david dodge : adjusting to a changing economic world remarks by mr david dodge, governor of the bank of canada, to the board of trade of metropolitan montreal, montreal, 11 february 2004. * * * good afternoon, ladies and gentlemen. it ’ s a pleasure to be with you here in montreal today. these are turbulent times, not just for business people, but for all canadians. we have come through a very difficult year, a year filled with surprises that have challenged us all. at times like these, it is easy to focus on the near - term issues and problems. but by doing that, we risk losing sight of the big picture. the bank of canada had plenty to say about the near - term outlook in its monetary policy report update a few weeks ago. so today, i want to talk about the longer - term trends at work in the economy. in doing so, i want to take a quick look back at some of the major economic events of recent decades, and examine how we approached the issues of adjustment at the time. then, i will discuss the adjustments that are needed now and in the future. in this way, i hope to draw on the lessons learned from the past. i will frame this discussion in terms of structural economic policies, macroeconomic policies, and the role of the exchange rate in facilitating adjustments. previous adjustment policies i will start by going back to the 1970s. there were at least two forces at play that highlighted the need for economic adjustments. the first was a significant drop in the rate of productivity growth. canada, like the united states, had become accustomed to productivity rising at a rapid pace during the 1950s and 1960s. with this growth in productivity came steady advances in real incomes. but the trend towards higher productivity slowed abruptly in the early 1970s. at the time, policy - makers, business, and labour assumed that the slowdown was cyclical. it wasn ’ t. economists still don ’ t have a complete explanation for it. but what we now understand more clearly is that the productivity increases of the 1950s and 1960s had a lot to do with the application throughout the economy of earlier advances in general - purpose technology. businesses took advantage of various technological advances in many diverse fields, enabling them to realize significant productivity gains. when productivity growth slowed in the 1970s, many people assumed that the slowdown was temporary and that rapid growth would resume on its own. this was a mistake. without solid productivity gains, the economy was unable to deliver the increases in

real incomes that everyone had come to expect. this situation was compounded by the second major event of the 1970s : the energy crisis. unfortunately, we in canada didn ’ t recognize the full implications of the energy crisis. we were slow to realize that higher oil prices also meant a reduction in the economy ’ s production capacity. canadian policy - makers tried to cushion the impact of the higher energy prices and slower productivity through increased transfers, subsidies, and easier monetary and fiscal policies. for example, the bank of canada added to liquidity by expanding the money supply too fast in relation to the slower growth in the economy ’ s production capacity. in the wake of these structural and macroeconomic policies, inflation rose, and fiscal deficits grew. this slowed the structural - adjustment process in the late 1970s and early 1980s. all of this was made worse by the shared misperceptions about the productivity slowdown. businesses, households, and governments all thought that economic growth would recover and that real incomes could continue to rise at their previous rate. but without strong productivity growth the economy could no longer satisfy these demands. but that difficult period from 1975 to 1985 taught us a lesson. we learned that structural adjustments are important and inevitable, and that macroeconomic policies have a role to play in making those adjustments work quickly and with less disruption. canada had the opportunity to apply those lessons in the 1990s. let me explain how. to begin, recall the state of canada ’ s economy as the 1990s began. although inflation had come down from the very high levels seen in the early 1980s, it was still relatively high by today ’ s standards. on the fiscal side, the picture was pretty grim and getting worse. public sector deficits eventually peaked at around 8 per cent of canada ’ s gdp, and public debt levels were continuing to mount. clearly, the situation was not sustainable. changes were urgently needed. the first major change came in 1991, when the bank and the government of canada agreed on a series of explicit inflation - reduction targets. the agreement called for an inflation target - defined in terms of the annual rate of increase of the consumer price index - that descended gradually to 2 per cent, the midpoint of a 1 to 3 per cent range. the agreement has been extended three times, with the latest one covering the period to the end of 2006. each time, the midpoint of the target range has been kept at 2 per cent. this framework has worked very well. from the end of 1994 to