Northern Juggernaut? A Look Inside the Canadian Economy with Don Drummond

Don Drummond is the Matthews Fellow on Global Public Policy at Queen’s University at Kingston. From 2000 to 2010, he was the Senior Vice President and Chief Economist for TD Bank Financial Group. In March 2011, he was appointed Chair of the Commission on the Reform of Ontario’s Public Services. 

When Canada is mentioned in the international business press, it is often mentioned in a positive light. We read about Canada’s sound banking system and relatively low public debt or we hear about its GDP and employment growth that has outstripped other G7 countries. But could you give us a more complete picture? What is going well in Canada’s economy and what is going not-so-well?

It is true that if you look at the so-called underlying fundamentals, we really seem to have distinguished ourselves from the major developed economies. But on the other hand, our record of output during the recession was not much better than that of the United States.

Historically our recessions have tended to be worse than those in the United States. This time we have been hit somewhat more lightly, and that was due to our sounder policies and stronger private sector business fundamentals. So, one could argue counterfactually that the recession might have been worse in Canada without those sound fundamentals.

The other aspect that distinguishes Canada sounds great at first but is more ambiguous in the long run, and that is that we have established a better employment record than the other developed economies, particularly the United States. The inverse of that, however, is that our productivity growth rate is fairly low. I think that is truly the Achilles heel of the Canadian economy. If we look at the Canadian economy over the last decade, we have had very little productivity growth—less than 1 percent a year. Despite everything that ailed the US economy, it had productivity growth of over 2 percent a year.

If we look back at the 24 OECD countries starting in the 1960s, Canada used to have the third-highest level of productivity. Now it is seventeenth. In fact, since 1980, only three of those 24 countries have had a slower productivity growth rate than Canada. So we may appear to be doing quite well in terms of output and employment growth rates, but in terms of productivity levels we’re still suffering. That translates into weak household income growth.

According to Statistics Canada, between 1997 and 2011, Canadian labor productivity declined 17% relative to the United States. What are some of the reasons for this, and what can Canadian policymakers do to close this gap?

Superficially, I would say the number one culprit is that we have underinvested in machinery and equipment in Canada. The best way to increase labor productivity it is to give workers a better stock of machinery and equipment to work with. On average, the Canadian worker has just a little more than half the stock of machinery and equipment to work with as his American counterpart.

But, as I said, that is the superficial answer because that just begs another question: why do Canadians have so much less machinery and equipment to work with?

Historically, Canadian companies have said that this is because the taxation of capital is very high in Canada. I have some sympathy with that as an historical argument, but that is not the case anymore. All Canadian governments started to bring down their rate of capital taxation beginning in 2000, and we now have much lower rates than the United States. So, in theory, we should have seen an increase in business investment.

We had a potential golden era of investment from 2003 to 2007 because we import much of our machinery and equipment, and the Canadian dollar was rising against the US dollar and almost all other currencies. This meant that imports in machinery and equipment were getting cheaper. Adding to that, corporations had a lot of retained earnings. Yet, they did not increase their business investment very much.

One reason for this could be the historical reliance of Canadian businesses on an undervalued Canadian dollar. This is certainly anecdotal, but a lot of businesspeople have given me the story that they thought the dollar would fall back down in value, so they did not need to make transformational changes. But by 2007, they realized the dollar was going to stay fairly high, and this is consistent with the numbers, which show a rise in business investment in 2007 until it got knocked off course.

A second distinguishing feature of Canada that accounts for some of the productivity gap is that we have a much heavier concentration of small businesses than the United States. As a percentage of GDP, the output of small businesses in Canada is roughly double what it is in the United States. Again, historically there has been a taxation reason for that. We have always had a much lower tax rate on small businesses than on large businesses, so if your business income rose and you started to lose the small business rate, the marginal corporate tax rate became quite high. Prior to 2000, it went up to about 56%, well above the top marginal personal income tax rate. So we actually had a feature of our tax system that gave an incentive to small businesses not to grow. If they did grow, they had an incentive to pay out earnings to their partners as bonuses so that it would count as personal income. That is the antithesis of what you want to do to grow your business.

But now the gap between the small business rate and regular rate has come down, and the marginal tax rate for small businesses no longer gets above the marginal tax rate for individuals. Yet businesses still appear to be disbursing retained earnings to partners, even though it is no longer advantageous from a tax perspective.

It could just be that old habits die hard. I think partly we are still living in the legacy of historical economic philosophies of Canada. If we go back to one of the founding fathers of the country, Sir John A. MacDonald, his economic plan was heavily based upon building the manufacturing system by protecting it through tariff barriers. So when a lot of industries started in Canada, they didn’t need to be particularly competitive because they had a captive market in Canada. To some degree I wonder whether that philosophy still governs some businesses, even though the tariffs have been gone for nearly two decades.

We do have some telltale signs of that philosophy. For example, only 4 percent of all the revenues from small and medium enterprise in Canada come from exports into emerging economies. And yet, as of 2009, emerging economies now constitute half the world economy. Our economic model still remains one in which we’re almost uniquely tied to the United States. Historically, that’s been a wonderful economic model because the US economy has grown very strongly, with very strong productivity growth.  But I would not expect that over the next 15 or 20 years. The United States is not going to be one of the growth leaders in the world, and Canada will have to change its economic model. We are seeing that come about fairly slowly.

You mentioned the persistently strong Canadian dollar, which makes it cheaper to import productivity-enhancing machinery and equipment. Will the strong dollar independently lead to a closing of the productivity gap, or do you see a need for concerted policy action?

The stronger dollar should help very much in Canada. I do not believe the claim that it is a disaster. Other than the obvious advantage the United States has in economies of scale, I do not think there is any reason the Canadian economy should have a lower productivity level. Hence, there is not any reason we should not be competitive at a dollar at parity. And even on the issue of economies of scale, we have to remember that, despite a few obstacles, we do have free trade with the United States. A theory of free trade between the two economies would say that you could operate out of Canada and still achieve US-type economies of scale. So I am not even sure the economies of scale argument holds true for Canada.

On the policy side, you may want to have a look at an article I wrote in the winter edition of the International Productivity Monitor called “Confessions of a Serial Productivity Researcher.” I basically said that, if you go back to the 1980s and early 1990s and look at the list of things I said the Canadian government should do to raise productivity, it’s done about 70% of them. Some might not have gone as far as they should have, but I think that policy agenda has been tackled in a very serious way.

And yet productivity growth has continued to weaken. That does not mean the policy changes were wrongheaded—the record probably would have been worse without them—but it does suggest that the answers do not fully lie in that policy agenda. There are still some things left to do. For example, we still have a difference between small and large business taxes. We have an Employment Insurance scheme that basically dissuades people from going where the jobs are. We still have interprovincial trade barriers. And we still have large segments of the economy—including the industry I worked in for ten years, the banking industry—that are effectively protected from international competition.

But you have to wonder: if 70% of the agenda didn’t do the trick, why should we believe that the other 30% will? I think the time has come to realize that the answers may not even lie in the policy arena; they may come back to this business culture issue. I do not know what, if anything, you could do on the policy front to change Canadian business culture. Current practice will change eventually, because businesses will likely realize that the US economy is not going to grow very rapidly, and they will look for other opportunities. But our interactions with the emerging economies more or less consist of selling commodities, and in many cases we do very little processing here in Canada.

Let's move to the issue of debt and deficits. You are currently the Chair of the Commission on the Reform of Ontario’s Public Services, which was convened to recommend ways to cut the province’s $16-billion budget deficit. The final report will contain recommendations for significant reductions in government expenditure. If reducing Ontario’s debt-to-GDP ratio is the ultimate goal, isn't the best strategy to increase growth rather than cut spending?

If I knew what to do to raise that growth, I would say yes. You want to do everything you can to increase the growth rate, but you also have to be realistic with your fiscal plan and not count on unduly optimistic growth anticipations. I was involved in budget-making at the federal levels for 23 years, and I can tell you that a lot of budgets got wrecked on the shoals because they had unrealistic expectations of growth.

There is a thought that the recession created a large stock of unused capital and labor, and I do not agree with that position. On the labor side, if that were true, you would be seeing declines in wages. Yet wages have been increasing fairly firmly—not rapidly, but firmly. On the capital side, much of the capital that got displaced during the recession was specific to industries like auto manufacturing, and that capital is not going to get redeployed in the same sector. And if it gets redeployed somewhere else, it’s not going to obtain the same value as before. So I don’t see these huge stocks of labor and capital that will allow the province to grow much faster than the potential growth rate. There might be some years of maybe 2.5 to 3 percent growth, but over the longer run I think Ontario can only count on 2 percent growth.

And you are right: you have got to do everything you possibly can to bolster that growth. But you cannot set a fiscal plan that depends on high growth, because it might not come. A lot of economists have studied how to increase the Canadian growth rate, and to their credit governments have implemented most of what we’ve recommended. Yet productivity growth has not gone up. If that has been the pattern over the last 20 years, why would you want to stake your budget plan on something different happening over the next ten years?

Income inequality has been getting a lot of attention lately. The top quintile of income-earners in Canada has significantly increased its share of national income over the last 20 years. What’s more, median household income increased by only 5.5% in the 33 years between 1976 and 2009. How serious a problem is this in your view, and what should be done about it?

There are three different issues here, and I think they are quite distinct. The flavor of the month is to talk about income inequality—the bottom compared to the top. And I do not dismiss that problem. There is a growing field of happiness economics that indicates that people self-assess their happiness largely in relative terms. But I think, economically, we also want to be very mindful of the absolute level. As you mentioned, the median income has gone basically nowhere in Canada over three decades, and I think that is very distressing, very troubling. But more troubling is the fact that the income of the bottom 20 percent has declined quite substantially, and it is continuing to decline. If you look at the real average or median incomes of the lowest quintile, they have been falling for quite some time. More recently, even the income of the second-lowest quintile has been falling. Inequality may be important, but I have a feeling that if I were living in that bottom quintile I would be more distressed that my real income is falling.

What do you do about that? Well, I think the primary response has to be on the education side because this is a reflection of the job market changing, in part because imports from emerging economies have erased a lot of the low-paying jobs we had before. The jobs becoming available are in the higher-value-added service industry, but those require higher education levels. So I think more education is the primary response that needs to take place, and, to the credit of the provinces, that is taking place.

A major area of concern for the Minister of Finance, Jim Flaherty, is record-high household debt. In the third quarter of 2011, the ratio of Canadian household debt to personal disposable income reached 153 percent. This is not something many people think of when they think of the Canadian economy. What can policymakers do to help Canadian households fix their balance sheets?

If you ask Canadians whether they realize that household debt in Canada is high as it is the United States, people do not believe you. We tend to think of ourselves as being very conservative and prudent when it comes to consumption. And there was a day when we were. That ratio you mentioned of over 150 percent was around 75 percent just ten years ago, so it has gone up an awful lot.

One of the reasons it has gone up in Canada and other countries is low interest rates. We have an offer right now of five-year mortgages at 2.99 percent interest, and that has never been seen in Canada historically. That is not a huge cost, so why not load up on debt? And of course there has been an explosion in consumer credit, mostly in the form of lines of credit.

So what can be done about it? Well, the first thing, which is the rule in public policy, is do no harm. A few years ago, the government actually extended the maximum amortization period of mortgages to 35 years. It then steadily reduced the minimum down payment from 10 percent to 5 percent. Finally it allowed people to borrow the 5 percent down payment, so that effectively people had no money in the home purchase whatsoever. I thought that was absolutely ridiculous policy, and ultimately so did the government because they changed both of those features. Now you are back to needing the 5 percent down payment, and the amortization period has been shortened to 30 years.

We have an anomaly in Canada in that we are one of the few major countries that has not had a decline in its housing prices. They are not increasing as rapidly anymore, but they went up in 2011. There was a survey that came out just this week that showed that Vancouver is the second-least affordable housing market in the world, only after Hong Kong. Way less affordable than New York. Some other Canadian cities didn’t fall too far behind Vancouver. So we could definitely stand to tighten up the housing market. You could require 10 percent down payments, for example. You could shorten amortization periods. There are several things the government could do, and they suggest every once in a while that they are prepared to do something.

The current Conservative government has a majority of the seats in the House of Commons, so it has a lot of room in which to work. Are there any specific policies that you would like to see it enact going forward?

Well, it is interesting you ask that. Our prime minister was at the World Economic Forum in Davos today, and he made some references to upcoming policy changes. I would agree with most of them. The one that caught everybody’s attention was the musing about changing the age of entitlement for Old Age Security from 65 to 67.

More pertinently, one of the difficulties I think we have in Canada right now is how immigration works. As a percentage of our population, we have one of the biggest intakes of immigrants in the world. But immigrants have not been doing very well economically in Canada. We used to have a pattern that every generation of immigrants made more than the previous one. And in a fairly short period of time, they actually used to make more than Canadian-born citizens. On paper they’re coming in with wonderful qualifications—they actually have more education than the Canadian-born. But after five years in Canada, immigrants with university degrees are making only a little more than 50 percent of what Canadians with university degrees are making. Their education credentials and foreign experience are not getting recognized.

The number one factor is difficulty with English and French. That was not really relevant up until the 1980s because most immigrants came from the United States or Europe. But as they come from other places now, there is definitely a language barrier, and the government has responded by increasing the points awarded to immigrants who speak English or French. I would say we need to take a closer look at the immigrant selection criteria and also improve the immigration settlement processes. Coming back to productivity, immigration is actually lowering productivity because immigrants are working almost as much as Canadians but earning much less income. I think that’s a major thing that needs changing.

The second thing we need to do is diversify our trade partners. We cannot succeed, as we have historically, with just the singular approach of selling to the US market. It is just not going to grow enough. Ironically, our only major trade negotiation in the works right now is with the European Union. If you think the United States is going to grow slowly, Europe will do even worse. It is still a good thing to do, but we must broaden our trade discussions. The Canadian government is making forays in that area, trying to build better relationships with India, China, Brazil, and other emerging economies. It is going to be a lot of work, but I think it is an area we need to make a great deal of progress in.

On the issue of interprovincial trade barriers, the government has run into difficulty in the courts. For a number of years it has been trying to establish a single securities regulator. The Supreme Court ruled that securities regulation was in the provincial domain, so perhaps we may not get rid of these remaining interprovincial trade barriers. But most of them have been eliminated by the provinces themselves. Even the security regulators in the provinces have more or less worked out a way to recognize each others’ requirements. So it would perhaps be nice to have a national securities regulator, but not critical.

One thing that’s on the horizon for Canada’s economic outlook is the fallout from the European sovereign debt crisis. How do you think it will affect the Canadian economy?

Not that much. We do have some trade relationships with the Eurozone, but they are mostly with the larger, more stable economies. We also do not have a lot of holdings of European debt in Canada. So it would impact us in the second round, but not as directly as what we saw in 2008 and 2009 because our financial linkages are pretty much singularly with the United States.