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 Economic survey of Canada 2008: Macroeconomic policies for the end of a boom cycle

Monetary policy has room to manoeuvre in dealing with the growth slowdown, and tax relief is providing substantial support to the economy this year, but fiscal policy is constrained by declining surpluses in the short term and ageing liabilities in the longer term. The tightening in domestic credit– fallout from the US credit crisis – and prospects for slower growth have led to substantial monetary policy easing. In addition, the strong currency and easing demand for tradables are helping to neutralise commodity price induced inflation, increasing policy room for manoeuvre. The budget surplus is set to shrink on account of weaker growth and tax cuts. As rising health and other ageing costs are also looming, expenditures need to be controlled for debt to be kept on a downward path. Resolute fiscal policy – in particular through investing abroad more of the public revenue resulting from high oil prices – could help mitigate real exchange rate appreciation.

Canada’s economy has greatly benefited from the commodity boom of the past few years, though the resulting exchange rate appreciation has put strains on the central regions that have a more balanced economic base. But the economy has proven flexible and has entered the current phase of global economic turmoil from an enviable position. Despite an expected slowdown in 2008, the economy is expected to rebound in 2009 and emerge from the credit crisis relatively unscathed. The baseline projection calls for growth well above recession territory – even if below potential rates – for both 2008 and 2009. Looking further ahead, there are significant risks to the Canadian economy from worldwide adjustments to the large global current account imbalances that have been building for some time, particularly in the United States. Nevertheless, weathering short  and medium term macroeconomic tempests should not detract policymakers from longer term structural issues identified in past Surveys. Recent experience in credit markets harbours lessons that the central bank and financial market regulators can use to strengthen financial system efficiency, stability and transparency. And the coming wave of baby boomer retirements calls for fiscal policymakers to improve expenditure controls, accelerate debt reimbursement and put more of current resource revenues aside to help prepare for the fiscal implications of demographic change.

Monetary policy has changed direction

Up to and through most of 2007, monetary policymakers were primarily concerned with domestic inflationary pressures arising from rising commodity prices, strong domestic demand and tight labour markets. By the end of 2007, however, emphasis had shifted to managing Canada’s response to the global financial market turmoil, the associated tighter domestic credit conditions and to concerns about a slowing US economy, which led to substantial monetary policy easing. The main immediate challenge for monetary policy is to design the appropriate policy stance to keep inflation on target as the Canadian economy reacts to the US slowdown and global financial market turbulence. This may well involve some further easing. But when credit conditions return to more normal levels and the economy starts to recover, interest rates will need to increase. Regulators should also be reviewing whether steps need to be taken to ensure that institutional incentives in the financial sector are appropriate. Longer term, research is ongoing at the Bank of Canada and elsewhere to assess whether it should switch to a lower inflation target, and/or to price level path targeting. As the Bank has stated, the research would need to uncover compelling evidence in favour of a change to alter a regime that has proven successful.

Financial markets should be modernised

Further efforts by the Bank and other regulators are desirable to improve transparency, flexibility and competition in Canadian financial markets. The current diversity of regulations – for example, each province has its own securities regulator – makes it difficult to maximise efficiency, and increases the risk that firms will choose to issue securities in other countries. A single regulator would eliminate the inefficiencies created by the limited enforcement authority of individual provincial agencies. Also, the impact on economic growth from reducing competition restraining regulation in the banking sector could be significant. It is now time, ten years after the first merger proposals were blocked by government, to welcome competition in financial markets by allowing Canada’s leading financial institutions to become global players by lifting the ban.

Governments’ fiscal position remains solid but exposed to negative risks

Canada’s fiscal situation has improved significantly since the mid 1990s, as deficits were turned into surpluses and Canada’s public debt burden declined from the second highest to the lowest among G7 countries. This, combined with lower interest rates, has reduced debt service costs substantially over the past decade. Government’s size relative to the economy has shrunk, as shown by lower revenue, spending and net debt relative to GDP. However, current primary expenditures as a share of GDP have risen slightly since 2000. Over the next few years the combination of recent sizeable tax cuts and lower economic growth will eat into budget surpluses, raising the prospect of renewed small general government deficits, especially if lower commodity prices were to pare tax payments by the resources sector.

Governments should slow down their spending growth and strengthen expenditure control mechanisms

Over the last decade, the federal government and almost all its provincial and territorial counterparts have underestimated revenue on average, and have reacted by a combination of debt reduction, tax cuts and spending beyond levels announced at budget time. However, it is unlikely that recent growth rates in public expenditures are sustainable. Given the likelihood that the current slowdown in economic activity will curtail future favourable revenue surprises, all levels of government should avoid spending beyond originally budgeted levels. Furthermore, with the imminence of ageing pressures on spending, budgets should be subjected to serious continuing expenditure reviews. The major areas for the federal government to focus on are the level of subsidies, especially in agriculture (see below) but also transfers to lower levels of government. For their part, the provinces should redouble their efforts to ensure their spending is efficient, notably in health care.

Despite its relatively enviable fiscal position, Canada faces the same long term fiscal challenges related to population ageing seen in other OECD countries. The old age dependency ratio is expected to more than double over the next 50 years, putting significant pressure on public spending mainly through rising health care expenditures, since the earnings based public pension system has now largely been put on a sustainable footing. Among the policies that could help alleviate the problem are: more rigorous spending controls; programme and financing reforms aimed at improving the efficiency of public expenditures, especially in health care; faster debt reduction; shifting provinces’ taxation to more efficient bases; and, above all, growth friendly policies to help future generations afford the rising costs of government programmes.

Source: Organisation for economic co-operation and development, Economics department, Economic survey of Canada 2008

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