David Dodge: Adjusting to global economic change
Remarks by Mr David Dodge, Governor of the Bank of Canada, to the Brazil-Canada Chamber of
Commerce, São Paulo, 10 March 2004.
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Good morning. I am glad to have the opportunity to meet with business leaders in São Paulo today. I
am also pleased to meet with my counterpart, Governor Henrique Meirelles, and with some of his
colleagues at the Banco Central do Brasil.
Geographically, Brazil and Canada are far apart. But from an economic viewpoint, we have more in
common than some might think. We share common issues and challenges. We both operate monetary
policy systems based on inflation targets and floating exchange rates. We are both being affected by
the recent slowdown in the world economy and by global economic imbalances. And we are both
working on the structural adjustments that are necessary to weather shocks and to thrive in a
changing environment.
Today, I want to focus my remarks on Canada's adjustment to changes in the global economy. I will
talk about our efforts to adjust to longer-term economic forces and about the challenges that these
forces present. Some of our experiences may be relevant to other economies that are making similar
adjustments in the face of similar economic circumstances.
Past adjustments
Our experience over the last couple of decades has taught us that structural adjustments are key to
adapting to change, and, just as important, that sound macroeconomic policies have a role to play in
making those adjustments with a minimum of economic and social disruption.
These lessons may seem self-evident. But Canadians have been reminded of their importance
through some significant and painful economic adjustments during the past 30 years.
For example, Canada was hit by an abrupt slowdown in productivity growth during the 1970s. That
slower productivity growth made it impossible to continue to provide the gains in real wages to which
Canadians had become accustomed. The situation was exacerbated by the OPEC oil embargo of
1973 and by the subsequent energy crisis that hit economies around the globe. The consensus of the
day was that the impact of those events on Canada would be temporary. And so Canadian
policymakers used macroeconomic and microeconomic policies to try to shield our economy from the impact
of those events. Instead of making the necessary adjustments, we tried to avoid them. As a result, the
eventual adjustment was slower and more painful than it needed to be. And we ended up with slower
growth, relatively high inflation, and large government budget deficits.
Canadians learned during this period that economic policies must be focused on adjusting to change -
even if that adjustment causes short-term difficulties. By the beginning of the 1990s, it was clear that
we needed a framework of policies to help with adjustment, to bring down inflation, and to put our
public finances in order.
The first major change came in 1991, when the government and the Bank of Canada agreed on an
explicit anchor for monetary policy. That anchor was a series of inflation-reduction targets that would
gradually lower the rate of inflation to 2 per cent, the midpoint of a 1 to 3 per cent range. The
agreement has been extended three times and currently covers the period to the end of 2006. Each
time, the midpoint of the target range has been kept at 2 per cent.
I want to note here that while the Bank and the government established the monetary policy anchor
jointly, the Bank alone takes responsibility for the conduct of monetary policy and for achieving the
inflation target. I want to stress the importance of that independence. Experience around the world has
shown that there are distinct advantages to having monetary policy carried out by an independent
central bank, not the least of which is separating the power to print money from the power to spend it.
Central bank independence is also a mechanism for building credibility among investors.
Central banks have a choice to make as to how to anchor their monetary policy. Some countries have
chosen a fixed exchange rate as their anchor. In doing so, their central banks give up the power to
control domestic inflation. In contrast, other countries - such as Canada - have chosen domestic
inflation as their anchor. By doing this, they leave it to foreign exchange markets to set the external
value of the currency. The key point is that, since capital is mobile, no central bank can successfully
control inflation and the exchange rate at the same time.
The choice of an inflation-targeting framework has served Canada very well. Since the end of 1994,
inflation has averaged almost exactly 2 per cent. Moreover, not only has inflation fallen, it has become
more stable than it was in the 1970s and early 1980s. Just as importantly, inflation expectations have
fallen into line with the 2 per cent target and have remained there. As for the floating exchange rate, it
helps the economy adjust to disturbances and fluctuations in the world prices of our products, notably
commodities. It also helps our economy adjust to changes in global savings and investment flows.
One of the most important advantages of adopting a system of inflation-control targets is that we at the
Bank of Canada can now explain more clearly to business, to labour, and to the general public what
we are doing and why. We do this through eight regularly scheduled interest rate announcements
each year, plus our regular Monetary Policy Reports and Updates. One should not underestimate the
benefits that arise from having the public understand the policies and actions of its monetary authority.
This understanding makes it easier for us to conduct monetary policy, and it allows citizens to judge
the performance of their central bank.
It has been less than five years since Brazil adopted its own inflation-targeting system in July 1999,
after floating its currency in January of that same year. The system is already proving to be extremely
helpful in reducing inflation rates in this country, even in the face of some large shocks. Establishing a
track record of credible inflation targeting leads to lower inflation expectations. These lower
expectations create a virtuous circle - they lead businesses and consumers to make pricing and
spending decisions that, in turn, help the central bank meet inflation targets. And consistently meeting
inflation targets allows citizens to make investment and savings decisions with confidence that inflation
will remain close to the target.
The second major adjustment that Canada had to make in the 1990s was to get its fiscal situation
under control. In the early part of that decade, the combined federal and provincial primary deficit
(which excludes debt-service costs) peaked at just under 3 per cent of GDP, and the total deficit was
close to 8 per cent. The combined public debt reached a peak of 100 per cent of GDP. While some of
the shortfall reflected cyclical factors, it was clear that the situation was unsustainable. So between
1993 and 1997, both federal and provincial governments in Canada made a determined, and
successful, effort to eliminate their deficits and run consistent primary budget surpluses.
The fiscal adjustments made by both levels of government helped to improve the credibility of our
economic policies and reduced the risk premium that investors demanded on Canadian bonds. While
this credibility is always useful, it is particularly beneficial during periods of crisis, when the spreads on
riskier investments tend to widen.
Consider Canada's experience with the Mexican currency crisis of 1994, before the credibility of our
monetary and fiscal policy was fully established. Spreads on Canadian bonds widened significantly
during that event, and consumption and investment slowed, leading to a period of weaker economic
growth.
Our credibility was better established by 1997, and so we were able to weather the financial crises in
Asia and Russia with only a slight widening of spreads. There was minimal uncertainty, and growth
actually strengthened in the wake of those events. When you compare these two experiences, you
can see that there is a real payoff from the achievement of fiscal and monetary credibility. And it does
not take too long for that payoff to be realized.
Canada's public and private sectors also made structural adjustments in the 1990s, leading to a more
flexible economy. This added flexibility helped us to weather the recent global economic slowdown.
Our governments, both federal and provincial, also took steps to reduce distortions in the economy. In
the latter half of the 1990s, federal industrial subsidies were cut by more than 60 per cent. Provinces
eliminated many of their own subsidy programs. The federal government reformed its unemployment
insurance system, and Canada's public pension plans were overhauled to make them self-financing in
the decades ahead. This involved some restructuring of benefits and an increase in contribution rates.
And contributions are now being invested in markets in order to generate the best possible returns -
with due consideration for prudence - over the long term.
Throughout this difficult period, governments worked hard to ensure that the burden of adjustment did
not fall disproportionately on those segments of the population that were least able to bear it. It was
only after the adjustment process was well underway that the federal government began to reduce
corporate and personal income taxes.
As governments take steps to improve the structure of their economies, it is equally important that
businesses make their own adjustments. During the 1990s, Canadian firms responded to the
challenges of freer trade by improving the quality of their products and by marketing them aggressively
to new North American customers. These adjustments were not easy. But they did leave Canada in a
better position to handle economic shocks and, therefore, to grow on a sustained basis.
To recap, a sound monetary policy supported by a floating exchange rate, sound fiscal policy, and
appropriate structural adjustments all did their part to help Canada's economy respond to the
changing circumstances of the 1990s. While these adjustments were difficult, the payoff came quickly.
By the end of the decade, Canadians were beginning to see higher real incomes.
Adjustments in the future
So that's a quick look at the lessons we have learned from past experience. Let's turn now to the
international forces at work in our economies and talk about what these forces will mean for economic
policies in the future.
In the global economy today, we see significant financial imbalances. The United States is faced with
a large fiscal deficit and a high and growing current account deficit, while some Asian countries are
accumulating record current account surpluses. The economies of China and India, as well as yours
here in Brazil, are becoming increasingly powerful players on the world stage. This increases the
competitive pressure facing Canadian producers. But it also means new, fast-growing sources of
demand and new opportunities.
So in the face of these forces, what kinds of adjustments are needed? I will talk about our situation in
Canada, but what I have to say is applicable to most economies.
The first thing I would say is that maintaining fiscal balance must remain a priority for Canada in the
years ahead. Our federal and provincial governments have made great progress on this front, but we
in Canada cannot afford to give back these hard-won gains. Neither can governments in this country.
Maintaining fiscal balance is as important for Brazil as it is for Canada.
This priority is heightened in Canada by our longer-term demographic challenges. Our ratio of public
debt to GDP will need to decline further to give us the flexibility to meet the demands of our aging
population.
My second point is that we must provide the appropriate microeconomic policies in areas such as
labour markets, intellectual property law, the environment, and foreign investment. The right
microeconomic policies are essential in order to increase productivity and raise living standards in the
future. This is true for every country.
However, we know that implementing the right economic policies can mean that some groups will bear
an unfair share of the burden of adjustment. This does not mean that we should shy away from the
task. But it does lead to my third point, which is that authorities must put in place the right policies to
facilitate adjustment, such as providing access to training, or helping workers relocate or shift into
expanding areas of the economy. In doing so, we should keep in mind that government help should be
directed towards people, and not towards specific businesses or industries.
So what can policy-makers do to provide a supportive economic environment for business? In my
view, promoting an efficient and robust financial system, including a strong banking sector, is critical.
And that is my fourth point. This is particularly true in countries such as Canada, where small and
medium-sized businesses create the majority of jobs. Growing firms must have access to credit within
a well-functioning financial system. Further, people need to have confidence in the banking sector, so
that savings can be efficiently recycled to help businesses expand.
A robust financial system can also be a country's best defence against international financial crises. A
key lesson from the Asian and Russian crises was that countries with strong banking sectors are much
less likely to be affected than countries where the banking sectors are weak.
Beyond the banking sector, countries should also work to develop healthy and efficient financial
markets. This is not a new idea. Canada's efforts to build domestic money markets go back over
50 years. And we built these markets living next door to the country with the deepest, most liquid
financial markets in the world - the United States. Now, and in the future, we will need to remain
focused on promoting healthy and efficient markets. This topic is an ongoing priority for research at the
Bank of Canada. In fact, later this year we will host, along with the German Bundesbank, a
G-20 workshop on building strong domestic financial systems.
My fifth and final point has to do with trade. Canada has a long history of supporting multilateral trade
agreements. We have seen, first-hand, how our economy has benefited from opening our borders to
trade. That is why we are committed to trying to extend the benefits of free trade to the whole of the
Americas through the Free Trade Area of the Americas (FTAA). It is why we also support your efforts
in Mercosur. And, most importantly, it is why we are committed to lowering trade barriers at the Doha
round of multilateral negotiations. I have seen many examples of the challenges that governments
face in reducing trade barriers and subsidies. We in Canada have our own difficulties in this regard
but, as an economist, I know that the economic benefits of freer trade make the effort worthwhile.
So those are the five areas that should be priorities for Canada in the years ahead: fiscal prudence,
the right microeconomic policies, appropriate social policies, a strong and stable financial system, and
more open trade. Monetary policy, for its part, will continue to be focused on keeping inflation low,
stable, and predictable, thus giving citizens, businesses, and investors confidence in the future value
of their money. To achieve this, we will try to keep supply and demand in balance.
Since the Bank of Canada has chosen low domestic inflation as its monetary policy anchor, we will
continue to have a flexible exchange rate. We recognize that a floating currency implies some
volatility. But I can tell you that Canada derives enormous benefits from having a floating currency
working in conjunction with a solid monetary policy anchor. It gives us the ability to set monetary policy
tailored to Canada's specific economic circumstances. It sends important price signals to economic
participants and helps our economy to make the necessary adjustments.
Conclusion
Let me conclude. For many firms and many employees, adjustment can be painful and difficult. But in
today's world, not adjusting is not an option.
Fortunately, in both our countries, we are making these adjustments under relatively favourable
conditions. Global demand is strengthening, and credit conditions are good. We have a better
knowledge of what we need to do. And we have made important progress in strengthening our
economic policy frameworks.
The challenges that we will face make it even more important for us to continue to strengthen those
frameworks in order to adjust to changing circumstances and to take advantage of potential gains. The
faster we are able to adjust, the greater the wealth that Canada and Brazil can create for their citizens.
That is not to say that adjusting will be easy. Indeed, the experience of recent decades proves that it
can be difficult, at least over the short term. But if we take the leap and seize the opportunities that
change will bring, our societies will surely benefit.