Stephen S Poloz: A new balance point - global trade, productivity and
economic growth
Remarks by Mr Stephen S Poloz, Governor of the Bank of Canada, to the Investment
Industry Association of Canada and Securities Industry and Financial Markets Association,
New York City, 26 April 2016.
* * *
I would like to thank Bob Fay and Louis Morel for their help in preparing this speech.
Introduction
The year 2016 got off to a rough start, with plenty of financial market volatility. Of course,
there is no shortage of fundamental issues to worry about: another downgrade to the outlook
for global growth, uncertainty about the economic transition in China, the pace of
normalization in the United States, worries about Europe, worries about Japan, just to cite a
few.
Financial markets have a love-hate relationship with volatility, and central bankers usually try
to see through it all. But one worry I hear a lot these days hits pretty close to home - the idea
that monetary policy just isn't working anymore. That's one myth I'd like to dispel right off the
top.
The fact is that policy actions - both monetary and fiscal - taken in the wake of the global
financial crisis prevented what would have been a second Great Depression. But many of the
negative forces that were acting then are still acting now. That's why ultra-low interest rates
are not causing rapid growth and inflation.
If you think monetary policy is not working, ask yourself what would happen if interest rates
suddenly returned to 3 or 4 per cent. Most would agree that such a move would trigger a
recession. This is just another way of saying that severe headwinds are still acting on our
economies, years after the crisis, and low interest rates are keeping them at bay.
It's a bit like riding a bicycle up a steep hill. Your progress may be slow, but that doesn't
mean your legs aren't working hard or that your bicycle is broken. Monetary medicine hasn't
cured everything, but it is working, and it has surely saved us from the worst.
Still, as central bankers, we need to take market anxiety, and the volatility it creates,
seriously, regardless of the source. Although volatility can go both ways, "market volatility" is
usually code for "market declines," which can erode consumer and business confidence and
cause a weakening in economic fundamentals.
So, what I would like to do today is address another current source of anxiety in financial
markets - the striking weakness of international trade. After all, international trade is the
lifeblood of the global economy. Firms, consumers and investors alike all rely on it to keep
the economy growing, create and sustain jobs and deliver investment returns.
The exchange of goods and services has been happening as long as people have been able
to produce more than they needed to survive, leaving them free to follow other pursuits.
Expanding exchange into the international arena is the next logical step, and that is exactly
how global history has unfolded.
Trade is a grand facilitator that permits people and firms to specialize and innovate. The
resulting improvement in living standards continues until trade reaches a balance point in the
economy where all advantages have been exploited. That balance holds until circumstances
change and people react to new opportunities.
Given the central importance of trade, it's not surprising that investors are worried about what
the data show. For roughly 20 years before the financial crisis, global trade had been
expanding by more than 7 per cent a year - about twice as fast as the world economy. Trade
collapsed in the wake of the crisis, but rebounded sharply in 2010. Since then, though, trade
growth has again slowed dramatically, trailing even the tepid pace of global GDP growth.
What is behind this slump in trade? Has the link between trade and economic growth
changed? Is the trade slowdown a warning of another global recession? And, if trade is
central to the productivity and efficiency of companies, what does the slowdown in trade
mean for productivity growth?
I hope to shed some light on these issues today, and help everyone better understand the
forces that are at work.
Explaining slow trade growth
Let's dig into the data a little. The post-crisis slump in international trade was initially
concentrated among advanced economies, particularly in Europe. More recently, the trade
slowdown has been centred in the emerging markets of Asia, including China. This has led
many investors to link weak trade to the slowdown in China, and therefore in the global
economy.
Recent work at the Bank of Canada and elsewhere shows that about half of the slowdown in
trade growth among advanced economies in the post-crisis period can be explained by weak
economic activity, especially sluggish business investment. Throughout this period,
companies have been dealing with high levels of uncertainty about the prospects for the
global economy, in some cases because of aggressive deleveraging. This has held back
investment and, in turn, contributed to soft trade. Investment spending involves capital
equipment, with inputs from many countries, and therefore is very trade-intensive. So when
economic growth slows because of weak investment, trade slows disproportionately.
While advanced economies were dealing with the worst of the crisis, China's economy
continued to expand. This supported demand for commodities, thereby keeping a portion of
international trade flows moving. Higher prices for commodities also prompted commodity
producers to make big investments and ramp up supply.
Ultimately, though, growth in China began to moderate to a more sustainable pace. More
importantly, the Chinese economy has begun to shift away from investment-driven growth
toward consumption, especially of services. Quite simply, this has meant less international
trade. Even so, China's imports of many commodities continue to grow at double-digit rates.
So, we have reason to expect global trade to grow more slowly than in the past: first,
because global investment spending is in a lull, and second, because China's economy is
restructuring toward more domestic consumption and less trade. We can certainly expect
global trade to pick up when the world economy gets back onto a self-sustaining growth
track, with stronger business investment. Still, as I just noted, cyclical factors can explain
only about half of the trade slowdown, so we have more explaining to do.
Indeed, I think we need to step back and consider the possibility that the rapid pace of trade
growth that prevailed for the two decades before the crisis was the exception, and not the
rule. Why would I say that? What we saw during the 1990s and 2000s was the result of the
natural incentive to use trade to increase specialization, in reaction to reduced trade barriers
and major advances in communication and transportation technology.
During those years, countries formed regional trading blocs through arrangements such as
the North American Free Trade Agreement and the European Union. Previously closed
economies, such as China, became more engaged by joining the World Trade Organization
(WTO).
This combination of elements gave the natural incentive to trade a great deal more room to
grow. It paved the way for companies to build global supply chains - the "integrative trade
model." A factory that made a product no longer needed to be next door to the product's
designers. Firms could now exploit their comparative advantage by specializing, not just in
one particular good or service, but in one part of a good or service. The result was an
explosion of specialization as markets became global and companies became more efficient.
As the Peterson Institute for International Economics put it in its recent persuasive report
Reality Check for the Global Economy, "trade boomed during the 1990s and early 2000s in
part because intermediate goods began globetrotting."
However, any trend that goes on for 15 or 20 years becomes ingrained in our expectations.
We should have realized all along that this process of integration simply could not continue at
the same pace forever. At some point, trade would reach a new balance point in the global
economy where firms had built optimal supply chains that crossed international borders,
slowing the integration process, at least for the present.
Yes, there are other structural reasons you can point to for the deceleration in global trade. A
troubling number of protectionist measures have been put in place since the crisis, for
example. But I believe that the most important structural factor behind the slowdown in trade
growth is that the big opportunities for increased international integration have been largely
exploited. China can join the WTO only once. That's not to say that further integration waves
won't happen - I certainly hope they will. But if global trade has reached a new balance
point, we should not fret that global export growth hasn't recovered to pre-crisis levels.
The link between trade and productivity
Even so, we need to think about what this assessment of the state of global trade means for
productivity. Productivity matters to all of us because its growth, along with the growth of
labour, determines the potential growth rate of an economy. We already know that
demographic forces are leading to slower labour input growth in most advanced economies.
Productivity growth is also slowing. This combination points to lower global economic growth
in the future.
And there's more. The most important input into the equilibrium real rate of interest - what
economists refer to as "the neutral rate" - is the underlying growth in economic potential.
Investors are only beginning to come to grips with the implications of this downward drift in
the neutral rate of interest and what it means for long-term investment returns.
Obviously, it matters a great deal whether productivity growth is likely to remain low or
recover as the world economy gains traction, and that depends on how you explain slowing
productivity growth.
Some have said that productivity growth is slow today because most of the truly important
inventions happened years ago, and today's technological progress is more incremental. But
I think a more natural place to look is at international trade, because companies that use
trade to increase specialization also increase their productivity. And if that process has
reached a natural limit, at least for now, then perhaps that also limits future productivity
gains.
A quick comparison of experiences in the United States and Canada illustrates my point.
Let's look at US and Canadian manufacturing over the past 60 years. In 1955, roughly
onethird of the workforce in both countries was employed in manufacturing. As has been well
documented, these shares have been declining, as they have in all advanced economies, as
companies built global supply chains and shifted activities to places that can produce the
same goods at a lower cost. Last year, the share of the workforce involved in manufacturing
was below 10 per cent in both countries, with the US figure a bit lower than the Canadian.
Of course, today's factories are much more productive than those in 1955. US manufacturing
is almost seven times more productive than it was 60 years ago, while Canadian factories
are roughly five times more productive.
Those are both big numbers, but what can explain the difference? The relative size of our
economies may be one factor, since there are clearly more opportunities for economies of
scale and scope in the larger US economy. But also consider this: over the same 60-year
period, the importance of international trade to the US economy more than tripled, while the
importance of trade for Canada only doubled. Here, I am measuring the importance of trade
by looking at total trade - exports plus imports - as a share of GDP.
One explanation for this difference is that Canada has always been dependent on trade. We
were founded on a resource-export model, and since trade started out being very important,
there is less room for its importance to grow. But, in my opinion, the basic insight here is that
US companies pursued globalization and offshoring more than Canadian companies did,
boosting the importance of trade to the US economy more than was done in Canada. When
a company procures one slice of its value chain offshore, it does so to reduce costs. The
result is that the average productivity of the domestic operation goes up. This isn't a
productivity miracle; it's simply arithmetic.
US firms are more likely to be larger than Canadian firms. That means they tend to have
more outsourcing opportunities. Smaller Canadian firms are more likely to be part of the
global supply chain of a multinational firm and have fewer opportunities to build an
integrative-trade supply chain. And, of course, if you are in a resource-extraction business,
there may be few opportunities to outsource.
Ultimately, the integrative trade model is a powerful force for advancing living standards. We
can see evidence of it in action everywhere. Most of us have examples in the mobile phones
we are carrying in our pockets right now. It's true, of course, that the globalization of supply
chains has required economic adjustments. These adjustments can be painful for individuals,
and it is incumbent on policy-makers to help buffer the transition by ensuring adequate safety
nets for workers and facilitating retraining and relocation. But the benefits of integrative trade
shouldn't be ignored. It has meant increasing incomes for economies. It has made many
products much more widely accessible to more people. And it has meant continued job
growth at home.
Implications and alternatives
My argument is that a significant part of the strong productivity performance in the two
decades before the crisis was due to globalization, and that the globalization process may
have brought trade in the global economy to a new balancing point. Understanding this is
one thing; the question is what can be done about it.
I see at least three reasons to hope for future progress. The first is that a lot of productivity
growth comes not from existing firms, who tend to be incremental about it, but from new
firms. A new firm with a new product or service tends to see giant leaps in productivity as it
goes from being a start-up to the "hockey stick" growth phase. A firm only makes that
transition once, but an economy can reap the benefit over and over if there is a strong trend
in new firm creation.
An expanding economy generally sees a pretty steady growth in the population of
companies. Under the surface, there is a steady rate of firm exit too. This is Schumpeter's
process of creative destruction.
So let me just point out that the growth of the population of companies slowed dramatically in
a number of countries in the wake of the global financial crisis. I've been watching the
Canadian and US data closely, because I'd interpret the emergence of firm creation as a
strong sign that growth had become self-sustaining. In the Canadian data, firm population
growth has picked up but remains slow, at around 1 per cent annually, well below pre-crisis
rates. But in the United States, there has been a steady acceleration of firm population
growth since 2011. The most recent figures are approaching 3 per cent annual growth, which
is back to pre-crisis levels. If I am right, the US economy is due for another period of better
productivity growth, and I have every reason to think that Canada will follow once we work
through our adjustment to lower resource prices. A reversal of the cyclical slowdown in
investment I mentioned earlier would also serve to support future productivity growth.
A second reason for optimism about productivity is that even if most major economies have
exploited most available opportunities for integration, gains may still be had from
improvements to existing supply chains. Economies evolve over time, and comparative
advantages are not set in stone.
Consider China, which for years was the main destination for outsourced production. Today,
its working-age population is shrinking. Unit labour costs have been rising quickly as the
economy moves up the value chain. Now, we're seeing signs that labour-intensive
production is shifting out of China and into nearby economies, such as Cambodia and
Vietnam.
All of this suggests that companies and investors may be able to find ways to improve the
efficiency of supply chains in many geographic areas. This will show up as a new wave of
integration and global trade growth. For policy-makers, of course, this means we should be
working to help initiatives such as the Trans-Pacific Partnership and the Comprehensive
Economic and Trade Agreement between Canada and the European Union become a
reality.
Third, nobody can predict the future disruptive technologies that would allow the global
economy to take its next giant step forward. History gives us no reason to be pessimistic with
respect to future technological progress.
Before I wrap up, let me make one more point. International trade, as measured by our
standard global trade statistics, is not the only way for companies to exploit integration
opportunities. Some companies find it more sensible to operate foreign affiliates in other
countries while managing them from home. For some firms, this model effectively acts as a
substitute for international trade.
And this business model has been growing, even while traditional exports and imports have
been slowing. We know that sales by Canadian-owned foreign affiliates now exceed total
exports from Canada, approaching 30 per cent of GDP. In other words, these foreign
affiliates are almost like another Canadian economy out there, supporting jobs in Canada in
areas such as research and development, engineering, design and marketing, not to mention
lawyers, accountants, and executives who manage the operation from home. In the United
States, foreign affiliates are even more important, with sales equalling more than 40 per cent
of GDP. This is a very real sign that companies are growing, becoming more productive and
creating jobs at home, whatever the official trade data show.
Conclusion
It's time to conclude. In a world full of anxiety, my goal today was to give investors one less
thing to worry about. Most of the cyclical part of the slowdown in trade should be reversed as
the global economy recovers, even if that is a slow process. Furthermore, there are
opportunities for progress on the structural side in terms of both trade and productivity if
conditions permit another wave of global integration. Moreover, the creation of brand-new
firms could be the most promising source of new trade and productivity growth.
I hope I've convinced you that the global economy can continue to recover, even if global
trade growth remains lower than its pre-crisis levels. The weakness in trade we've seen is
not a warning of an impending recession. Rather, I see it as a sign that trade has reached a
new balance point in the global economy - and one that we have the ability to nudge
forward.
As for monetary policy, the Bank of Canada will continue to work on building a positive
economic environment for investors, firms and consumers. We know that sound, clearly
communicated monetary policy can facilitate trade, productivity and growth. And that's good
for everybody.