The Weather Is Still Nice in Canada

Although the credit crisis in the U.S. has spilled over various borders and financial systems, the Canadian economy still managed to perform better than expected in the second quarter of 2007. Our GDP increased 3.4% on an annual basis, fuelled mostly by strong and steady consumer spending. Now, the chorus of analysts who believe that the Bank of Canada is likely to raise interest rates one more time this year is getting louder and louder again.

Such a performance comes on the tail of the first quarter’s strong performance, when the Canadian economy grew 3.9% on an annual basis, although economists were calling for a rate of 3.7%. Propelling Canada’s GDP to jet speed were the usual suspects: robust labor market, low opportunity costs and strong domestic demand.

After the country’s second quarter performance results were released, one economics strategist — among many, I should say — Jacqui Douglas of TD Securities Inc., commented that, “This just illustrates the fact that the Bank of Canada’s next move is going to have to be a rate hike, and that market expectations for a cut in the overnight rate are clearly overdone.” (Grant, T., “Second Quarter Growth Tops Forecasts,” Globe and Mail, August 31, 2007.)

Well, that would be a textbook example of the Keynesian view on macroeconomics, not that there is anything wrong with it. You see, a Keynesian macroeconomist believes that the economy, if left to its own devices, cannot function properly. So, if the Bank of Canada were to leave the interest rates alone, Keynesian macroeconomists believe that inflation would take flight and seriously distort the long-run equilibrium between the real and potential GDP.

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So far, so good! The Keynesian macroeconomic reasoning makes a lot of sense. The only problem is that looking at the aggregate demand/aggregate supply model like this, in a vacuum, isolated from other macroeconomic factors of production, provides only a limited view on the overall economy.

One of the most important factors of production — the supply of capital — has come under heavy fire due to the crisis in the U.S. credit market. And although the crisis originated in the U.S., that does not mean the rest of us can ignore the weakness in the world’s dominant economy. So, without adequate supply of capital (please don’t confuse this factor of production with the quantity of money), firms may be forced to decrease production, thus decreasing the demand for labor and wages. If fewer people are able to earn income, consumer spending decreases. If consumer spending decreases — well, you guessed it — the economy slows down, perhaps to the dangerous point of completely stalling.

Another problem with fiscal policy is properly timing whatever measures need to be taken. I believe that, at the moment, the Canadian economy is performing well, but not to the point of overheating. I still think the Bank of Canada should not have hiked interest rates in July, at least not until the scope of the credit crisis in the U.S. was fully known. The idea is not to stall the landing, or worse, shortcut it. Timing can be everything!

Just one more thing! Although there are many voices in Canada saying that our credit market has extremely limited exposure to subprime lending, it does not necessarily mean we are completely out of the woods. First, there are domestic firms that have invested a portion of their assets in this troubled sector, just as there are financial institutions that were players in it. Those investments will have to unravel somehow, but the outlook isn’t too good for them at the moment.

Second, the pumping of money into financial systems by central banks will take the solving of the problem only so far. I’m afraid this particular rift in the economic system will take much more and much longer to fix. In the meantime, extreme volatility in global stock markets is likely to continue, negatively impacting corporate earnings, the labor market and, ultimately, the GDP.