt to levels that will be sustainable in light of forthcoming demographic pressures that we,
like so many other nations, will be facing.
But flexibility and good macroeconomic policy at home still aren't enough to guarantee our future
prosperity: it's crucial to us all that we maintain a well-functioning international financial system, an
issue to which I will now turn.
Promoting a stable, well-functioning international order
It seems very clear to me that it is absolutely in the best interests of Canada and Australia to promote
freer trade and greater financial stability around the globe. With respect to trade, it is vital that the
multilateral negotiations that began five years ago at Doha under the World Trade Organization be
restarted and brought to a quick and successful end, and that we all work to continue to strengthen the
WTO. The future prosperity of so many nations, in the developing world as well as the developed,
depends on these crucial trade talks.
In terms of international financial issues, I think we can all recall quite clearly a fairly recent example of
what can happen when the international financial order breaks down. The Asian financial crisis
occurred almost a decade ago, yet who can forget how rapidly it swept around the globe; knocking
down currencies, shaking up markets, spreading to other emerging-market economies, and throwing
many into a tailspin. Demand for commodities contracted sharply during the Asian crisis, which
eventually led to a dramatic decline in many world commodity prices. Some commodity prices hit lows
not seen since the end of the Second World War, and that led to a sharp depreciation of our
currencies.
Some progress has been made since then, including the establishment of bodies such as the
Financial Stability Forum and the G-20. The G-20 brings together systemically significant industrial
and emerging-market economies and, as you know, will be meeting in Melbourne later this month. I'm
looking forward to this meeting, and I want to say how much I appreciate your country's strong support
of this very important forum. Such a forum can provide emerging markets, in particular, with an
opportunity to improve the quality of their macroeconomic policies and their regulation of financial
systems. And I think it's fair to say that thanks to these and other efforts, the global financial system
today is more robust than it was in the late 1990s.
But there is so much more that must be done. The Asian financial crisis reminds us of how closely
connected economies have become, and of the vulnerabilities of open, trading nations like ours. We
can best flourish when the rules of the game are clear and when everyone follows them in deed, as
well as in word.
This is why the work of strengthening the International Monetary Fund is so important. Born 60 years
ago at Bretton Woods, New Hampshire, the IMF was part of a movement to create an international
order, whether in finances or trade, that would work to the benefit of member states. As economies
become more integrated and new players have emerged on the global stage, the Fund's central
purpose - to promote a well-functioning international monetary and financial order - is more relevant
than ever. And it remains crucial to countries such as ours, which are heavily involved in global trade.
Underlying this purpose is a basic premise: that the welfare of all our citizens is enhanced by a
growing global economy, with rising standards of living and with realized gains from the exchange of
goods and services across countries.
Canada's need for a well-functioning international financial order helps to explain why we have been
working so hard to see real reforms to strengthen the IMF, and to shift everyone's focus back to the
original goals of its founders. With the size of capital and trade flows in today's global economy, we
need - now more than ever - a fortified IMF that is truly able to promote a well-functioning,
marketbased international financial system. By "well-functioning," I mean a financial system that is both
efficient and stable, so that markets can do their job of allocating savings to investments through the
pricing of capital, and of smoothing economic adjustments through movements in relative prices.
How should the IMF be reformed? Well, to solve global problems, we need to have everyone
represented at one table and all participants fully engaged. But since 1997, the work of the IMF has
suffered. Over the past number of years, many emerging-market economies have shifted some of their
attention away from the centre of the global financial system, towards regional initiatives. This trend
must be reversed. The fastest-growing parts of the world economy should have a growing voice at the
IMF. At its recent meeting in Singapore, the Fund began the process of making itself appropriately
representative of today's global economic reality.
But the importance of this step will be lost unless we can improve the Fund's effectiveness in
promoting a framework that supports a well-functioning global economy. I believe the key to that
improvement lies in a strengthened surveillance function.
So, how exactly should surveillance be strengthened? In my view, the IMF can play a pivotal role in
mitigating serious global risks by serving, in the words of John Maynard Keynes, as a "ruthless truth
teller." This expression is a wonderful turn of phrase, not only for its colourful language, but because it
neatly encapsulates the critical objectives of effective IMF surveillance. The Fund's surveillance should
determine the "truth" about the economic policies and circumstances of member countries, and then
"tell" or communicate this truth transparently to all members and to the international community at
large.
To determine the truth, the IMF must be focused on the right surveillance priorities; namely, the
exchange rate, monetary, fiscal, and financial policies of member countries. Surveillance should focus
on these areas alone, and on the potential spillover effects that these policies may have on other
members. These are the priorities that reflect the reality of an increasingly integrated global economy.
This is not to say that there is one single prescription for macroeconomic and financial policies that all
countries must rigorously follow. But what is important is that the particular policies chosen by a
country must not hinder economic adjustment. The purpose of IMF surveillance must then be to
determine whether the policies being followed by a country are coherent, and whether they have the
potential to cause spillover effects in the rest of the world. Surveillance must not get bogged down in
domestic microeconomic issues that have little or no bearing on the functioning of the global economy.
Once the Fund staff have done their best analysis of the truth, the Fund must communicate, or tell it,
clearly and transparently. I understand that being told the truth can be difficult for national authorities.
After all, I was one of those national authorities back in the 1990s who was on the receiving end of
IMF criticism. While at that time, we in Canada did not enjoy hearing the truth about our deteriorating
fiscal situation, the criticism did help provide the impetus for us to take some tough decisions.
Transparent truth telling also serves a very important function in that it allows markets to discriminate
in the event of a global disruption. When investors have good, reliable information, they can make
better decisions. This can help limit contagion and minimize the occasions when countries are
sideswiped by the poor policy decisions of others. This is particularly important for emerging
economies that do not have the wealth, income levels, or institutional capacity to withstand a serious
shock.
While the meanings of "truth" and "tell" are fairly clear, what can be said about the word "ruthless"?
What this means is that surveillance must be uncompromising and free from interference, political or
otherwise. If the policies of any country - large or small - pose risks for spillovers or impede
marketbased adjustments in the global economy, the truth must be told. Market integration and leverage
have magnified the potential impact of policy spillovers. While risk sharing has also increased, markets
remain far from complete; more and more countries can now have systemic effects.
To sum up, we need to agree that the IMF should provide a candid assessment of policies that can
create external instability or that can prevent adjustment to external imbalances. A more robust IMF
can help to maintain the stability of the international financial system that is so important to our
businesses and to our economies generally.
Conclusion
It's very clear that Australia and Canada have both benefited greatly from the strong global economic
growth in recent years. But we can't take that growth for granted. I have discussed domestic policies
that are especially important for open trading nations like ours: sustainable fiscal policies, a monetary
policy based on inflation targeting, a flexible exchange rate, and flexible markets that can respond to
changing economic circumstances. By following these prescriptions, both Australia and Canada
should be well placed to cope with whatever developments come about in the global economy.
But we must also work hard to help shape that global economy. We need to do our utmost to ensure
continued free trade in goods and services and to resist protectionism. And we must work together
and with other countries to make the international financial system as efficient and effective as
possible. An important part of that effort must be to modernize the IMF.
With a stronger international system and solid domestic policies, both Australians and Canadians can
look forward to continued strong economic growth in the years ahead.