The Economic State of the Nation: How Canada Can Grow Its Way to a Better Future

Canadians rolled into 2023 with intense misgivings about our economy, uncertainty about its outlook and concerns about the health of their pocketbooks. A gradual resolution of the pandemic’s economic hangover will likely be accompanied by some of the challenges that have plagued the Canadian economy for decades. 

 

 The “Before Times” Weren’t Great 

 

The 2008–2010 global financial crisis was the last big economic ruction to hit the world’s major countries simultaneously. Thanks to prudent regulatory frameworks, which moved the World Economic Forum to name Canada’s banking system the “soundest” in the world for the eight years between 2007 and 2015, none of our financial institutions failed. Canada experienced the mildest downturn and fastest recovery among G7 countries. 

Then our oil-producing provinces were hit hard by a 70 per cent decline in prices between 2014 and 2016, driven by abundant new petroleum supply from American shale producers and slowing global demand. Canada’s economy got sideswiped in the ensuing years by former U.S. president Donald Trump’s trade war with China and the renegotiation of the North American Free Trade Agreement, which together triggered another global slowdown in 2019. 

Canada’s soft private investment and productivity left us in a tough spot heading into the pandemic. Canadian companies were investing only about half as much per worker as their peers in the U.S. As a result, Canadian workers don’t have the tools, technology and processes to work as effectively as their American peers. On average, an hour of work in Canada produces only about three-quarters as much as the same hour of effort in factories and offices south of the border. 

Real gross domestic product (GDP) growth trended above four per cent during the early 1970s; between 2014 and 2019 it averaged just a hair over two per cent. While this bested the G7 average and was one of our longest-ever uninterrupted expansions, growth closely tracked the Bank of Canada’s 1.9 per cent estimate of our underlying potential. This is the modest pace of gains the Canadian economy can sustain without excess inflation unless we get serious about boosting Canadian efficiency. 

 

Getting Back to the Old Normal 

 

More Canadians died from COVID-19 in 2022 than in 2021 or 2020. But, rightly or wrongly, we’re getting back to something closer to our old economic normal, even if our health-care system is still overwhelmed. 

By different measures, both economic activity and employment have been above pre-pandemic levels for several quarters. Still, Canadian GDP hasn’t caught up to the path it would have been on if the pandemic hadn’t happened. The Canadian economy has healed, but with scars.

Inflation remains our big economic open wound. At the beginning of 2022, the Bank of Canada expected our year-on-year rate of price increases to fall to two per cent by now – about five percentage points lower than it actually was at press time.

Ottawa has good company in its forecast error: Nearly every major central bank failed to anticipate 2022’s inflation spike. Each of them has scrambled to raise interest rates quickly to bring inflation back under control. 

Monetary-policy authorities came by their mistakes honestly. At the start of the year, Omicron was surging and it looked like the economy would need more of the support low interest rates could provide. Instead, we reopened more quickly than analysts anticipated, and then soaring food and fuel prices hit after Russia invaded Ukraine. 

We know that wider adoption of cryptocurrencies wouldn’t have saved us from this price spike. In fact, inflation in Bitcoin terms has been running around 10 times as fast as price increases in the world’s major currencies, including the Canadian dollar. The 13 per cent of Canadians who own Bitcoin saw the purchasing value of their holdings drop by around 63 per cent in 2022.

 

 A Mild Recession Looms 

 

Our inflationary spike is starting to look transitory after all: Recent price data are consistent with a return to the Bank of Canada’s target range by the end of this year. 

Slowing inflation reflects falling global commodity prices and easing supply-chain bottlenecks. These international factors account for about 85 per cent of Canada’s recent price surges. But cost indices for fuel and food are closer to levels prevailing before Russia invaded Ukraine in February 2022. Similarly, supply-chain tensions have eased 75 per cent from their highs. 

If inflation is being driven by external factors, it’s fair to ask why Bank of Canada Governor Tiff Macklem has had to raise interest rates so much that the TSX has tanked and a mild recession is nigh.

First, global prices feed into domestic inflation. Additionally, the recovery from 2020’s shutdowns has been almost too successful. Canadians are demanding more than we can supply, which creates domestic price pressures. Wage increases at over five per cent year-on-year are the largest nominal gains workers have seen in ages. 

Pandemic support measures didn’t blunt Canadians’ willingness to work. We have seen the highest-ever shares of core working-age Canadians engaged in the labour market. Labour shortages have instead been driven by two years of throttled immigration, accelerated retirements by older workers and skills mismatches as Canadians shifted demand from goods for remote work to services that got them out of the house. 

The central bank also has to address Canadians’ expectations of future inflation. October surveys put these projections, which guide wage and price negotiations, at more than five per cent for consumers and more than four per cent for businesses. The bank has to ensure that these expectations aren’t baked into inflationary pressures for years to come. 

Bond investors believe that the Bank of Canada can dampen inflation without hiking rates much further or tipping the economy so far into recession that unemployment rises substantially. As higher interest rates cut demand for goods and services, we should see job postings taken down, rather than more layoffs. 

Even without a deep recession, high mortgage rates are set to have a long-lasting impact on our cities. Years of insufficient building have left us with some of the lowest ratios of housing inventories to our urban populations that we’ve seen in decades. This ratio is set to fall further as high borrowing costs knock more buyers out of the market and cause developers to cancel projects. People still need a place to live, which has driven up rents at a record pace. Families with kids have been forced out of some of our largest cities and activity has been pushed to mid-size towns. Federal plans, for record inflows of new immigrants and temporary workers in the coming years, mean we’re not heading for a housing crash: Instead, housing affordability could get worse, because we don’t have the skilled labour and technology we need to build homes quickly. 

 

On the Brighter Side 

 

We entered 2023 with several challenges, but we’ve also got some economic aces in our hand. A mild recession is arithmetically likely after two years of strong growth, but it’s not inevitable: The Canadian economy expanded nearly twice as fast as expected in the third quarter of 2022. 

We’ve got the fastest-growing population in the G7 and the best-educated workforce. As global supply chains reset, we’re the only G7 country with free-trade agreements covering four continents. Canada has the energy and resources the world needs for a green transition. 

Our federal government’s finances remain enviable. Ottawa provided $211 billion in pandemic support to Canadians, but we’ve still got the lowest public debt-to-GDP ratio in the G7, our deficit is pegged at only 1.3 per cent of GDP this fiscal year, and the burden of servicing our federal debt is the lowest it’s been in a century. We’re manifestly not on the edge of a sovereign financial crisis.

Equity and debt markets should soon begin a slow process of consolidation that will repair recent dents in Canadians’ balance sheets. For retirees, this fix could take years: Asset re-pricing and inflation have sliced about 25 per cent off the real annual income they could expect to receive from their current retirement savings. 

 

Growing Our Way to a Better Future

 

We have to address some of the same issues we grappled with before COVID-19 hit. Top of the list: Canada’s anemic economic growth. The Organization for Economic Co-operation and Development predicts that we will see the slowest GDP expansion among its 38 industrialized-country members between 2020 and 2030, and even further out to 2060.

There are three ways to raise our growth potential: expand our labour force, increase investment and boost productivity.

We’ve long relied on larger immigration inflows to enlarge our ranks of workers. This is getting harder as our labour force greys, other countries age and competition intensifies for immigrants. The federal government will have to raise the eligibility age for Old Age Security to 67 to encourage older Canadians to stay in the workforce. 

Canada’s lacklustre private investment rates have been impervious to attempts to nudge them upward. The Trudeau government has cut key corporate taxes, accelerated deductions for capital spending, enhanced subsidies, encouraged companies to work together to generate complementarities and tightened intellectual property protections — with marginal results. Expect more of these measures in April’s budget. 

This leaves productivity improvements — changes in technology and skills — to boost growth. Yet, Canada’s productivity growth is expected to lag the industrial world for the next few decades unless we make substantial changes to the way governments and businesses work. 

This is a daunting task. But innovation happens at economic inflection points such as the one we’re in: for instance, Groupon, Uber and Airbnb all came out of the 2008 crisis. We’ll have to start learning from other countries’ successes and apply these insights here if we’re to climb out of our productivity hole. 

This is the agenda for 2023: It’s time for Canada to grow. 

A version this article appeared in the Feb/Mar 2023 issue with the headline ‘The Economic State of the Nation’, p. 34.

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