Mr. Thiessen reports on the future performance of the Canadian economy
Notes for remarks by the Governor of the Bank of Canada, Mr. Gordon Thiessen, to the Canadian
Club of Winnipeg, in Winnipeg on 25/3/98.
It can take anywhere from one to two years for monetary actions to have their full
effect on the economy. Because of this, the conduct of monetary policy must be based on a view of
what the economy will be like -- not tomorrow, not in a month -- but rather in one to two years' time.
That is why in speeches in Vancouver and Toronto last year I spoke about where the
Canadian economy might be heading in the future; what this might imply for our economic
performance over the medium term; and what should the contribution of monetary policy be.
Understandably, these important issues can get pushed aside because of the public focus on the
current economic situation and on recent movements in short-term interest rates and in the external
value of the Canadian dollar.
Today, I would like to use this opportunity to revisit these medium-term issues. In
doing so, I will be underlining the crucial role played by productivity improvements in our economic
performance. The best place to start is with a brief review of the recent record.
Recent economic performance
As we approach the end of the decade, we can take satisfaction in the good economic
performance of the past two years and in the notable improvements in our economic fundamentals.
The Canadian economy has expanded at an average annual rate of 4 per cent since mid-1996 and,
even with the dampening effects of the Asian crisis, it is expected to continue to grow at a healthy
pace this year. This should contribute to further gains in employment and reduce the amount of
unused capacity.
Inflation is low, and we are committed to keeping it low. Last month, together with
the federal government, we announced that we would extend our target of holding inflation inside a
range of 1 to 3 per cent to the end of 2001. Moreover, government deficits have virtually
disappeared, and the ratio of public debt relative to the size of our economy is finally on a downward
path -- for the first time in about 25 years. Low inflation and improved fiscal health represent major
contributions towards the sounder economic fundamentals I mentioned a moment ago. They are no
doubt the main reason why our interest rates have been below US rates.
The other key area where there have been important improvements in recent years is
in the private business sector. Since the early 1990s, Canadian businesses have taken up the
challenge of structural adjustment, which their US counterparts had started several years earlier, in
response to the gathering momentum of technological change, globalization, and heightened
competition.
With the benefit of low inflation and low interest rates, Canadian businesses have
been investing in new technology and streamlining their operations to enhance productivity. Their
success in doing so will be crucial to our future economic performance.
The importance of productivity growth
Why this emphasis on improving productivity? Whether viewed from the perspective
of an individual firm or of the economy as a whole, it is almost impossible to overemphasize the
importance of rising productivity for overall performance and prosperity.
Productivity growth is what allows firms to hand out real wage increases, while
holding their production costs down and remaining profitable.
From a broader perspective, productivity growth is a key element that determines
economic welfare and the general well-being of a society. At any point in time, our perception of
how well we are doing economically is probably influenced by where we happen to be in the cyclical
fluctuations that affect any economy. But over the longer term, the trend in productivity growth for
the economy as a whole is the basis for growing incomes and rising standards of living.
Now, I know that for some people any discussion of the need to increase productivity
can be rather unsettling. They tend to associate improvements in productivity in an individual
company with downsizing and layoffs. And from there it is only a short step to the belief that strong
economy-wide productivity gains can only mean a more difficult job market and higher
unemployment.
But the history of industrial economies shows that growth in productivity has actually
gone hand in hand with improved overall employment conditions. This is borne out by the
experience of countries like Japan in the 1980s and, more recently, the United States and the United
Kingdom. That was also our experience in Canada during the 1950s and 1960s.
Canada's productivity record
So how has Canada fared in the productivity department since the 1950s and 1960s?
Not all that well, I'm afraid. After a relatively strong showing from the end of the Second World War
to the early 1970s, our productivity performance became rather lacklustre. Productivity growth is
estimated to have slowed from an average rate of about 2 per cent in the 1950s and 1960s to less than
1 per cent in the 1980s and 1990s, although it has picked up recently with the recovery in economic
activity.
I should note that economists do not fully understand why productivity growth in
Canada (and, indeed, in other industrial countries) has slowed so sharply since the mid-1970s. I do
not propose to try to untangle this puzzle today. Nonetheless, there are a few points I would like to
make with respect to the Canadian situation.
The sharp rise in the world price of oil in the 1970s no doubt dealt a major shock to
Canadian industry. Because of our climate and because of the importance of primary commodity
production in our economy, we are major users of energy. Adapting to higher energy costs certainly
took considerable time.
In my view, two other important factors inhibited productivity improvements through
much of the 1970s, 1980s, and early 1990s: large fiscal deficits and high inflation.
Government deficits through the 1980s and early 1990s tended to crowd out private
sector investment by appropriating an ever-increasing share of Canadian savings. It was, of course,
possible for businesses and governments to get foreign financing. But the accumulation of a large
public sector debt and the rapid buildup of foreign indebtedness eventually resulted in appreciable
premiums being built into our interest rates. High inflation through the 1970s and 1980s had a similar
effect on interest rates. For these reasons, interest rates were high, even after adjusting for inflation.
This discouraged some of the investment that would have contributed to gains in productivity.
Moreover, because high inflation increases uncertainty about the future, businesses
and individuals seek protection from its ravages or try to profit from it. Either way, scarce economic
resources were diverted from productive investments towards hedging and speculative investments.
I do not mean to suggest that the factors I have mentioned here explain all of our
productivity problems. But they no doubt worked against the investment that was needed to help us
adjust to both the oil price shocks of the 1970s and the global forces of the past two decades, and to
make headway in terms of productivity growth.
Let me now turn to the question of what we can expect in terms of productivity in the
future.
Future productivity trends and Canada's economic potential
Increases in productivity do not just happen. We need to work hard to achieve them.
In a world of rapid technological change and intense international competition, there are
opportunities and incentives for productivity gains -- provided we do what is necessary to take
advantage of the possibilities.
Productivity comes from the interaction of business investment in new capital
equipment, a skilled labour force, and the adoption of new technology. It takes entrepreneurship and
innovation to pull it all together. Typically, this interaction works best when businesses operate in a
stable, low-inflation economic environment and when markets are competitive. Producers are then
under pressure to perform in terms of price, quality, and service.
With low inflation, a balanced fiscal position, and low interest rates, the economic
policy environment is better now than it has been for over 25 years. This should provide the
underpinnings for solid economic growth and increased savings and investment in the future.
With this support from improving economic policy conditions, business investment
has indeed been buoyant, particularly since mid-1996, and notably in high-technology equipment
such as computers. As well, more and more businesses, led by high-tech enterprises, are reported to
have introduced new production technologies. Progress has also been made in learning new skills,
removing labour market rigidities, and improving the adaptability, flexibility, and efficiency of our
labour force. But more undoubtedly needs to be done in this area.
It is likely that these trends will continue in the future, and will spread to sectors that
have been lagging behind. With ongoing technological change, deregulation, trade liberalization, and
intensified global competition, the pressures and incentives are certainly there for further
productivity gains.
Thus, the trends are positive, and the direction of our economy is clear. What is not
clear is just how much our economic performance will improve. We cannot attach precise estimates
to future growth in productivity. Neither can we judge the end results of the major structural changes
that have taken place in the private sector of the Canadian economy. Because of this, we need to take
a somewhat agnostic view about the production potential of the Canadian economy and about the
lowest unemployment rate that can be sustained over time.
Monetary policy response -- making the most of the economy's production potential
What are the implications of all this for the conduct of monetary policy?
When we at the Bank look one to two years into the future to set a course for
monetary policy, we must take into account changes in the trends that affect the potential of the
economy to produce over time. At the same time, we must recognize that our ability to predict that
potential is restricted by the many uncertainties involved.
In these circumstances, the best way for monetary policy to help the economy realize
its potential is to focus on encouraging a sustained economic expansion over time. How do we do
this? By keeping inflation low. As we move towards full capacity over the next year or so, it will be
important to set monetary conditions at levels that forestall a resurgence of inflation and the painful
boom and bust cycles that go with it.
A responsible, credible monetary policy will allow us to explore the limits of the
economy's capacity to produce, to create jobs, and to support rising standards of living. The recent
US experience amply demonstrates the advantages and benefits of such a policy.
I believe that the recent extension of the inflation-control targets and the increasing
credibility of those targets give monetary policy more scope to test the limits of our economic
potential than at any time since the 1960s.
Now that I have discussed the rationale behind the Bank of Canada's medium-term
strategy, let me explain our recent actions to raise the Bank Rate.
As I said earlier, the underlying momentum of the Canadian economy remains
positive. Despite the problems in Asia, Canada's external environment is still favourable, given the
strength in our major non-Asian trading partners, particularly the United States. In addition, the
dampening effects on domestic demand from the fiscal consolidation efforts of the past four years are
diminishing. And monetary conditions continue to support the economic expansion. Given these
circumstances, the persistent decline in the external value of the Canadian dollar through December
and January implied a further easing in monetary conditions that looked to us to be excessive.
Moreover, the speed of the decline in the currency risked undermining investor confidence in
Canadian dollar assets. That is why we took action.
Concluding thoughts
Let me conclude by summarizing my main points today.
For much of the period since the 1960s, we have not had conditions in place that
would allow the Canadian economy to fully realize its potential. With low inflation and a sound
fiscal position, we now have the foundation that should permit us to move towards full capacity and
to explore what our economy can deliver in terms of sustained growth in output and employment and
better standards of living.
Canada's private sector has been responding to the universal challenges of rapid
technological change, globalization, and heightened competition by undertaking major restructuring
initiatives to become more efficient, productive, and competitive. Although we do not know for sure
just how much more productive we are going to be as a result of these initiatives, there is good
reason for optimism.
The best contribution the Bank of Canada can make to this process is by continuing to
provide a stable, low-inflation environment. With an eye to the medium term, this will require setting
a course for monetary policy that will ensure that the Canadian economy reaches full capacity
smoothly and then continues to grow over time at a non-inflationary and therefore sustainable pace.
The longer economic growth is sustained, the more benefits we will see in terms of improved
incomes and employment.