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Inflation is too high and the economy’s been warped by years of cheap money. Now might be the time for some strong medicine

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Illustration by Eric Chow/The Globe and Mail

This time last year, the R-word was on everyone’s lips – and panic was setting in.

With energy prices soaring and consumers rushing back to restaurants and hotels, annual inflation spiked to 8.1 per cent, forcing central banks to get aggressive with their interest rate hike campaigns. In July, the Bank of Canada went so far as to surprise with a full percentage point rate increase, its largest since 1998. The question wasn’t whether Canada would have a recession, but, rather, just how painful it would be.

The early indicators were pretty grim. Canada’s national home price index dropped 16 per cent from its peak; the S&P 500 Index, a benchmark for U.S. stock market performance, slumped 25 per cent; and the tech sector seized up, leading to tens of thousands of layoffs – and, ultimately, the collapses of Silicon Valley Bank and First Republic Bank.

A year later, the economic outlook is much less gloomy. That recession everyone feared? It never materialized – at least not yet. Unemployment rates in Canada and the United States are sitting near record lows. And earlier this week, Canada reported stronger-than-expected economic growth in the first quarter, fuelled by resilient consumers.

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Governor of the Bank of Canada Tiff Macklem holds a press conference at the Bank of Canada in Ottawa after the release of the 2023 bank's financial system review on May 18, 2023.PATRICK DOYLE/The Canadian Press

If anything, the economy might still be running too hot, which puts more pressure on the Bank of Canada ahead of its next rate decision on Wednesday. The central bank has kept its policy rate at 4.5 per cent since January, but now it must weigh whether a new hike is needed, even if it increases the chances of tipping the economy into recession.

What no one seems to ask is: What if a recession is a good thing? What if a prolonged economic slump is exactly what Canada needs?

Historically, the economy has gone into recession roughly once a decade because, in simple terms, it overheats and needs a reset. Yet at this point Canada and the U.S. haven’t actually faced a recession in more than a decade. This doesn’t include the COVID-19 pandemic, but that was more like a natural disaster, and the crisis prompted governments to unleash trillions of dollars worth of recovery spending.

Without question, recessions are painful, and they are often felt more acutely by people with lower incomes. There is no sugar-coating that. But usually they aren’t as brutal as the 2008-09 global financial crisis.

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Mark Wiedman, head of of the global client business at BlackRock Inc.Photo illustration by the Globe and Mail

To start, a recession now would help to quash runaway inflation. Moving from 8-per-cent annual price growth to 4 per cent hasn’t been too challenging, but going lower from here will be a grind. The longer that inflation runs hot, the greater the danger that it becomes entrenched, and that’s the really scary part. Chaos ensues when businesses and households can’t predict what their costs will be.

The economy has also been warped by years of cheap debt – a byproduct of ultralow interest rates and the vast sums of money created to facilitate stimulus spending. “Fifteen years of that amount of liquidity, or free money, distorts the financial system,” says Mark Wiedman, of the global client business at BlackRock Inc., the world’s largest asset manager. “It also starts to distort the real economy.”

Inflation for day-to-day goods and services was actually anemic for decades until it finally took off in 2021. But a new study by McKinsey estimates that asset price inflation – price increases of real estate and financial assets such as stocks – created about US$160-trillion in “paper wealth” globally since 2000.

In Canada, much of the paper wealth has accumulated in the housing market. Strong demand, low supply, cheap money and rampant speculation have conspired to drive up prices to eye-watering levels. Canadian households are now the most indebted among the Group of Seven countries, as a percentage of gross domestic product (GDP), largely due to the oversized mortgages they’re paying down.

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A patron fills a shopping bag during a visit to the Daily Bread Food Bank in Toronto in April 2023. Inflation has caused food prices to soar so much that visits to Canadian food banks are at record levels.Fred Lum/The Globe and Mail

The distortions run deep. Plenty of struggling businesses that would have failed in a normal economy have been kept alive by cheap credit. Housing has become one of the hottest investments around, pushing many prospective buyers and renters beyond their breaking points. Food prices have soared so much that visits to Canadian food banks are at record levels, even as Canada enjoys some of the strongest economic growth in the G7.

Policy makers dream of gently smoothing out business cycles, of deftly engineering a soft landing by adjusting interest rates and fiscal policy. But there are limits to how long a country can safely defy gravity.

The tech sector is already reckoning with a radical rethink. Perhaps the whole economy would benefit from a similar reset, so that financial assets stop growing faster than the real economy and GDP is less reliant on government spending. In other words, now might be the time for some very strong medicine.

How a recession could help

Early this year, a group of prominent U.S. economists put out a rather conclusive paper on what it takes to kill runaway inflation. By studying four advanced economies, including Canada’s, since the end of the Second World War, they identified every instance of sky-high price increases and how each ended. The common denominator was rather glaring.

“There is no post-1950 precedent for a sizable central-bank-induced disinflation that does not entail substantial economic sacrifice or recession,” the paper declared. The researchers included Stephen Cecchetti, the former head of the monetary and economic department at the Bank for International Settlements; Michael Feroli, chief U.S. economist at JP Morgan; and Frederic Mishkin, a former U.S. Federal Reserve governor who has long collaborated on research with former Fed chair Ben Bernanke.

In an interview, Mr. Cecchetti made it very clear: “You need to cool the economy off.”

Because inflation has come down rather quickly over the past six months, falling to annual rates of 4.4 per cent in Canada and 4.9 per cent in the U.S., there are hopes that maybe the historical data don’t hold up any more. The pandemic was such a unique event – technically, the U.S. recession lasted a mere two months – that perhaps current prices really can be managed down without an upheaval.

What’s missing from that argument is that disinflation, or slower price growth, isn’t linear. Hiking rates is a surefire way to get some quick wins, but getting from annual inflation of 4 per cent to 2 per cent – which is where central banks want to be – is much harder to do.

Bank of Canada officials have repeatedly stressed that in order to truly tame inflation, something needs to give in the labour market. At the moment, it’s so tight that wages are rising by around 5 per cent on an annual basis. On the surface, that’s not disastrously high. But because Canada’s productivity growth is so weak, those higher compensation costs are tough to manage. The danger, then, is that consumers will foot the bill via higher prices.

The central bank’s most recent projection is that inflation will fall to around 3 per cent annually by this summer, but the last leg of the inflation battle will be challenging. “I would remind you,” Bank of Canada Governor Tiff Macklem said in April, “that we actually need a period of weak growth.”

The housing market could also benefit from a cooling. The rapid interest rate hikes to date took some froth out of the system, but it’s very possible the drop in home prices will be short-lived. Many local housing markets are heating up again with bidding wars, and rebounding home prices are heaping even more pressure on the rental market, because so many people are priced out of ownership. It’s now common to see rent increases of 20 per cent and 30 per cent when units turn over in mid-sized cities such as Halifax and London, Ont.

The problem is that there simply aren’t enough dwellings being built, particularly rentals, and it’s tough to boost construction in today’s market. “Rental housing is really hard to build right now,” said Brad Jones, senior vice-president of development at Wesgroup Properties Ltd. in Vancouver. Because of higher interest rates, elevated construction costs and a shortage of skilled workers, rental development is “not really viable,” he said.

It’s tempting to blame this scenario on record immigration – Canada’s population grew by more than one million people in 2022, and the 2.7-per-cent annual growth was the most since the late 1950s – but it’s a complicated issue. Business groups have been lobbying for more immigration, because their members are desperate for lower-skilled workers to fill job openings.

An economic downturn could take the heat off the labour market, reduce the desperation for immigration and that could then ease demand for housing. In an economy, everything is connected.

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Many local housing markets are heating up again with bidding wars, and rebounding home prices are heaping even more pressure on the rental market, because so many people are priced out of ownership.Ammar Bowaihl/The Globe and Mail

Of course, some Canadian companies would inevitably fail in a recession – but many economists argue that is not necessarily a bad thing either. As of 2019, about 5.5 per cent of all businesses in Canada were “zombie firms,” according to a landmark study Statistics Canada published earlier this year. Zombies are companies that earn less than the interest payments on their debt for three consecutive years, and are at least 10 years old.

These are not harmless firms, lurching slowly through their markets. They have weaker earnings than healthy rivals. They’re more indebted. They pay their employees less. Worse yet, they hamper the performance of stronger competitors.

“They don’t exist in isolation. They compete for the same resources as healthy companies, whether it’s investment dollars or employees,” said Danny Leung, director of the economic analysis division at Statscan, and one of the paper’s co-authors.

The paper noted that financial support for businesses during COVID-19 – a necessary thing to stave off economic collapse – may have prolonged the lives of companies that were on the brink of closing. Business insolvencies fell sharply during the acute phases of the health crisis.

Insolvencies have started to pick up again as companies struggle with higher interest rates – government data show that more than 2,500 firms that collectively received around $1-billion in federal wage subsidies have become insolvent so far – but a recession could actually be a catalyst for more rapid change.

“During recessions, companies that are barely viable exit, and then that labour, that capital, that entrepreneurial talent, is freed up to move to other places,” said David Williams, vice-president of policy at the Business Council of British Columbia. “That’s the wonderful thing about a market economy, is that it rewards successes and it punishes failures.”

But instead of permitting a downturn, Canada keeps chasing economic growth at all costs – and that includes endless federal deficits. Even though federal debt-to-GDP ratio is projected to fall over time, the GDP we’re striving for papers over some weak economic results. On a per-capita basis, real GDP – which factors in inflation – is about the same today as in 2017, and it isn’t expected to improve over the next few years.

“We are in, essentially, a lost decade for improvements in living standards,” Mr. Williams said.

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Diane Swonk, chief economist at KPMG U.S.Photo illustration by the Globe and Mail

Reality check: Recessions can also be devastating

Diane Swonk has heard the same argument for decades: “What we need is a ‘good’ recession.” When the economy gets hot, business owners start venting about just how hard it is to hire workers, so they pray for something that restores normalcy. The same is true for people priced out of a hot housing market.

“It sounds great in theory, to have a mild recession, to get rid of all these excesses,” says Ms. Swonk, chief economist at KPMG U.S., the accounting and consulting giant. “The reality is, the pain of it is quite stark.”

That’s not to say a downturn would be all bad. She appreciates the frustrations and how a reset could take some pressure off. But recessions can be intractable. “The idea that you can calibrate it so that it is mild and short-lived,” she says, “that’s just way outside of our bounds.”

Ms. Swonk has been around long enough to see entire regions destroyed by a downturn. As the former chief economist at Chicago-based Bank One, which became part of JP Morgan, she’s seen U.S. towns that never recovered from the recession in the early 90s and another after the dotcom crash.

Thousands of jobs with routine tasks – such as cashiers – are culled during recessions as companies seek efficiencies through automation, and those workers struggle to regain employment. Some never do. After the financial crisis, millions of Americans aged 25 to 54 were alienated from the labour market. Their participation rate – the percentage either working or looking for a job – took more than a decade to fully recover.

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Vesna Bulovan, left, and her daughter Jovana, use the self checkout at the Metro grocery store in Toronto. Cashiers are often among those laid off during recessions as companies seek efficiencies through automation.Fred Lum/The Globe and Mail

“Change means that there are going to be some losers and some winners,” says Henry Siu, an economist at the University of British Columbia. “For those specific workers who are no longer able to find employment as a machine operator, as a cashier, or as a forklift driver, clearly this phenomenon sucks.”

At its core, the idea that a recession will cleanse things is tied to renowned Austrian-born economist Joseph Schumpeter’s theory of “creative destruction.” The free market might be messy, he argued in the 1940s, but it delivers growth in the long run. Job losses and corporate bankruptcies are all part of the process.

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Stephen Poloz, former Bank of Canada governor.Photo illustration by the Globe and Mail

It’s a theory former Bank of Canada governor Stephen Poloz knows well. “It all sounds fine on paper,” he says. But Mr. Poloz makes something very clear: “Usually, it’s really rich people who lay this out.” He wonders: “Why is it the responsibility of the regular worker to be unemployed to cause this cleansing?”

Mr. Poloz also stresses that there’s another unique variable in the current business cycle. “The pandemic is a very special case,” he says. “We have to allow for a pause in the natural cleansing process given what we went through.”

Corporate profits may have swelled during the pandemic, but many small business owners barely made it out and are still saddled with tens of thousands of dollars of debt they took on simply to survive. In February, the Canadian Federation of Independent Business – the small business lobby – found that 58 per cent of its members still had pandemic-related debt, at an average of $106,000 each.

But it’s also easy to get lost in the debate. Mr. Cecchetti, the lead researcher on the study of past periods with high inflation, is very sympathetic to all these arguments, but he offers a counterpoint: “We’re never going to be able to avoid all pain for all people at all times,” he says.

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Paul Volcker, former Federal Reserve chairman, in April 2015. In 1979 Volcker raised interest rates aggressively to tame double-digit inflation, sending the U.S. into a recession.BRENDAN SMIALOWSKI/AFP/Getty Images

When inflation was scorching hot in the late 1970s and early 80s, the Federal Reserve learned its lesson. In 1979, then Fed chair Paul Volcker hiked interest rates aggressively to tame double-digit inflation, sending the U.S. into a recession. Facing blowback from politicians, the Fed started to lower rates in 1980.

But this move was premature: Inflation was still far too high, prompting another round of tightening that brought lending rates to around 20 per cent. This time, the U.S. was pushed into a second – and deeper – recession, and the unemployment rate jumped to nearly 11 per cent. It was a bruising period, but once inflation was under control, the economy took off.

Short-term pain for the long-term greater good became the gospel for central bankers.

That’s changed in the past 15 years. Now pain is avoided at all costs. It is hard to pinpoint precisely why, but one credible theory is the financial crisis was so terrifying that it forced policy makers to pull out their bazookas to restore order. Once central bankers and politicians had a whole new set of policy tools available, they got a bit addicted to their power.

“My view on monetary policy is always get in and get out quickly,” says Don Drummond, the former chief economist of Toronto-Dominion Bank, who chaired the Commission on the Reform of Ontario’s Public Services in the aftermath of the 2008-09 crisis.

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The central bank’s most recent projection is that inflation will fall to around 3 per cent annually by this summer, but the last leg of the inflation battle will be challenging.Ammar Bowaihl/The Globe and Mail

Today, central bankers are at the other end of the spectrum. “They’re far too activist,” he says, lamenting that they intervene in the economy through programs such as quantitative easing for much longer than they ever would have before. “That’s a grave danger.”

In defence of central bankers, global economic growth was anemic for many years after 2008-09, so it was hard to reset. And when the pandemic hit, even bigger bazookas were needed to stabilize things.

But at what point does the stimulus drip need to stop? While it props up metrics such as GDP growth, the economy’s foundation doesn’t necessarily get any stronger.

Perhaps the goal for policy makers shouldn’t be to avoid all pain, but to minimize it where they can. If that becomes the target, they might realize this is actually a rather opportune time to let the economy weaken. Corporate bankruptcies remain remarkably low; unemployment is barely noticeable; and the financial system is on much better footing following reforms made after the financial crisis. If a recession hit and everything collapsed from here, maybe this economy was all a charade to begin with.

Of course, that thinking might be ridiculous in the current political climate. Politicians are at each other’s throats and incivility is off the charts. But it is crucial that those in power remember that the economy is always a balancing act.

Canadian Imperial Bank of Commerce chief economist Avery Shenfeld cautions that any cooling-off period would not be “victimless.” But he knows that is only half the picture. ”Others will find that less of their paycheque is then eroded by inflation.” And that’s a major boon.

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