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Adjusting to Global Economic Change

Good morning. I am happy to have the opportunity to be in Buenos Aires and to meet with all of you here at the Canadian Embassy. I am also glad to have the opportunity later on to meet with my counterpart, President Alfonso Prat-Gay, and with some of his colleagues at the Banco Central de la Republica Argentina.

There is a great physical distance between our two countries—in terms of latitude, there are about 80 degrees of separation between Buenos Aires and Ottawa. But despite that distance, Canada and Argentina are closer, and have more in common, than you might think. We are both federations, with a certain natural tension between the national government and relatively powerful provinces. We have roughly the same number of people, and we share the challenge of living next door to a much larger neighbour. Both our countries have an abundance of natural resources. We are both important producers and exporters of agricultural products, and we have worked together for years in the Cairns group as allies in the effort to eliminate trade-distorting agricultural subsidies. And we are both being affected by changes in the global economy.

Today, Argentina faces significant financial difficulties. As a Canadian, I can appreciate the tremendous pressure that the citizens of Argentina and its policy-makers must now be feeling. A little over a decade ago, Canada was facing very difficult economic and financial circumstances. While the declines in incomes and employment we saw were not as severe, we too had a debt problem. At one point, the Government of Canada was spending one out of every three dollars it took in on servicing its debt—a situation not unlike the one Argentina faced in 2001.

In my remarks today, I want to focus on Canada's adjustment to global economic changes. I will talk about our efforts to adjust to longer-term economic forces and the challenges that these forces present, in the hope that some of our experiences may be relevant to you here today.

Past Adjustments

Our experience over the past few decades has taught us that structural adjustments are key to adapting to change and, just as important, that sound macroeconomic policies have a role to play in making those adjustments with a minimum of economic and social disruption.

These lessons may seem self-evident. But Canadians have been reminded of their importance through some significant and painful economic adjustments during the past 30 years.

For example, Canada was hit by an abrupt slowdown in productivity growth during the 1970s. That slower productivity growth made it impossible to continue to provide the gains in real wages to which Canadians had become accustomed. The situation was exacerbated by the OPEC oil embargo of 1973 and by the subsequent energy crisis that hit economies around the globe. The consensus of the day was that the impact of those events on Canada would be temporary. And so Canadian policy-makers used macroeconomic and microeconomic policies to try to shield our economy from the impact of those events. Instead of making the necessary adjustments, we tried to avoid them. As a result, the eventual adjustment was slower and more painful than it needed to be. And we ended up with slower growth, relatively high inflation, and large government budget deficits.

During this period, Canadians learned that economic policies must be focused on adjusting to change—even if that adjustment causes short-term difficulties. Towards the end of the 1980s, Canada was facing a number of economic and fiscal challenges. Government spending levels were near historic highs. Public debt levels were increasing rapidly, as was the percentage of that debt held by foreigners. Real estate prices were rising quickly, adding to fears that inflation was poised to accelerate. By the beginning of the 1990s, it was clear that we needed a framework of policies to help with adjustment, to bring down inflation, and to put our public finances in order.

The first major change came in 1991, when the federal government and the Bank of Canada agreed on an explicit anchor for monetary policy. That anchor was a series of inflation-reduction targets that would gradually lower the rate of inflation to 2 per cent, the midpoint of a 1 to 3 per cent range. The agreement has been extended three times and currently covers the period to the end of 2006. Each time, the midpoint of the target range has been kept at 2 per cent.

In Canada's case, the central bank and the federal government jointly established our inflation-targeting policy. But it is the Bank alone that decides how to conduct monetary policy in order to meet the inflation target. I want to stress the importance of that independence. Experience around the world has consistently shown that there are distinct advantages to having monetary policy carried out by an independent central bank, not the least of which is separating the power to print money from the power to spend it. Central bank independence is also a mechanism for building credibility among investors.

Central banks have a choice to make as to how to anchor their monetary policy. Some countries have chosen a fixed exchange rate as their anchor. In doing so, their central banks give up the power to control domestic inflation. In contrast, countries like Canada have chosen low domestic inflation as their anchor. By doing this, they leave it to foreign exchange markets to set the external value of the currency. The key point here is that, since capital is mobile, no central bank can successfully control inflation and the exchange rate at the same time.

The choice of an inflation-targeting framework has served Canada very well. Since the end of 1994, inflation has averaged almost exactly 2 per cent. Moreover, not only has inflation fallen, it has become more stable than it was in the 1970s and early 1980s. Just as importantly, inflation expectations have fallen into line with the 2 per cent target and have remained there. As for the floating exchange rate, it helps our economy adjust to disturbances and to fluctuations in the world prices of our products, particularly commodities. It also helps our economy adjust to changes in global savings and investment flows.

Another important consequence of adopting a system of inflation-control targets is that we at the Bank of Canada can now explain more clearly to business, to labour, and to the general public what we are doing and why. One should not underestimate the benefits that arise from having the public understand the policies and actions of its monetary authority. This understanding makes it easier to conduct monetary policy and gives citizens a measure by which to judge the performance of their central bank.

Canada's experience with inflation targets is consistent with the experience of other countries that have adopted this type of framework. Inflation targets have been found to be particularly useful in helping countries with high inflation make the transition to a low-inflation environment. Targets can also help establish and maintain overall policy credibility.

I know that Argentina is considering the establishment of formal, explicit inflation targets. I am glad that we at the Bank of Canada are able to share our positive experience with your central bank. In our case, it took a bit of time for all the benefits of inflation targeting—such as well-anchored inflation expectations and improved policy credibility—to become entrenched. But now that they are, they are tremendously helpful for our economy.

The second major adjustment that Canada had to make in the 1990s was to get its fiscal situation under control. In the early part of that decade, the combined federal and provincial primary deficit (which excludes debt-service costs) peaked at just under 3 per cent of GDP, and the total deficit was close to 8 per cent. In terms of debt levels, federal and provincial government debt reached a peak of about 100 per cent of GDP. While some of the shortfall reflected cyclical factors, it was clear that the situation was unsustainable. So between 1993 and 1997, both federal and provincial governments in Canada made a determined, and successful, effort to eliminate their deficits and run consistent primary budget surpluses.

The fiscal adjustments made by both levels of government helped to improve the credibility of our economic policies and reduced the risk premium that investors demanded on Canadian bonds. This credibility is particularly useful during periods of crisis, when the spreads on riskier investments tend to widen.

Consider Canada's experience with the Mexican currency crisis of 1994, before the credibility of our monetary and fiscal policy was fully established. Spreads on Canadian bonds widened significantly, and consumption and investment slowed, leading to a period of weaker growth. By 1997, our credibility was better established, so we were able to weather the financial crises in Asia and Russia with only a slight widening of spreads. There was much less uncertainty, and growth actually strengthened in the wake of those events. When you compare these two experiences, you can see that there is a real payoff from the achievement of fiscal and monetary credibility, and it does not take too long for that payoff to be realized.

Canada's public and private sectors also made structural adjustments in the 1990s, leading to a more flexible economy. The added flexibility helped us to weather the recent global economic slowdown.

Our governments, both federal and provincial, also took steps to reduce distortions in the economy. In the latter half of the 1990s, federal industrial subsidies were cut by more than 60 per cent. Provinces eliminated many of their own subsidy programs. The federal government reformed its unemployment insurance system, and Canada's public pension plans were amended to make them self-financing in the decades ahead. This involved some restructuring of benefits and an increase in contribution rates. In addition, contributions are now being invested in markets in order to generate the best possible returns—with due consideration for prudence—over the long term.

Throughout this difficult period, governments worked hard to ensure that the burden of adjustment did not fall disproportionately on those segments of the population that were least able to bear it. It was only after the adjustment process was well underway that the federal government began to reduce corporate and personal income taxes.

As governments take steps to improve the structure of their economies, it is equally important that businesses make their own adjustments. During the 1990s, Canadian firms responded to the challenges of freer trade by improving the quality of their products and by marketing them aggressively to new North American customers. These adjustments were not easy. But they did leave Canada in a better position to handle economic shocks and, therefore, to grow on a sustained basis.

To recap, a sound monetary policy supported by a floating exchange rate, sound fiscal policy, and appropriate structural adjustments, all did their part to help Canada's economy respond to the changing circumstances of the 1990s. While these adjustments were difficult, the payoff came quickly. By the end of the decade, Canadians were beginning to see higher real incomes.

Adjustments in the Future

So that's a quick look at the lessons that we have learned from past experience. Let's turn now to the international forces at work in our economies and talk about what these forces will mean for economic policies in the future.

In the global economy today, we see significant financial imbalances. The United States is faced with a large fiscal deficit and a high and growing current account deficit, while some Asian countries are accumulating record current account surpluses. Several emerging-market economies, particularly in Asia, are becoming increasingly powerful players on the world stage. This increases the competitive pressure facing Canadian producers. But it also means new, fast-growing sources of demand and new opportunities.

So in the face of these forces, what kinds of adjustments are needed? I will speak about our situation in Canada, but what I have to say is applicable to most economies.

The first thing I would say is that maintaining fiscal balance must remain a priority for Canada in the years ahead. Our federal and provincial governments have made great progress on this front, but we cannot afford to give back these hard-won gains. Canada also faces longer-term demographic challenges. Our ratio of public debt to GDP will have to decline further to give us the flexibility to meet the demands of our aging population.

The second point is that we must provide the appropriate microeconomic policies in areas such as labour markets, intellectual property law, the environment, and foreign investment. The right microeconomic policies are essential in order to increase productivity and raise living standards in the future. This is true for every country.

However, we know that implementing the right economic policies can mean that some groups will bear an unfair share of the burden of adjustment. This does not mean that we should shy away from the task. But it does lead to my third point, which is that authorities must put in place the right policies to facilitate adjustment, such as providing access to training, or helping workers relocate or shift into expanding areas of the economy. In doing so, we should keep in mind that government help should be directed towards people, and not towards specific businesses or industries.

So what can policy-makers do to provide a supportive economic environment for business? In my view, promoting an efficient and robust financial system, including a strong banking sector, is critical. And that is my fourth point. This is particularly true in countries such as Canada and Argentina, where small and medium-sized businesses create the majority of jobs. Growing firms must have access to credit within a well-functioning banking system. Further, people need to have confidence in the banking sector, so that savings can be efficiently recycled to help businesses expand.

A robust financial system can also be a country's best defence against international financial crises. A key lesson from the Asian and Russian crises was that countries with strong banking sectors are much less likely to be affected than countries where the banking sectors are weak.

Beyond the banking sector, countries should also work to develop healthy and efficient financial markets. This is not a new idea. Canada's efforts to build domestic fixed-income markets go back over 50 years. And we built these markets living next door to the country with the deepest, most liquid financial markets in the world—the United States. Now, and in the future, we will need to remain focused on promoting healthy and efficient markets. This topic is an ongoing priority for research at the Bank of Canada. In fact, later this year we will be hosting, along with the German Bundesbank, a G-20 workshop on building strong domestic financial systems.

My fifth and final point has to do with trade. Canada has a long history of support for multilateral trade agreements. We have seen, first-hand, how our economy has benefited from opening our borders to trade. That is why we are committed to trying to extend the benefits of free trade to the whole of the Americas through the Free Trade Area of the Americas (FTAA). It is why we also support your efforts in Mercosur. And, most importantly, it is why we are committed to lowering trade barriers worldwide at the Doha round of multilateral negotiations. I have seen many examples of the challenges that governments face in reducing trade barriers and subsidies. We in Canada have our own difficulties in this regard. But, as an economist, I know that the economic benefits of freer trade make the effort worthwhile.

So those are the five areas that should be priorities for Canada in the years ahead: fiscal prudence, the right microeconomic policies, appropriate social policies, a strong and stable financial system, and more open trade. Monetary policy, for its part, will continue to be focused on keeping inflation low, stable, and predictable, thus giving citizens, businesses, and investors confidence in the future value of their money. To achieve this, we will try to keep supply and demand in balance.

Since the Bank of Canada has chosen low domestic inflation as its monetary policy anchor, we will continue to have a flexible exchange rate. We recognize that a floating currency implies some volatility. But I can tell you that Canada derives enormous benefits from having a floating currency working in conjunction with a solid monetary policy anchor. It gives us the ability to set monetary policy tailored to Canada's specific economic circumstances. It sends important price signals to economic participants and helps our economy to make the necessary adjustments.


Let me conclude. For workers, for firms, and for governments, adjustment can be painful and difficult. But in today's world, not adjusting is not an option. This is true for every economy.

Fortunately, the external environment is favourable for making adjustments. Demand in the global economy is strengthening, and the geopolitical risks have eased. We have a better understanding of which policies are the right ones. And we have made important progress in strengthening our economic policy frameworks.

The challenges that we will face make it even more important for us to continue to strengthen those frameworks in order to adjust to changing circumstances and to take advantage of potential gains. The faster we are able to adjust, the greater the wealth that Canada and Argentina can create for their citizens.

That is not to say that adjusting will be easy. Indeed, the experience of recent decades proves that it can be difficult, at least over the short term. But if we take the leap and seize the opportunities that change will bring, our societies will surely benefit.