When Canadian analysts talk about competitiveness, they almost always bring in the subject of productivity. It's argued that Canada's productivity growth has been poor, resulting in declining competitiveness. Certainly, our economy appears less competitive than it used to be, based on the evidence of Canada's large trade deficit. If we could work harder or smarter to get productivity up, it is claimed, competitiveness would improve.
But what if it works the other way around? What if it is competitiveness that affects productivity? That is to say, what if an overvalued exchange rate, by reducing competitiveness and the scale of output, causes lower productivity?
That was the upshot of several papers presented at the recent conference of the Canadian Economics Association. Among the leading analysts from Statistics Canada and Industry Canada who study the subject, there is a growing consensus that there is a large cyclical element in productivity. Weak demand, leading to excess capacity and lost economies of scale, have been found to play a substantial role in worsening productivity growth.
One of the papers, presented by two economists from Statistics Canada, was particularly germane. They started out with the declining trend in manufacturing productivity growth, which has been very poor since 2000. They proposed a method for correcting the estimates of manufacturing productivity to remove the effects of cyclical variations in capacity utilization. When they did this, they found that the downward trend in recent years pretty much disappeared. That is not really surprising, as manufacturing has suffered multiple shocks from international recessions and the more than 60 per cent appreciation of the Canadian dollar.
I personally presented a paper entitled "A Sectoral Analysis of Ontario's Weak Productivity Growth" at a session organized by Andrew Sharpe of the Centre for the Study of Living Standards. It was quite complementary to the Statistics Canada paper; they took a top-down macro approach, while I used a micro approach that looked at the detailed performance of about 50 industrial sectors, in both manufacturing and services. As they did, I found that most of the productivity weakness was due to weak demand.
Ontario's business sector had zero productivity growth in the latest six-year period of data, ending in 2011. Indeed, Ontario was by itself responsible for most of what is referred to as Canada's dismal productivity. This is because so much of Ontario's economy is tied into the United States. The U.S. economy has been weak, but Ontario has done even worse, as it has lost market share in the U.S. due to the high exchange rate. The U.S. employment recovery since the recession has been notoriously poor, but if we consider only private-sector employees, Ontario has performed even worse in terms of job creation. I discussed this in depth in a paper I wrote for the Mowat Centre for Policy Innovation.
When looking at the productivity numbers by detailed sectors, what emerges is that the economy's average productivity growth rate can be misleading. It is the random outcome of a wide range of underlying variation. There are some important sectors (e.g., retail trade and finance) that have maintained decent productivity growth. There are some sectors, especially in manufacturing, where the level of productivity is far below its previous level – not merely weak growth, but decline. In some industries (e.g., steel), some of the largest players have shut down, essentially changing the character of that sector.
Overall, the implication is that the weakness of productivity is caused by weak aggregate demand. Strong demand creates economies of scale and distributes overhead costs over a larger base. The weakness of demand in recent years has also been associated with compositional shifts in the economy. Employment and output have plunged in manufacturing (whose level of productivity is above the economy-wide average), while it has grown in some service sectors with below-average productivity. Such compositional shifts would reduce the average productivity of the economy, even if there was no change in the productivity of any individual sectors.
It has often been claimed that the period of the low dollar in the 1990s served as a crutch for Ontario's exporters, allowing them to get away without trying hard to improve their productivity. The data in the accompanying graph belie this claim. Ontario's manufacturing productivity (output per hour worked) increased by about 50 per cent during the 1990s. In the period since the dollar's rise, manufacturing productivity growth has averaged near zero.
The weakness of demand in Ontario is largely due to falling exports, caused by the high Canadian dollar and the weak U.S. economy. While a strong rebound in exports does not appear to be around the corner, the worst is probably behind us. There should be a continuing gradual improvement in exports in the coming years, leading to some increase in productivity growth.
The finding that the weakness in productivity is largely cyclical does not, of course, mean that the supply side doesn't matter. The real investments in innovation and human and physical capital that lead to long-run progress remain vital. Unfortunately, when there is excess capacity, these long-term factors are defeated. Companies do not want to invest in new capital, and sit on their cash instead. New university graduates fail to find jobs in their chosen fields, and are unemployed or underemployed. In the worst-case scenario, their skills become stale and they never become properly employed. That would be a national tragedy.
In the short term, policy tools should aim to achieve greater flexibility and mobility in the economy. Underemployed workers should be encouraged and assisted to move to regions where their skills are in greater demand. Monetary policy is inevitably a key part of the solution. The Bank of Canada has a great deal of influence over the value of the exchange rate simply through the messages that it communicates to markets. It needs to be sensitive to the fact that the dollar's trajectory has significant impacts on Canada's potential growth.
Peter S. Spiro is an economic consultant and a Fellow of the Mowat Centre for Policy Innovation at the University of Toronto's School of Public Policy and Governance. His website is www.peterspiro.com