Appearing Before the Senate Committee On Banking, Commerce and the Economy

Madam Chair and Senators, thank you very much for the opportunity to appear before you today.

I very much appreciate the efforts of the Senate to consider the major policy challenges facing Canada in a more thoughtful, less partisan way. That is especially important in regard to the issues this committee is considering.

Let me be direct. We are at a fragile, dangerous moment in Canada’s economic history.

Evidence is accumulating that we are poised on the brink of a significant, potentially lengthy economic downturn. It may have already started. Employment in Canada has declined for three consecutive months (by a cumulative total of over 110,000 jobs). That has never happened before in history, without the country being in recession. Other indicators of contraction abound.

This negative trajectory is all the more disappointing because it comes on the heels of what will go down as one of the most successful policy interventions in history: the macroeconomic rescue mission which responded to the initial COVID-19 pandemic.

In essence, we are snatching defeat from the jaws of victory.

Some of the factors in the current weakness are beyond our control: arising from global developments (such as the war in Ukraine, or this week’s unprecedented events in the UK) over which we have no direct control.

But to a large extent, the current macroeconomic problems are self-inflicted: a predictable and avoidable result of the inappropriate application of textbook monetary policy to a situation (global pandemic) that was never described in any economic textbook.

As we know, the economic contraction associated with the imposition of health restrictions to stop COVID spread in 2020 led to the fastest, deepest downturn in Canadian GDP and employment ever.

But the rapid and powerful fiscal and monetary interventions undertaken by Canada’s government, and most others around the world, prevented that shock from turning into a sustained recession – or, more likely, depression.

Output and employment rebounded faster than almost any economists, myself included, predicted. That was thanks to the spending power provided by extraordinary personal income supports, the stability in employment relations facilitated by the wage subsidies, and above all by Canada’s relatively successful public health effort to limit contagion, illness, and death. 

Canada’s response was second best in the G7, measured by excess deaths per capita. Since the economy is composed of human beings – people who get out of bed every Monday morning, and go to their jobs to work, produce, generate incomes, and pay taxes – keeping humans healthy is the first and primary prerequisite for economic success. 

The idea that there is some kind of trade-off between protecting health, and protecting the economy, was always a lie, fomented by short-term thinking on the part of narrow interests more interested in immediate revenue and profit than long-run well-being.

The fact that Canada’s economy quickly regained pre-COVID levels of employment and output is an astounding victory, that economists will be studying for decades to come.

The claim is made that Canadian policy-makers overdid that rescue effort: because total household income went up, for example, with COVID income supports more than offsetting the decline in employment income during the initial COVID recession. I reject that argument. The interventions that were made, and the subsequent course of GDP and pre-tax-and-subsidy incomes, are not mutually independent. Those interventions explain why the economy did not contract further and for longer. Without those interventions, household incomes would be much lower today.

The same goes for arguments that the Bank of Canada overshot the mark with its monetary stimulus. The economy turned out to be far stronger than expected at the beginning of the pandemic. That was not an “error” in forecasting – it was the result of that rescue effort. It’s not just that the Bank of Canada could not have foreseen the rebound in GDP and employment and spending. (It couldn’t be expected to.) More important, we must acknowledged that the Bank’s own actions helped achieve that stronger-than-expected rebound.

That all these unprecedented events should still be causing further disruptions and challenges should be no surprise. Chief among those challenges right now, of course, is the acceleration in inflation over the last year.

Claims are made that this inflation is the personal responsibility of the Prime Minister, or the result of the Bank of Canada “printing money”. This is outright, crude misinformation.

The acceleration in inflation is a worldwide phenomenon. It clearly reflects unique pressure points arising from the pandemic. These factors include:

• Disruptions in supply chains resulting from COVID shutdowns and related factors (in strategic sectors like semiconductors, automobiles, building materials, and more).
• Related disruptions in transportation and shipping, also tied to health restrictions on travel and border crossings, which caused large but temporary jumps in shipping and logistics costs.
• A shift in the allocation of consumer spending away from services (consumption of which was restricted due to health restrictions) and toward goods, spurring initial price shocks in several key merchandise categories.
• Energy price shocks nominally sparked by the Russian invasion of Ukraine: even though global oil supply has not been reduced (it has in fact increased since the invasion), the operation of speculative, financialized energy futures markets has nevertheless caused large price increases which have been reflected in Canadian domestic prices (even for energy produced, refined, and consumed here).

It must be stressed there is no connection between the size of government deficits and inflation. Some countries with larger deficits have experienced slower inflation (like Japan), and some with smaller deficits have experienced higher inflation (like Germany). This is a global phenomenon.

Inflation is a concern: one of many macroeconomic challenges we face in the current environment. Other challenges include creating and sustaining decent employment, addressing inequality, and climate change. Inflation is not the only concern we face, nor the most important.

The new threat is that central banks around the world, feeling bruised by criticism that they “overdid” monetary stimulus during the initial months of the pandemic (a criticism which is not legitimate), and/or were “too slow” to respond to inflation as it emerged, have now rediscovered their true religion.

They are determinedly but inappropriately applying textbook remedies to post-COVID inflation: using the sledgehammer of higher interest rates, applied indiscriminately across all sectors, to reduce domestic demand, increase labour market slack, and thus reduce price pressures.

The argument stated by the Bank of Canada that current inflation is caused by excess domestic demand pressures is wrong and self-justifying. Many indicators were already visible in second-quarter 2022 GDP data that domestic final demand in Canada is not growing unsustainably, and in fact is already softening in several key areas (including residential investment, consumer durables, and even government services and investments). The second quarter also featured the biggest accumulation of inventory in Canadian history, a sure sign demand is weakening; without that inventory build, GDP growth would have already been negative that quarter.

The argument that inflation results from an overheated domestic labour market, “labour shortages,” and rising labour costs is also not consistent with the evidence. Nominal wage increases have lagged far behind inflation, real wages have declined by over 3% (with more erosion in store), and the labour share of GDP has declined by over 2 percentage points since the pandemic. None of these indicators are consistent with the hypothesis of a “wage-price spiral” that so worries the central bankers.

What is clear in the economic data is that profit margins for Canadian businesses have widened considerably in the course of the current inflationary episode. Indeed, after-tax corporate profits have increased: reaching their largest share of GDP ever in the second quarter (almost 20%), up by almost 5 percentage points since the pandemic. This is strong evidence of “profit-price inflation,” not “wage-price inflation,” yet the emphasis of monetary policy continues to be on suppressing the incomes and spending power of ordinary working people. This is ineffective, and unfair.

Nevertheless, the rote application of decades-old textbook remedies to a unique and unknown present-day challenge continues apace. The Bank of Canada’s actions are mirrored around the world by severe and rapid tightening from other central banks – although it should be noted that the Bank of Canada’s response has been among the most severe of any central bank (more so than central bank actions in Europe, the U.K., Asia, and Australia).

We are only beginning to see the damage from these actions. Falling asset prices (for equities, other financial assets, and real estate) are one immediate effect. Rising debt services charges (mortgage payments for many households will soon double, or worse) will bite deeply into consumer spending. Interest-sensitive spending by both consumers and businesses is already slowing.

In terms of the impact on inflation, since present inflation did not result mostly from domestic demand factors, we should not expect any quick payoff from these painful measures in the form of lower inflation. There will be some short-term moderation of inflation resulting from the reversal of some of the global factors that started the problem in the first place – such as recent declines in shipping costs, agricultural commodity prices, and some energy costs. But those are not the result of interest rate hikes; they would have happened anyway. Meanwhile, unintended side-effects of higher interest rates push some components of the CPI bundle higher, not lower: including rents and all-in costs of home ownership (including soaring interest costs).

As events in the U.K. this week have proven, the global interest rate shock will also produce knock-on effects on financial stability that are unpredictable and potentially very destructive. Because of interconnections between indebtedness, leveraged trading, and asset prices, spreading financial failures among both households and institutions are likely in the volatile months ahead – perhaps sparking a broader and contagious crisis of confidence.

The backdrop to these worrisome macroeconomic and financial developments is a rise in divisive, anti-democratic sentiment and movements in many parts of the world. The outcome of the recent election in Italy is just the most recent manifestation of that trend. Pain and dislocation resulting from a self-inflicted recession will create a ripe environment for the expansion of those sentiments. We know we are not immune to the risk of anti-democratic and even violent extremism here in Canada.

I acknowledge my assessment is pessimistic, but I believe this pessimism is grounded in a realistic analysis of current conditions, current policy responses, and statements (by the Bank of Canada and other central banks) that they will not be deterred from continuing to tighten monetary conditions even if the economy slips into recession, until such time as inflation retreats to its target rate (likely some years from now). In this light, the recession we are heading into will be neither short nor shallow – because central banks will keep their feet on the brake pedals long after the recession has started.

Briefly, the policy implications of my analysis include the following:

Policy-makers need to consider more carefully the full range of factors that are causing current inflation, rather than assuming it is rooted in overheated domestic demand and labour market conditions. This mis-diagnosis of the problem is contributing to inappropriate policy responses.

Anti-inflation policy should then start by addressing those true causes of inflation. Supply chain problems and infrastructure bottlenecks should be ameliorated by investing in new capacity and infrastructure – something that is discouraged, not encouraged, by higher interest rates. Price controls and excess profits taxes on key inflationary sectors (especially energy and housing) can help to directly moderate price pressures. Reducing fees for public services (such as early child education, public transit, and ancillary health care costs including dental costs) can also incrementally reduce inflation.

Policy must also aim to protect Canadians against the effects of inflation until its true causes are addressed. Income support programs need to be enhanced: this is especially true for unindexed provincial welfare programs. Targeted measures like the GST credit should be expanded.

Workers should be given the freedom and support to negotiate wage increases that keep up with inflation. This does not in itself cause or “lock in” inflation: combined with productivity growth, having nominal wages that merely keep up with inflation are in fact a disinflationary influence (since unit labour costs will be rising less rapidly than prices). And some day, the current unusually large profit margins captured by business will have to come back to earth – including by companies absorbing some of the impact of higher labour costs, rather than passing them on (and then some) to consumers as has been the case in the last year.

Another conclusion is that we will simply have to endure current inflation, until some of its more transitory causal factors abate in coming years (as is already occurring). Mid-single-digit inflation need not be an economic catastrophe, so long as Canadians (particularly low-income and working Canadians) are protected from its worst effects.

Patience, compassion, and a more nuanced and multi-dimensional understanding of both the problem and its most promising solutions can help Canada traverse the coming, dangerous months – and cement the historic policy victories that were attained earlier in the pandemic. On the other hand, sending the economy into a painful, avoidable, unequal and self-inflicted recession, all in the name of protecting the “reputation” of an inflation target that was arbitrary and one-sided in the fist place, would constitute a self-defeating policy mistake of the highest order.