Glen Hodgson is senior fellow at the Conference Board of Canada.
The Canadian and U.S. economies are currently performing well, with solid growth and low unemployment rates. This positive short-term outlook presents an ideal opportunity to plan for challenges ahead – such as getting ready for the inevitable next crisis before it hits.
Crises can be grouped under three broad headings: economic and financial shocks; disruptions to the physical environment; and threats to national security. Economic crises include events such as the 2008-09 financial crisis, deep or prolonged recessions, or some combination. The physical environment can experience crises of varying magnitudes, such as earthquakes, severe floods, forest fires and industrial disasters. And national-security crises can include cyberthreats or military interventions. There are bound to be economic consequences arising from all types of crises, but let’s focus here on widespread economic and financial shocks.
The excellent book This Time is Different, by Ken Rogoff and Carmen Reinhart, documents the approximately 200 financial crises since the emergence of capitalism three centuries ago. The United States was the epicentre of the 2008-09 crisis, caused by the rupturing of a speculative housing bubble that had been fuelled by high-risk mortgages. Canada was largely spared the worst effects, although the resulting deep recession was felt here along with most other places in the global economy.
In addition to financial shocks, painful recessions do and will occur. Alberta, Newfoundland and Labrador, and Saskatchewan fell into recession in 2015 as a result of the collapse in global oil prices. And, of course, any roadblock in the contentious North American free-trade agreement negotiations would pose a threat both to near-term growth, and to the resilience and competitiveness of the entire regional economy.
Jurisdictions should ideally have a full array of policy tools available to respond to financial crises and recessions. Responsive monetary and fiscal policy are the central tools for dealing with the immediate recessionary difficulties, breaking the negative psychology of recession and kick-starting growth.
So, what’s the status of Canadian and American contingencies today? For much of the past decade, monetary policy was used aggressively and innovatively to rebuild a foundation for economic growth. The U.S. Federal Reserve, along with central banks in Europe and Japan, resorted to exceptional measures – notably quantitative easing, to drive down long-term interest rates and re-liquefy the economy. The Bank of Canada was able to avoid using quantitative easing, but did rely on exceptionally low interest rates for a long period.
It is now time to restore more normal monetary conditions in Canada and the United States. The Conference Board of Canada expects interest rates to rise in 2018 by 50 to 75 basis points across the board. These increases will help put the monetary genie back in the bottle and rebuild central banks’ capacity to cut short-term interest rates when eventually required.
In the event of the next recession or financial crisis, both Canada and the United States will inevitably be expected to use fiscal-policy tools in response. However, we have been slow to rebuild that fiscal capacity. Most Canadian governments have public debt levels today that are higher than a decade ago, although most are also still within a manageable range. Federal debt at around 35 per cent of GDP is higher than ideal; but some exceptional fiscal stimulus could still be provided, if required, to help break the psychology of recession.
In contrast, the U.S. federal government has not balanced its books for two decades. Public debt has doubled as a share of the economy during that period, climbing to 80 per cent of GDP. Yet, the U.S. federal government is now injecting fiscal stimulus at the peak of the economic cycle. The Trump-Congressional Republican combination of deep tax cuts and added spending will increase the U.S. debt-to-GDP ratio further. In turn, this unnecessary fiscal stimulus is likely to put further upward pressure on long-term interest rates – thereby undermining the growth ambitions of the fiscal action. In the event of recession, the United States could spend even more, but debt levels would approach and even exceed 100 per cent of U.S. GDP – entering risky territory.
The capacity to manage systemic financial risk also appears to be diverging between the two countries. The United States is slowly dismantling many of the measures it put in place after the 2008-09 financial crisis, such as the Dodd-Frank controls on financial institutions. Canada is not automatically following suit, and indeed is slowly tightening conditions in areas such as access to mortgage financing.
It can be hard to imagine the next economic or financial crisis that will inevitably occur, especially at a time when the Canadian and U.S. economies are performing well. But this is precisely the time to prepare. Monetary authorities in both countries are now on a path to rebuilding their capacity to intervene in the event of a downturn. However, fiscal-policy makers in Canada, and particularly in the United States, have some distance to go to rebuild the capacity to deal with the next crisis.