Wednesday, January 5, 2011

Monetary Cure?

This comes out of a question I asked when the Parliamentary Budget Office was giving a seminar here. In one set of forecasts, the PBO is projecting that interest rates will remain low for the next several years. Given the lack of inflationary pressures we’re seeing and speed of the recovery south of the border, this makes a lot of sense to me. In a different forecast, they were predicting that Canadian labour productivity wouldn’t be rising very quickly in the foreseeable future. Again, I can believe this.

The problem arises when you put the two together and this was basically the question I asked. What I was initially intrigued by was the apparent contradictory nature of these two predictions. Of course it was the last question and I didn’t get to ask a follow up, so you get to suffer.

Start with the idea behind a monetary stimulus. The whole point of reducing interest rates is to encourage consumers to buy (on finance) durables and firms to engage in more investment spending. This is a pretty textbook story so far. Reduce interest rates, increase consumption and investment, and presto the economy recovers.

Investment in economics isn’t quite the same as what most people think of as investment. When we talk about investment, we’re talking about the purchase of new physical capital not financial capital. We’re talking about the stuff that tends to make people more productive like machinery, computers, and so on. So a monetary stimulus should be followed by a period of increased productivity as new capital comes “online” and increases labour productivity.

The problem with the story so far is that it ignores the excess capacity many measures show in the Canadian economy. If there is a lot of excess capacity in the economy, we aren’t likely to see a lot of investment in new capital. Why buy more capital when you aren’t using what you’ve already got? So, for the monetary stimulus to have any impact on the Canadian economy, all the heavy lifting has to be done by consumers. This is actually what’s happening. Consumer debt is on the rise in Canada and is now reported to be higher than (relative to income)in the U.S. It is possible we’re setting ourselves up for a debt driven bubble in consumer spending.

There’s another catch. Consumer spending generally doesn’t go to stuff made in Canada. Look at almost all your consumer goods, electronics, appliances, etc. Not very much of it is made in Canada. A lot of it is made in places like China or Korea. So a spike in consumer spending doesn’t do a whole lot for the Canadian economy.

So the follow up question remains. Is the monetary stimulus of low interest rates likely to do us any good or is the cure likely to be worse than the disease?


the_iron_troll said...

Isn't it possible that Canada has lots of capital, but not the right *kind* of capital? Bunches of useless automotive plants, maybe?

economistatlarge said...

You're right about the type of capital. It is also possible that firms will use the opportunity to upgrade to better tech that's embedded in capital.

Either of these things would then lead to an increase in labour productivity, so the second forecast is out of line with the first.

Anonymous said...

Unfortunately, we are too dependant on cheap dollar economics.

A strong dollar, which I believe is here to stay for a considerable time, I hope will provide the impetus to improving productivity in Canada - a measure that has time and again been the achilles heel of the Canadian economy.

You might think that a higher dollar is the thing we need when Canada imports most high tech and other equipment. Excellent time to buy.

Although there is excess capital, how much of that capital is current - are they still relevant or obsolete or soon to be? Good time to upgrade and innovate.

A strong(er) dollar might be the cure we need along with (ahem) higher interest rates - yes, higher rates - not because I see inflation down the road (there's inflation now - I don't believe in the current inflation statistics) but a cure all for the general financial morass. Nothing beats cleaning house than a good'ol hike in interest rates.

From a corporate view - who cares about higher rates - they're flush with cash. They don't need to borrow. So, from the public view, higher rates might impact some but for arguments sake, I think that is good thing. How hurtful can a 100 basis point increase from near all-time lows be? If they are, that says something more about how incompetent the Canadian consumer has been to their well-being and not about making right policy choices.