John Rapley is a political economist at the University of Cambridge and managing director of Seaford Macro.
Economists are debating whether the Bank of Canada’s interest rate hikes have gone too far and might now cause a recession. But it may be the wrong debate. Rather than ask if the economy is in recession, we should ask how we’re going to react to the next recession.
That’s because recessions are inevitable in economic cycles. If not now, we will have to confront one some day. When that day comes, we should not simply jolt the economy back to life as if with a defibrillator, as we’ve been doing for years with our single-minded focus of lowering interest rates. Instead, we should treat recessions as opportunities to fix the specific underlying economic problems that brought us there, and thereby make the economy stronger in the long run.
There’s a problem with what we’ve been doing. In recent decades, the conventional approach to fighting recessions has been to simply flood the economy with cheap money. That is not in itself an issue. Monetary stimulus is to be expected during a recession. But the issue is what this cheap money is paired with: nothing.
Governments have stepped back and largely left it to the private sector to kick-start the economy back to life. In this model, any fiscal stimulus by governments was short-lived, with much of it in the form of tax cuts rather than direct transfers. The government, in short, was to stay out of economic management. But if effective at recession-busting, this method has had much less success at reigniting dynamism, and in reviving labour productivity in particular.
Instead, as a growing body of economic thought concludes, this hyper-focus on lowering interest rates has steered investment away from productive activity and into rent-seeking behaviours that exploit policy-induced scarcities.
Canada illustrates this all too well. This country followed other Western governments in using the window of opportunity that followed the 2008 financial crisis, when inflation and interest rates were in the basement, to cut taxes rather than invest in, say, improving its infrastructure.
Instead of unleashing a burst of new productive activity, this money in no small measure fuelled a house price bubble, which nevertheless did not cause enough house-building to absorb a rising population. As for infrastructure, Canada now has the questionable distinction of being, among other things, the only Group of Seven country without high-speed rail.
Had governments in Canada engaged in a major push of housing and infrastructure investment after the recession, we might not be where we are today.
If we want to get serious about our economy, therefore, we need a new policy direction. We can look to the United States for some insights. Right now, the Biden administration is talking up a “new Washington consensus” – the idea that the state replaces the free-market approach of the old consensus, and establishes the primacy of fiscal over monetary policy, and of the state over markets.
One can debate the details of the current U.S. policy. It’s too early to say if the rebound it has ushered in will last, or if the new economic activity will suffice to pay off the debts incurred to do it. However, it’s growing increasingly clear that the days of rolling back the government to free up the market have passed. This is what policy makers must keep in mind for the next recession.
The next time around, we should begin by assessing where we stand – our strengths and our weaknesses. Top weaknesses for Canada include its continued dependence on commodity exports. Our infrastructure is also buckling under waves of immigration we have not properly settled.
We have a particularly acute health condition in the economy as well: As Canada’s population ages, its labour productivity weakens. This isn’t a uniquely Canadian illness, to be sure. All G7 economies are grappling with these twin challenges, and are dealing with a long-term slowdown.
But even though Western economies are in their sunset years, they can still enjoy a long dotage if they can find a way to re-energize their increasingly sluggish performance.
And in many of our weaknesses, we can find strengths and opportunities. Canada stands to benefit from a new commodity supercycle, as the continued rise of the developing world boosts demand for the energy and minerals Canada has in abundance.
As well, while the way the country has gone about it may not be perfect, Canada’s openness to new residents stands a world apart from, say, our major European allies, most of which are turning darkly hostile to foreigners. Amid growing labour shortages, that will give Canada a significant edge in attracting talent.
Moreover, we have another strength in good institutions. While trust in government is a concern in Canada, as elsewhere, its public and civic institutions haven’t come under the relentless assault that we’ve seen in Britain or the U.S., where even members of the government spout deep state conspiracies.
The next time Canada faces a recession, rather than rely entirely on monetary stimulus, we should lean into these strengths, take advantage of low interest rates and consider a major fiscal program.
And rather than engage in the sort of industrial policy being used by the Biden administration, which draws government into the messy business of deciding which industries it will nurture, there is some relatively low-hanging fruit the government could pick which could do a lot to raise labour productivity, while still leaving it to the private sector to choose winners.
First off, new Canadians need to be housed. In that challenge lies an opportunity – to create more productive cities that permanently raise the dynamism of the economy by improving the quality of infrastructure, thereby allowing more people to move around more efficiently.
More broadly, building houses and infrastructure promotes job and wage growth. Not only has it been shown to create greater economic stimulus than other types of spending, it has a positive effect on labour productivity, leaving the economy stronger against future headwinds. Such efforts must be a core component of any fiscal program.
It would be smart to fund such programs with debt. Improving such things as health and child care shouldn’t be funded by debt, since it amounts to current expenditure that does not provide direct financial returns. But the capital expenditure of a well-planned infrastructure program, which yields an asset that matches the value of the spending, is another matter. It’s reasonable to expect bond investors would look favourably on a fairly ambitious scheme of public investment.
Take, for example, Canada’s proposed high-frequency rail project, which recently narrowed down its potential builders to a list of three. Its estimated cost of $30-billion to $40-billion may seem like a lot of money, but if debt of such size produces an asset of similar value and is amortized over the life of the project, its fiscal impact would be limited – potentially even neutral, given that the asset would produce an income stream while augmenting Canada’s net worth.
Lastly, in any recession, this country should get serious about investing commodity gains and resist the urge to do what we’ve always done: spend them as they come in. Canada can look to Norway, a country which also benefits from oil and gas revenues. But unlike Canada, Norway has used these to future-proof its economy by investing heavily in decarbonization, and to build a sovereign wealth fund. That fund now exceeds US$1-trillion, enabling Norwegians to look to the future with confidence.
Some critics will maintain that the government should never get in the business of investing, that the public sector never does things more dynamically than the private sector. But as we’ve seen, it doesn’t follow that releasing money to the private sector leads to better results.
Besides, the recent U.S. experience appears to vindicate the crowding-in hypothesis of traditional Keynesians: Private investors will kick into action once the state creates an enabling environment for them to do so. In response to Bidenomics, U.S. factory construction has risen noticeably.
Such a public investment program would not be easy in Canada. Fiscal federalism would complicate the delivery of some such investments, and the temptation for politicians to favour their friends would remain ever present.
The Bank of Canada would thus need to watch closely for what is going into new investment and what is going into current spending. Debt matched by new assets differs from debt used to cut taxes or raise salaries. Too much of the latter would justify the central bank tightening the screws on the government to nip inflation in the bud.
Nor would the politics of such transformative change be easy. A significant chunk of the Canadian public is invested in the existing low-growth model. That’s because part of what transforming Canada’s economy entails would require increasing the supply of houses, which would depress house prices. Meanwhile, re-engineering cities and infrastructure to raise the economy’s productivity would run smack into NIMBYism that wants to keep things as they are.
Arguably, though, the time for easy choices has passed. No doubt there are politicians who will still try free-market policies, still hopeful of a different result. But we now have enough evidence to say, with increasing confidence, that those policies won’t work. And the opportunities to try again won’t keep coming our way forever.