The Odd Conversion of Mainstream Economists to the Virtues of Depreciation
The long-overdue depreciation of Canadaâ€™s currency is gathering steam. The dollar lost 8 cents against its U.S. counterpart, in fits and starts, over 2013. Itâ€™s lost another 2 cents since the start of 2014, and negative sentiment about the currency is accumulating among financial analysts and traders.
Indeed, once the expectation that the loonie will fall becomes entrenched among enough of the red-suspendered trading set, that belief quickly becomes self-fulfilling. Speculators who think the loonie will fall, sell or short the asset to take advantage of that fall, and this only accelerates the decline. So we can expect the dollar to continue weakening â€“ perhaps faster and further than would have seemed possible until very recently.
On last nightâ€™s CBC Bottom Line economics panel, I thought I was going out on a limb with my bearish prediction that the dollar would be in the mid-80s by the end of this year. But then I was trumped by Patti Croft, former RBC economist (who once was very bullish on the loonie): she said it could reach 80 cents in â€œthe blink of an eye.â€
The present downturn is a welcome, but overdue, reversal to a decade-long, pointless, and destructive financial detour for our currency. From 2002 through 2007, the loonie shot up over 60 percent. For the next five years it bounced around par with its U.S. counterpart. Now, finally, it is heading back down.
At or near par with the U.S. greenback, the loonie was substantially overvalued by any fundamental measure. The most common way to estimate the â€œfair valueâ€ of a currency is according to relative price levels in different countries (what economists call â€œpurchasing power parityâ€). On this basis, the Organization for Economic Cooperation and Development pegs the loonieâ€™s benchmark at 81 cents (U.S.). [You can see the whole set of OECD PPP estimates here.]
Temporary factors (like investor expectations, big financial flows, or unusual success in export markets) can push the exchange rate away from its fair value â€“ for a while.
But even waterfowl canâ€™t stay aloft forever, and itâ€™s been clear for years that eventually the loonie must come back to earth. At par, the inflated dollar made Canadian-made goods and services artificially expensive to foreign buyers (imposing a cost penalty of around 25 percent). Consequently, anything we sold to foreigners (other than resources, which are usually denominated in U.S. dollars) was priced out of the market. Even resource industries are hurt by overvaluation: while it doesnâ€™t affect their sales volumes as much (given U.S. dollar pricing for most commodities), it does cut into profits and incomes back home â€“ once those revenue streams are translated into Canadian dollars.
In 2004 I published a report for the CAW predicting the loss of 400,000 manufacturing jobs if the dollar stayed above 85 cents (U.S.).Â But sadly, it turns out my guess was conservative: almost 500,000 disappeared since the currency took off.
And itâ€™s not just manufacturing that suffered from the loonieâ€™s flight of fancy. Other export-oriented sectors were hammered even worse. Tourist visits to Canada, for example, plunged by almost half since 2000 (from almost 50 million per year to just 25 million), not surprising given Canadaâ€™s status as one of the most expensive destinations in the world. Thatâ€™s a worse decline than was experienced in manufacturing, yet it gets little public attention. Border towns have been devastated; huge flows of southbound cross-border shopping every weekend made matters worse.
Indeed, Canadaâ€™s overall trade performance was among the worst in the world throughout the loonieâ€™s manic episode. Exports plunged from 44 percent of GDP in 2000 to just 30 percent last year â€“ making a mockery of the federal governmentâ€™s supposed â€œtrade agenda.â€ Combined with surging imports, this has produced an enormous deficit in international payments: over $60 billion last year, the highest in history. Since late 2008, Canadaâ€™s debt to the rest of the world grew by $290 billion. (Thatâ€™s twice as much as the growth in federal government debt over the same period.)
The federal government likes to boast of its â€œsound fiscal management,â€ justifying the stealth austerity it has used to achieve a faster-than-expected balanced budget (never mind the macroeconomic side-effects of the cutbacks). But federal government debt is owed mostly to ourselves. And assuming that the debt-financed spending was productively spent, this serves a useful social purpose.
Our growing foreign debt, in contrast, is more unambiguously problematic. Running up debt, twice as quickly, to foreigners in order to sustain an uncompetitive trade balance, isnâ€™t prudent â€“ itâ€™s reckless.
Unfortunately, Canadian policy-makers (including Finance Minister Jim Flaherty, and successive Governors of the Bank of Canada) endorsed, and even perversely celebrated, the dollarâ€™s rise over the past decade. Unlike other countries which intervene to manage exchange rates (such as Norway, Australia, Switzerland, Brazil, China, or Japan), Canadian authorities let the currency float wherever markets took it.
While the loonie was taking off, I made several deputations to Bank of Canada officials warning of the negative consequences for our real economy (sometimes jointly with manufacturing executives). The Bankâ€™s line, and they were sticking to it, went like this: The Bank is in the business of targeting inflation, and inflation only. We take the exchange rate and trade balance into account when we formulate our forecasts of inflation. But we do not take action to move the exchange rate. To do so would be self-defeating, and would undermine the solid economic benefits that come from low and stable inflation.
Most mainstream economists, accepting the Bankâ€™s logic, also tacitly or explicitly endorsed the dollarâ€™s rise during this time. Those of us who worried about the overvalued loonie were even targeted with near-McCarthyist ideological attacks for a couple of years. Our arguments that an oil-fueled loonie was damaging the rest of the export-oriented economy were dismissed as anti-Alberta ravings â€“ on par with the subversive actions of foreign-financed environmentalists. The dollar was not too high. Even if it was, oil was not to blame. And at any rate, a high dollar helps Canadian manufacturers (making it cheaper to import capital, forcing companies to innovate, etc. etc.).
If they really believed that, how do we now understand the sudden near-unanimity among mainstream economists (including everyone on our CBC panel last night) that the current decline in the dollar is good for Canadaâ€™s economy? Finance Minister Flaherty (the same guy who not long ago cited the high dollar as proof of Canadaâ€™s â€œstrong fundamentalsâ€) seemed to endorse the depreciation last week â€“ although he immediately contradicted himself by saying that he still wants it to be affordable for Canadians to travel abroad. And mainstream analysts across the board (banks, business, and media) are all heralding the dollarâ€™s decline as a harbinger of better economic times ahead.
The Bank, for its part, has been silent. Indeed, some have credited Governor Stephen Poloz, in part, with engineering the depreciation. (I donâ€™t believe that â€“ although the Bankâ€™s newly dovish tone on interest rates, reflecting the obvious and stubborn stagnation of Canadaâ€™s macroeconomy over the last two years, has certainly played a role in the current downturn.)
To some extent, this inconsistency in mainstream thinking about the dollar might reflect their laissez faire assumption that if the market decides something (even a market as flighty and speculative as foreign exchange trading), it must be efficient and legitimate. Through that lens, when the dollar was high, that was good â€“ and when the dollar is low, thatâ€™s good, too. And to a degree, discussion about the dollar was polluted (as noted above) by the same oil-boosting impulse that has distorted other Canadian policy debates during this era of the â€œpetro-state.â€ Acknowledging that the high dollar (so obviously linked to the oil boom) was damaging, might directly or indirectly undermine the view that oil is king. Thatâ€™s not acceptable, so we really shouldnâ€™t go there. Whatever the reasoning, it is very odd to say the least that I have suddenly been joined by most other economists in welcoming the current depreciation â€“ and, indeed, egging it on.
Finally, Canadaâ€™s lacklustre employment record and miserable trade performance are sinking into the consciousness of traders. Speculative behaviour will now hasten the loonieâ€™s downturn â€“ possibly even causing the currency to overshoot the PPP benchmark in the other direction.
Unfortunately, much of the damage from this pointless, decade-long to-and-fro will be permanent. Many industrial jobs that exited Canada since 2002 wonâ€™t come back, even if the dollar returns to normal. Global companies worry that if currency traders are infected by another bout of loonie-mania (sparked by oil prices or some other cause), our government will once again let it happen â€“ destroying competitiveness in the process.
So while I welcome every downward tick, I am still not popping champagne corks. Canadian policy-makers havenâ€™t learned the lessons of its pointless, destructive escapade â€“ which means it could happen all again.
A shorter version of this commentary previously appeared in the Globe and Mail.