John Kenneth Galbraith
The Bank of Canada hiked it's policy rate by 25 basis points to 1.5% on July 11, in a move that was widely anticipated by the consensus.
As the C.D. Howe Institute's Monetary Policy Council (of which I am a member) said on July 5,
All but one of the nine MPC members who attended this meeting called for an overnight rate target higher than the current one at the upcoming meeting on Wednesday 11 July. The near unanimity reflected the group’s view that Canadian economic data in the second quarter have rebounded from a sluggish beginning to 2018. Output has risen since April, with the Business Outlook Survey suggesting we are at or above productive capacity. The labour market is also showing signs of tightening with growth in average hourly earnings at its highest level since 2008.This is the conventional wisdom which nearly everyone with an educated opinion accepts. It is based on the notion that the economy has reached or exceeded its' full capacity. The unemployment rate, which ticked up last month, had previously fallen to its lowest since comparable data became available in 1976. Wage growth, as measured by average hourly earnings of permanent employees reached 3.9% in May, the highest since 2008.
One analyst, who I have high regard for, recently wrote,
The Canadian economy is in an interesting position approaching the middle of 2018. Growth has slowed in recent quarters, after a very strong 2017H1. There are convincing signs, however, that this slowing reflects the economy hitting capacity constraints, rather than a sudden fall off in demand. Consistent with this, genuine inflation pressures have become more evident. Canada is the only G7 country to experience a significant acceleration in wage inflation as the unemployment rate has fallen below traditional estimates of NAIRU.All these factors suggest that the Bank of Canada is behind the curve on its policy of rate normalization.When I read such analysis or the financial press, the message that comes through is that:
- Because growth of demand (or GDP) has been stronger than potential, Canada's economy has reached or exceeded it's full productive capacity; and
- Because the labour market has reached a 40+ year tightness, wage growth is accelerating and putting upward pressure on inflation;
- The Bank of Canada should play catch up in "normalizing" it's policy rate.
I believe that neither of the first two points is an accurate description of the current situation in Canada and therefore, that the conclusion about Bank of Canada policy does not follow.
Why is Canada facing capacity pressures?
I don’t share the view that growth has slowed because of capacity constraints that have pushed up wages. I believe the latest acceleration in wages in a slowing economy was driven by sharp increases in minimum wages in several provinces, which began in 2017.
Across Canada's ten provinces, the minimum wage rose by a weighted average 4.1% in 2017 (led by an 11.5% hike in Alberta) and by 11.0% in 2018 (led by a 20.7% hike in Ontario). Minimum wage hikes, not excess labour demand, have forced employers to raise wages not only for minimum wage employees, but also for employees who had moved to above-minimum-wage status, to maintain some equity and premium for experience. With 15% of employees affected directly or indirectly, these minimum wage hikes are sufficient to explain the majority of the acceleration average hourly wages for the total workforce. The sharp increase in early 2018 is probably also partly responsible for employment having declined 50,000 in the first five months of 2018.
I would characterize capacity utilization reaching cyclical highs even as growth has slowed as being caused by insufficient business non-residential investment. The chart below compares Canada and US real nonresidential business investment to GDP.
Over the past two decades, Canada has lagged the United States in business investment in plant, equipment and intellectual property. Canada's real investment rose as a percentage of GDP in the periods leading into 2008 and into 2014 when global crude oil prices were strong, boosting investment in Canada's oil and gas industry, led by growth of oil-sands production. Since the collapse of crude oil prices in 2014, followed by aggressive new government regulations and taxes in pursuit of climate change objectives, Canadian business investment fell to recessionary levels in 2016-17. While US business investment as a percentage of GDP has risen to a 20-year high, Canada's investment has fallen toward two decade lows.
The mix of Canada's business investment also demonstrates weakness. The charts below show Canada-U.S. comparisons of business spending on machinery and equipment, nonresidential structures and intellectual property.
US spending on machinery and equipment reached 6.5% of GDP in 1Q18, its' highest level in over 20 years. Meanwhile, Canada's spending on M&E was one-third lower at just 4.1% of GDP, still below the level reached prior to the Great Financial Crisis.
US business spending on intellectual property has been rising strongly and reached 4.5% of GDP in 1Q18. This was well over double Canada's spending of just 1.8% of GDP.
Canada's business spending on non-residential structures rose to 5.5% of GDP in 1Q18, well below the peak level of 7.5% reached in 2Q14. The decline in crude oil prices slowed energy investment after 2014 and increased regulation stalled investment in pipeline building. Canada still devotes almost double the US investment to nonresidential structures.
Canada's mix of business investment, which has been heavily skewed toward energy investment is a disadvantage when crude oil prices are weak and when governments prioritize environmental concerns. Canada has badly lagged the United States for decades in investment in machinery and equipment and intellectual property, but in both cases the US is opening up a widening gap.
What's Behind Canada's Weak Business Investment?
To some extent, Canada's lagging business investment is the result of differences in the industrial structure of the two countries. Canada has abundant natural resources and has long been a leader in capital investment in the extraction and transportation of these resources. When natural resource prices weaken or when governments adopt taxes and regulations that discourage resource development Canada's business investment can weaken quite dramatically. The United States has long been a leader in high technology industries and in the implementation of new technologies to increase business productivity and efficiency. As the pace of technological development accelerates, the US seems to be widening and deepening its advantage in business investment in both machinery and equipment and intellectual property.
While industrial structure is important, the influence of government policies can also be very important. Some recent policy developments in the US and Canada clearly seem to have tilted incentives toward higher investment in the US and weaker investment in Canada.
- Corporate Tax: The Trump Administration has lowered corporate tax rates and encouraged repatriation of foreign profits. Canada has, so far, left its corporate tax rates unchanged. In 2017, the federal government raised the ire of small business by suggesting that they were not paying their "fair share" or taxes, before backing down on proposed changes.
- Carbon Tax: The Government of Canada introduced a carbon tax of C$10 per tonne in 2018, rising to C$50 per tonne by 2022. The Trump Administration has pulled out of the Paris Climate Accord and the President has tweeted "I will not support or endorse a carbon tax!"
- Regulation: President Trump has instructed the Environmental Protection Agency to cut regulations on industry and speed up decisions on permits. In Canada, environmental regulations have been tightened and the process to gain approval for pipelines and other energy projects has been made more complicated and time-consuming (see here).
- Trade Policy: The Trump Administration has:
- demanded major changes to NAFTA which are unacceptable to Canada (and Mexico), thereby leaving negotiations in limbo;
- imposed a 20% duty on Canadian softwood lumber after the US Commerce Department ruled that Canada was unfairly subsidizing the industry (a claim made many times in the past but never upheld under WTO or NAFTA dispute settlement procedures);
- implemented 25% tariffs on steel and aluminum imports on "national security" grounds, refusing to exempt Canada, a close ally;
- threatened 25% tariffs on all auto imports, using the same "national security" justification.
Trump’s tax and regulatory moves and the uncertainty generated by his trade policies have discouraged business investment in key Canadian goods producing industries. Meanwhile Trudeau’s attempts to tighten small business tax rules and the introduction of new regulatory obstacles to pipeline building and other energy projects have curtailed Canada’s future ability to get oil to export markets, depressed prices of Canadian crude and discouraged investment.
The net result has been to tilt incentives to invest away from Canada and in favour of the United States. The comparative charts shown above of US and Canadian business investment-to-GDP provide strong evidence that this is the case. Further supporting evidence is provided by the chart below, which shows Canada's foreign direct investment flows.
The chart clearly shows that while Canadian direct investment abroad is near its' 20-year highs, foreign direct investment flows into Canada have fallen toward 20-year lows. US, Canadian and other foreign companies have a choice as to which side of the border to invest. They are increasingly choosing to invest in the US. The attraction of lower corporate taxes and reduced regulation combined with punitive US tariffs and uncertainty over the future of NAFTA provide powerful incentives to make capacity-expanding investment in the US, not in Canada.
What is Canada's Response?
So far, Canada has not responded effectively to Trump's tax and regulatory moves. On corporate taxes, the 2018 Federal Budget provided neither action nor a plan to revise Canada's corporate income tax, which prior to Trump's changes, had been relatively attractive.
The federal government has not budged on its' plan to enforce a Canada-wide carbon tax, but provincial governments in Saskatchewan and Ontario oppose the plan and a change of government in Alberta would add a third important opponent, making it difficult for the federal government to implement its' carbon tax plan. Uncertainty over the future of carbon taxes remains a negative for business investment.
On regulatory measures, the Trudeau government, after allowing a dysfunctional regulatory process to cause the Northern Gateway Pipeline and the Energy East Pipeline projects to die, approved the Trans-Mountain Pipeline. However, because of protests by the Government of British Columbia, environmental activists and indigenous groups, the private investor, Kinder Morgan, shelved the project. The Federal Government kept the project on life support by purchasing the Trans Mountain Pipeline from Kinder Morgan for C$4.5 billion and promising to build it. Opponents will still make strong efforts to block the project, leaving Canada with insufficient capacity to get its' oil to world markets.
On trade policy, the federal government has chosen to retaliate against Trump's steel and aluminum tariffs with and equal value of tariffs on a range of US imports, a move which could provoke Trump into further escalating the trade war. Trump has shot Canada in one foot with his tariffs and duties on lumber, steel and aluminum and his threats of tearing up NAFTA and imposing tariffs on autos. Trudeau has shot Canada in its' other foot by imposing tariffs on US goods consumed by Canadians and his rhetoric that Canada "will not be bullied", which has contributed to the standstill in NAFTA negotiations. Let's be clear: Trump's trade policies and threats are dangerous and, if carried out, pose a clear risk to the global growth. But retaliation by US trading partners only increases that risk.
Is Canada Operating at Full Capacity?
It seems clear to me that Canada's economy is suffering from an investment drought. While unemployment is low by historical standards, weak business investment is resulting in many Canadians working at jobs well below their potential. Self employment is at a record level. Young people have great difficulty finding jobs that match their education and qualifications. Higher levels of business investment would surely create more full time private sector employment and stronger GDP growth. Traditional measures may suggest that Canada is near full capacity, but in my view, it is nowhere near full potential.
I am hopeful, however, that the next few years will see Canadian voters electing governments more attuned to the necessity of building a positive investment climate. Change is already underway in Ontario and is pending in Alberta. Only when federal and provincial governments begin working together on a comprehensive strategy to improve the climate for business investment will Canada reach its' potential.
In the meantime, tightening monetary policy is unlikely to improve Canada's economic prospects. Bank of Canada tightening in response to politically motivated spikes in minimum wages or to temporary upward pressure on Canadian inflation from US and Canadian tariff hikes is clearly inappropriate. Until Canada is able to bring about a lasting improvement in its' investment climate, a Bank of Canada monetary policy strategy of standing pat while the US Fed tightens monetary policy more aggressively would tend to weaken the Canadian dollar, thereby providing a boost to our export competitiveness and a needed adjustment cushion the blow from US protectionism.