Canada Works: Remarks by Mark Carney, Governor of the Bank of Canada

Remarks by Mark Carney
Governor of the Bank of Canada
Chambre de commerce du Montréal métropolitain (CCMM)/
Board of Trade of Metropolitan Montreal
Montréal, Quebec

21 May 2013

Canada Works

Introduction
It is almost six years since the start of the global financial crisis, and its dynamics
still dominate the economic outlook.
In the United States, households are emerging from a painful period of
deleveraging. Their economic expansion continues at a modest pace, with
gradually strengthening private demand partly offset by accelerated fiscal
consolidation. Despite recent progress, the U.S. economy has not yet achieved
escape velocity.

Europe remains in recession, with economic activity constrained by fiscal
austerity, low confidence and tight credit conditions. Deep challenges persist in
its financial system. Without sustained and significant reforms, a decade of
stagnation threatens.

Europe can draw lessons from Japan on the dangers of half measures. It is now
more than two decades since the Japanese financial crisis erupted. To end its
debilitating legacy, Japan has just embarked on a bold policy experiment. Its
success or failure will have a major impact on the outlook over the coming years.
Amongst the G-7, Canada is unique. For us, the global financial crisis was an
external rather than internal shock. When Canadian policy-makers responded
quickly and forcefully, our financial system channelled credit to where it was
needed and our economy adjusted smartly.

As painful as our recession was, Canada suffered less. By the start of 2011, all of
the output and all of the jobs lost during the recession had been recovered

A further 480,000 jobs have been created since, with the vast
majority of them full-time and in the private sector. Nearly all the new jobs are in
industries that pay above-average wages.

Relative to our peers, Canada is working.

Why did we fare better? Our outperformance reflects four critical advantages:

• responsible fiscal policy,
• sound monetary policy,
• a resilient financial system, and
• a monetary union that works.

I will discuss these foundations of our prosperity in more detail, but I don’t intend
to oversell them. These are the cornerstones of Canada’s prosperity, but lasting
growth depends on what is built on this foundation through longer-term
investments in infrastructure, human capital, innovation and new markets.

A Monetary Union That Works
Canada’s monetary union has the essential elements of an effective currency
union: an integrated economy, fiscal federalism and labour market flexibility.
Allow me to elaborate.

An integrated economy
While the composition of provincial output varies, the Canadian economy is
highly integrated. Consider the case of commodities.
When commodity prices increase, all provinces benefit. All else equal, the
Canadian dollar appreciates. Its adverse impact on our non-commodity exports is
partially offset by the fact that a stronger currency reduces the cost of
productivity-enhancing machinery and equipment and imported inputs to
production.

Various mechanisms distribute benefits across provinces: fiscal
policy; increases in personal wealth through income and ownership of stock; and
movements in internal real exchange rates and interprovincial trade.
During the recession and its aftermath, the importance of interprovincial trade
was clear. For example, the increased demand from other provinces for
Quebec’s goods and services significantly offset lost international exports.
Movements in provincial real exchange rates are another important part of the
adjustment process. Although there is one exchange rate for Canada as a whole
(we all use Canadian dollars), price differentials across the country yield different
real provincial exchange rates.
This matters.

Trade between provinces helps offset weakness in international
trade . Consider the Alberta/Quebec real exchange rate. When higher energy
prices stimulate production and investment in Alberta, extraction, construction
and labour costs there rise. This increases the real Alberta exchange rate,
making goods and services from the other provinces, including Quebec, more
competitive. Interprovincial trade is boosted, spreading benefits from energy
price increases throughout the economy.

It is interesting to compare developments in the Canadian and European internal
exchange rates. For example, since the euro was introduced, Spanish
competitiveness (as measured by GDP deflators) has fallen by about 30 per cent
relative to Germany. During the same period, the Alberta exchange rate moved
even more dramatically, rising 40 per cent relative to Quebec . Intra-
regional exchange rates in Canada have generally been more volatile on
average than most internal exchange rates in the euro area.

And yet, the challenges of regaining competitiveness are central to the economic
travails of Spain. This is because Spain is experiencing a balance of payments
crisis. In the years following monetary union, Spain ran large intra-euro-area
current account deficits, funded in part by foreign purchases of real estate and
inflows to the Spanish banking system. When these dried up, domestic activity
collapsed. There are few institutional mechanisms within the Economic and
Monetary Union (EMU) at present to offset the shock.

In Alberta’s case, a rising tide has lifted all boats. That is because the Canadian
monetary union has what Europe does not: a single financial market; a flexible,
national labour market; and significant fiscal transfers. These smooth the
adjustments brought about by the large shifts in relative prices.

Fiscal federalism helps to share risks
Despite the equilibrating movement of real provincial exchange rates, shocks to
our economy can still have a more significant impact on some regions than
others. Since monetary policy works at an aggregate level to support aggregate
demand, it cannot easily deal with such distributional consequences.

Fiscal transfers are thus an important element of a successful monetary union.
They are sizeable in Canada, representing 8 per cent of GDP across all levels of
Government. Canada’s equalization program helps stabilize the impact of asymmetric shocks.
For example, between 2006 and 2011, federal support programs, including
equalization payments and Canadian social and health transfers, grew more
rapidly for provinces whose economies were hardest hit by the crisis.

The Employment Insurance program also shares risk. Through transfers to
2 per cent of the working-age population, the program particularly benefits
provinces with higher unemployment rates .

In the medium term, one of the building blocks of European fiscal federalism
could be a pan-European employment insurance scheme built on a common
European labour market. This would reduce impediments for those looking
across the continent for work, while providing a cross-country automatic
stabilizer.

Labour market flexibility
For Canada and Canadians to work, workers must be able to move to different
jobs, and wages must adjust to help maintain full employment.
By international standards, the Canadian labour market is highly flexible,
although there is still room for improvement.

Our labour mobility as a whole is similar to that in the United States.
By some estimates, the Canadian labour market is almost four times
as flexible as the European labour market.
An obvious example of this flexibility is the way that Canadians have responded
to the higher wages and employment opportunities in the energy sector. Last
year, there was a net inflow of more than 40,000 people into Alberta from the rest
of Canada, a level of mobility that approaches its previous peak.
Deviation of EI beneficiaries claim per capita relative to national average (2001-12)

Deviation of unemployment rate relative to national average (2001-12)
As a consequence, labour markets are becoming more similar across the
provinces. In particular, the dispersion of employment rates in Canada has fallen
steadily over the past 30 years to levels comparable with those in the United
States. Again the contrast with Europe, where it has risen substantially, is striking.
Bank of Canada research suggests that the main reason behind these
improvements has been the increased sensitivity of provincial population growth
to labour market opportunities—Canadians are going where the jobs are.

Finally, wages are flexible in Canada. Results from the Bank of Canada’s wage
setting survey indicate that, while firms are typically reluctant to reduce base
wages, incentive pay offers a possible source of downward flexibility in total
compensation.

About 90 per cent of Canadian private sector firms currently use
short-term incentive pay plans.
Such risk sharing is an effective way to maintain
employment and profitability during uncertain and volatile times.

A Resilient Financial System
An important lesson from Europe’s experience is the critical role that a sound
financial system plays in the monetary policy transmission mechanism. It helps to
ensure that changes in central bank policy are transmitted effectively to all
regions to support growth and employment. When a sizeable share of a country’s
banking sector has (or is perceived to have) deficient capital and liquidity
positions, credit doesn’t flow to where it is needed.

Recent experience in Europe has shown the particular problems a monetary
union faces when banks become less willing to lend across borders within the
union. This fragmentation has reinforced the links between sovereign and bank
Canada United States Euro Monatery Union. Employment rate convergence in
three currency areas Mean absolute dispersion of provincial, state or country away
from currency area average.

Economic and Monetary Union solvency.
As European leaders now recognise, without major reforms to create a
banking union, EMU is fundamentally weakened.
In Canada, the existence of largely centralized prudential regulation and deposit
insurance pools risk across the country. When combined with a large number of
national banking institutions, this greatly reduces the risk that localized economic
and financial disruptions impair provincial solvency.

Since the strength of the Canadian banking system has been well documented, I
will concentrate on Canada’s sound regulatory framework. Its key elements are:
First, supervision is focused and proactive. Consolidated prudential supervision
is not burdened by other objectives such as the promotion of home ownership or
community reinvestment. The staged intervention approach of the Office of the
Superintendent of Financial Institutions (OSFI) means it works with institutions to
correct problems at an early stage, while they are still manageable.

Second, efforts to promote financial stability are coordinated. Federal authorities
consistently share information, coordinate actions, and pool advice to the federal
government on financial sector policy. Most notable in this regard has been a
series of actions to slow the rate of increase in household debt. The Bank of
Canada also works with provincial authorities to implement a number of global
initiatives.

Third, Canada has clear and credible recovery and resolution mechanisms,
including lender-of-last-resort policies, a deposit insurance scheme with risk-
weighted premiums, and bridge-banking powers that enable the rapid closure of
failing institutions and the swift re-opening of their viable operations. In its most
recent budget, the federal government announced it will consult stakeholders on
how best to implement a bail-in regime to recapitalize failing Canadian banks that
are systemically important to our domestic economy through the very rapid
conversion of certain bank liabilities into regulatory capital.

Fourth, bank capital regulation is prudent. Prior to the crisis, Canadian capital
requirements were higher than international norms thanks to OSFI’s insistence
that common equity form a large share of required capital. Since the crisis,
Canadian banks have become considerably stronger. Their common equity
capital has increased by 80 per cent, or $77 billion, and they already meet the
new Basel III capital requirements six full years ahead of schedule.

Finally, the entire financial framework is regularly reviewed and updated, in
accord with the statutory requirement to renew the federal legislative and
regulatory framework for the financial system every five years. This has proven
invaluable given the pace of change in the financial system. In addition,
Canada’s regulatory system is subject to regular, rigorous external examinations.

A Massive and Disciplined Policy Response
Allow me to review. The structure of the Canadian economy, the risk sharing
across the federation, labour market flexibility and financial stability together
meant that Canada could adjust quickly to the shock of the global financial crisis.
It also meant that when Canadian policy-makers responded, they were able to do
so swiftly and massively.

During the crisis, the Bank of Canada aggressively cut our policy rate until it
reached one-quarter of one per cent, the lowest it can effectively go. The Bank
then provided extraordinary guidance on the likely path of interest rates
necessary to achieve the inflation target in order to maximise the monetary
stimulus from its policy rate.

Canada’s inflation-targeting regime was a critical anchor during those turbulent
times. It gave the Bank a simple, unwavering goal to guide its policy actions. It
provided financial markets and Canadians with a clear means to understand why
the Bank did what it did. And that understanding kept inflation expectations well
anchored around the 2 per cent target throughout the period, maximising the
stimulative impact of our policies.

Although fiscal policy is always less nimble than monetary policy, it also
responded aggressively. Government expenditures rose by almost 3 percentage
points of GDP within a year, with government contributing about one-third of
GDP growth in 2010.

Government expenditures rose rapidly during the recession.
The effectiveness of fiscal policy was underpinned by Canada’s strong fiscal
position.
From the mid-1990s onwards, successive governments ran more than a decade
of surpluses, cutting the government debt-to-GDP ratio from almost 70 per cent
in 1995 to 22 per cent in 2008. As a result, Canada’s net debt relative to GDP
went from being the second-highest ratio among the G-7 countries in 1995 to the
lowest. This fiscal flexibility provided leeway for governments to respond while
maintaining our credit standing at the highest levels.

Having clear policy frameworks has disciplined the post-crisis response. Fiscal
consolidation has begun, with the combined deficits of all levels of government
falling from 4.8 per cent in 2009 to an expected 2.8 per cent this year.
Disciplined by its inflation target and reflecting the relative strength of the
economy, the Bank of Canada was the only G-7 central bank not to engage in
quantitative easing, and we have been the only one to move away from
emergency settings of interest rates. In addition, mindful of the risks to financial
stability arising from rapid increases in household debt, the Bank has maintained
a tightening bias on interest rates over the past year, in part to complement
efforts of the federal government and OSFI to achieve a constructive evolution of
household debt.

Conclusion
In the immediate aftermath of the crisis, the broad economic strategy in Canada
has been to grow domestic demand and to encourage Canadian businesses to
retool and reorient to the new global economy.

Stimulative monetary and fiscal policies proved highly effective in supporting
robust growth in domestic demand, particularly household expenditures, which
grew to record levels.

As effective as it has been, the limits of this growth model have been clear for
some time. We cannot grow indefinitely by relying on Canadian households
increasing their borrowing relative to income . Nor can residential
investment remain near a record share of GDP, particularly given signs of
overbuilding and overvaluation in segments of the real estate market.
Domestic demand, which pulled Canada out of the recession, is now slowing.
Consumer spending is expected to grow at a moderate pace over the next few
years. The Bank expects residential investment to decline further from historically
high levels. The contribution of direct government expenditures should be
modest for some time, consistent with the ongoing need to consolidate budgetary
positions.

Thus, the challenge for Canada is to rotate the sources of growth toward net
exports and business investment.
Exports are currently more than $130 billion less than they would have been had
this been a “typical” postwar recovery.
In the short term, the Bank forecasts some rebalancing and a pickup in real GDP
growth. However, relative to previous cycles, investment is expected to remain
below average and the contribution of net exports to be very weak.

Is that really the best we can do?
Yes, there are immense uncertainties in the world economy, but we need to
focus on what we can control. We cannot save the euro or fix America’s fiscal
challenges.
Business fixed investment is projected to grow at a slower pace
than in the average cycle

Should we just wait out a decade-long deleveraging process in the rest of the
G-7? Or should we control our destiny by building on our strengths in the new
global environment?
To find and compete in new markets will require a concerted, multi-year effort by
workers, firms and governments. These efforts should be guided by three
principles.

Openness is better than protectionism. Trade brings innovation, growth and
jobs. That is why Canada is pursuing a series of bilateral trade discussions with
economies such as the European Union and India, and will participate in the
multilateral negotiations of the Trans-Pacific Partnership involving a number of
Asian countries. Emerging-market economies do not just account for one-half of
all of global import growth, they also are essential to securing Canada’s positions
in global supply chains.

Economic flexibility is essential. Markets change, industries rise and fall,
exciting new products emerge and then become commoditized. In a rapidly
shifting world, only sustained education, ingenuity and investment can maintain
competitiveness. This means we must continuously invest in our workforce. With
technology and trade transforming the workplace, the need to improve skills
across the spectrum of work has never been greater.

Sound macroeconomic policy is the cornerstone of prosperity. Fiscal
profligacy erodes economic sovereignty; price stability is paramount.
The advantages I have discussed today are self-reinforcing. Our monetary
union—with its resilient, national financial system at its core—gives monetary
and fiscal policy traction. A strong fiscal position means that Canadian
governments have had the flexibility to respond as needed. Our principles-based
macroeconomic policy frameworks help ensure that extraordinary actions do not
give rise to extraordinary fears. And the discipline they instill means that stimulus
will be withdrawn appropriately as threats diminish.

All of this has meant that, unlike the rest of the G-7, Canada does not need to
repair.
To keep Canada working, we need to build.