A Conversation with Stephen Poloz on Canada’s Economy, Inflation, Interest Rates and Productivity
This week on the podcast, our guest is Stephen Poloz, former Governor of the Bank of Canada, Author, Special Advisor at Osler, and recently appointed by Finance Minister Chrystia Freeland to lead a working group to explore how to catalyze greater domestic investments by Canada’s pension funds.
This is Stephen’s second appearance on the podcast. The first was in 2022 after he released his book The Next Age of Uncertainty.
Here are some of the questions Jackie and Peter asked Stephen: What precipitated the thesis that Canadian pensioners are better off with more investment in Canada? What can you say about the pension investment working group, the deliverable you are working towards, and the potential timing? Why has inflation been so persistent in Canada and globally? What are your expectations for Canadian interest rate announcements in the future? Carolyn Rogers, senior deputy governor of the Bank of Canada, recently said in a speech, it’s time to “break the glass” and respond to Canada’s productivity “emergency” – do you agree that productivity is an emergency? How important is free trade with the United States for Canada’s economy? What are your thoughts on the Canadian government committing tens of billions of dollars to support the EV sector in Canada? Are you concerned about Canada’s ongoing deficit budgets and growing debt levels?
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Episode 246 transcript
Disclosure:
The information and opinions presented in this ARC Energy Ideas podcast are provided for informational purposes only and are subject to the disclaimer link in the show notes.
Announcer:
This is the ARC Energy podcast with Peter Tertzakian and Jackie Forrest. Exploring trends that influence the energy business.
Jackie Forrest:
Welcome to the ARC Energy podcast. I’m Jackie Forrest.
Peter Tertzakian:
And I’m Peter Tertzakian. And welcome back. So, as we record, Jackie, what is this week two of the water, week three of the water issue. I see your hair looks pretty good. Did you shower? Did you shampoo? How’s it going?
Jackie Forrest:
Well, I did have a lot of feedback about my dry shampoo. I realized the limit for dry shampoo is definitely three days, because after that, your one-minute shower is not going to get rid of the layers of dry shampoo. So, I’m learning new things as we go.
Peter Tertzakian:
You’re learning new things.
Jackie Forrest:
Yeah.
Peter Tertzakian:
Okay. Well, at least you’ve cut your water consumption by two thirds as with respect to the hair. I’m, as I mentioned in the last podcast, off grid, at least when it comes to water, living out in the country on a water well. But this is a fairly serious issue, and I think the big news in the last week or so, certainly from a news conference I’ve heard, is that the city has reached out to the oil and gas industry. Seems logical. We’ve got two of the biggest pipeline companies in the country if in the continent headquartered here. As an example, I mean, we’ve got pipelines running through the province’s veins here, so we should be able to try and hopefully figure this out fairly quickly.
Jackie Forrest:
Well, and there’s a lot of temporary pipes used in the oil field too. They roll out those big pipes. Maybe they’re not water grade or,-
Peter Tertzakian:
Well, they’re not concrete and water grade, but the idea of engineering the movement of fluids from point A to point B seems to be a core expertise in this city. So hopefully, I mean, I don’t want to be an armchair quarterback, but hopefully we can get this issue resolved before Stampede.
Jackie Forrest:
Figures crossed.
Peter Tertzakian:
Yeah, good. So, speaking of greater issues that span the country, let’s this week talk about affordability, inflation, the interest rates and so on. And we’re delighted to have back for a second time our guest, Stephen Poloz, former governor of the Bank of Canada, author and special advisor at the law firm, Osler. Stephen was also recently appointed by the Deputy Minister of Finance, Minister Chrystia Freeland, to lead a working group to explore how to analyze greater domestic investments by Canada’s pension funds, which is really topical because energy requires a massive amount of investment. We’ve talked about that in terms of energy transition, decarbonization and so on.
And so, the call for pension funds to invest more in this country in the energy space and other infrastructural projects, maybe even water, who knows, is top of mind. So this is the second time, as I mentioned, we’ve had Stephen joining our podcast. The first was in 2022, not long after releasing his book, The Next Age of Uncertainty. And Jackie will put a link to that in the web notes. And it’s a fitting title considering the last few years of uncertainty or certainly I feel the anxiety of uncertainty. So who better to talk about it with us than Stephen? Stephen Poloz, welcome.
Stephen Poloz:
Thanks very much. Good to be here.
Jackie Forrest:
All right, well Stephen, I think our listeners know you well as the former governor of the Bank of Canada, but maybe just tell us briefly before you got into this large panel, which we’ll talk about, what you’ve been up to?
Stephen Poloz:
Well, as you mentioned in the intro, I did join the law firm, Osler, Hoskin, Harcourt. That’s a special advisor role. Being part of the best law firm in Canada is a fantastic, wonderful culture. And I’m on the board of directors at Enbridge, which I know you know extremely well. And also at CGI, which is a Montreal based IT services company. Has like 90,000 employees around the world. And at OMNI Conversion Technologies, that’s a tech company that conversed municipal solid waste into hydrogen with a negative carbon footprint, pretty cool technology. Advising a few startups and I’m on the advisory board for the Kruger family, you know Scotties tissues, those folks. And I’m on the Board of Governors at my alma mater, University of Western Ontario. So, I like to kid around, that adds up to 60% or so of my time in retirement, which leaves about 100% of my time free.
Peter Tertzakian:
Sounds to me like it’s 160% of your time with all those commitments.
Jackie Forrest:
And we have this new one. So, let’s do some context setting about your new panel. For those that haven’t been following it, we have talked about it on the podcast a couple of times. The Canadian pension funds are under some scrutiny for not investing enough domestically. And the federal government highlighted this in the fall economic update in 2023, asking for more transparency about how much was really being invested in Canada, but also just encouraging more Canadian investments by these big pension funds. Now in March of 2024, we had 100 CEOs urge the finance minister and the provincial counterparts to mandate Canadian pension funds to invest a certain amount of money into Canada. And their points were that there’s been a real falloff. They said that in 2000, 28% of the total assets of these big Canadian companies were held by Canadian pension funds, and that’s down to 4% now.
And increasingly, they think that the domestic investments by getting the pension funds to invest more here would boost productivity and strengthen the economy. We’re going to talk about that, but productivity is a real issue in Canada, and they think that that would help solve that. Now the pension funds see it differently, and I’m just going to quote Evan Siddall, the CEO of AIMCo, Alberta’s biggest pension fund. He wrote an op-ed arguing that pension funds need diversity in their investing and independence from government interference. And he also noted that the CEO letter did not include other types of investments. They were just focusing on the public investments, so publicly traded companies. But when you looked at other types of asset classes like fixed income, real estate, infrastructure, private debt, actually it would be quite a bit larger.
So, he suggests that Canada just needs to make it a better place to invest and then pension funds would put their money here. Notably, I would just mention that there are places in Canada where there are domestic requirements. In fact, in Quebec that’s required in the case of certain portion of their money has to go into Quebec. They call it a dual mandate for the pension funds so that they must have a good financial return, but also contribute to the Quebec economy. So, with that context, this new panel was announced in budget 2024, a working group to explore how to catalyze this greater domestic investment.
Peter Tertzakian:
So, Stephen, I guess as Jackie went through that introduction, I was sort of thinking it’s a chicken and egg problem in some ways, like potentially the pension funds would be inclined to invest more in Canada if the productivity was better, if the returns were better. But the government is saying, well, the productivity in the runs would be better if the pension funds invested. So how do we make sense of all this?
Stephen Poloz:
Yeah. Well, as you can tell just from that quick summary, no wonder a lot of people are confused about this, Peter. First of all, Evan’s note, his op-ed was exactly right. The criticism that’s being leveled at the funds is that they only invest a small portion in publicly traded Canadian equities. But of course, they invest in commercial real estate, they invest in private equity, invest in a lot in bonds, and they invest in infrastructure. In fact, the big categories that have been growing for all pension plans all around the world have been private equity and infrastructure. Money has to come from somewhere. So what you do is you gradually, they’ve been reducing the amount that’s in public equities, which is like a very liquid, easiest thing to adjust and trying to substitute very, very long-term assets, long duration assets in order to have a better match between the liabilities that they have, which are like a 50-year plan. Right. It’s your life plan that’s in that pension plan.
And so ideally, if you’re just starting a plan today and you’re going to be collecting, say 40 years from now, they want assets invested now that’ll still be paying 40 years from now, not a bond that’s going to roll over just in a couple of years. So historically, the pensions in the very deep past were required to hold most of their money in Canada, and that proved to be a really, really bad idea. All the pension plans that I know of were underwater back then, unable to come up with enough to satisfy their liabilities basically because there’s not enough diversification available in Canada. And diversification as broadly as possible is the key to reducing risk while having your same return, which means you’re boosting risk adjusted returns. Anyway, the premise therefore is a little bit misleading.
In the background also, pension liabilities are in Canadian dollars, right? So, you want a fairly good match with Canada. So, we’d all wish I’d say that Canadian pension plans would invest more in Canada or could invest more in Canada. We wish Canadian companies would invest more in their own companies here in Canada. Basically, the big number is that the big pensions are more like 30 to 40% invested in Canada overall, which is very high number in fact judged in that context. And I don’t think anybody’s in position to prejudge what is exactly the right number.
Peter Tertzakian:
So that 30 to 40%, I just want, for our audience just clarify, that’s 30 to 40% of all invested dollars,-
Stephen Poloz:
That’s correct.
Peter Tertzakian:
Not just in public equities, which is what the mandate that you’re going after, which is much smaller.
Stephen Poloz:
Well, actually that’s what was in that letter that you referred to. My mandate is a little simpler and it is to look for impediments or things that might be slowing down Canadian pension investment in Canada and see if it’s possible for us to remove or ease some of those impediments so that all things equal, they’ll see more opportunities to invest in Canada. Almost the pensions will say, I’d love to invest more in Canada. I just don’t have those opportunities in front of me. So, I think that viewed in that way is a very positive process. The idea is to go through all this while respecting the mandates as they are. And in other words, I think of it as using a carrot, not a stick to bring about a higher amount of investment in Canada.
Jackie Forrest:
Okay. That is a different framing than maybe the media has been sort of putting it in. So, thanks for clarifying. Now we’re early in this process, but could you just say a little bit about the working group and the deliverable and timing that you’re working towards?
Stephen Poloz:
Yeah, absolutely. So well, first of all, I’ve been inundated with helpful input from interested parties, not just the pension plans, but lots of interested Canadians. And so to simplify that, I’ve decided it’s a working group of one. That’s me. So, there’s no table with masters of the universe sitting at it.
Peter Tertzakian:
It’s easy to vote, isn’t it? It’s easy to vote on stuff.
Stephen Poloz:
It’s easy to vote.
Peter Tertzakian:
Yeah.
Stephen Poloz:
And I have a nice support team in the Department of Finance that’s collating things and bringing new information to the table, my table. And so we’re looking for those impediments, keeping the input as concrete and as simple as possible so we can remove some and attract more investment. As for timing, I’ve just in the last say 10 days received the concrete input from 15 pension plans across the country, which is a good geographic distribution and a bit of size distribution. And so we’re distilling from those the things that they believe they need in order to invest more in Canada. Not necessarily their biggest wishlist, but their need list. From there… I don’t know exactly the timing, but I’ve promised the minister that I’ll report by summer. I think summer’s less than a week away, so I’m thinking in summer is probably more appropriate. But I do know that they’ll want this kind of input probably before they do their August cabinet retreat, that kind of thing. So I’m targeting in July.
Jackie Forrest:
And then I just had a quick question. The 30 to 40%, that’s the first time I’ve heard that number. If you go back to the fall economic update of 2023, there was a requirement for more transparency about how much is actually invested in Canada. Is that a new number that’s come out of your work? Because I just haven’t heard that before.
Stephen Poloz:
No. Most of the pensions are reasonably open in that broad brush sort of way. Some of them will have lower numbers and some have much higher numbers than that, the smaller ones in particular because the bigger you are, the more opportunity you have to do the diversification that’s global and that’s an important thing to think about. As these plans, some of them will get enormous as time goes on and it would be truly foolhardy to focus more and more of that weight on Canadian investments. The main purpose of these things is to provide for people’s retirement. It is not to create something jazzy here in Canada, but look, as I said, every dollar that’s invested in the world is being competed for. And I would say that Canada has not been competing that well for investment dollars in probably 10 years or perhaps longer. We’ve been competing badly.
Jackie Forrest:
All right. Well, we look forward to hearing…you’re going to have a busy summer. We look forward to hearing more about what comes out of your panel of one or your working group of one, but let’s switch to inflation, that’s on a lot of people’s minds, and interest rates. So, when we had you here in May, at that point you and many others felt inflation was not going to stick around too long. Of course, it has been quite resilient, been around almost two years, and today it still remains above the 2% target, but it’s way down from the 8% growth we had in the summer of 2022. Why do you think inflation has been so persistent and contrary to what a lot of people thought earlier on?
Stephen Poloz:
Yeah, so at the time, most economists understood that it would last a little while just because of how we measure inflation, but we all were guilty of using what is a technical term that economists use. It’s transitory. To you, transitory just sounds really quick. It is going to be gone fast. But in economist jargon, transitory doesn’t mean that. It means something that will go away all by itself. And no one talked really about the time. And here’s how you get to the time. First of all, we measure inflation on a year-over-year basis, which means that if, let’s say, in the spring of 2022, which is when we had the invasion of Ukraine that, say, the price of oil went up… I think it was around $30 or I forgot the exact number. So, let’s suppose that’s the only thing that happened.
Price of oil goes up by $30 so let’s say 30% or 40%. The year-over-year growth rate of inflation pops up that very month. And how long does it stay up? Well, it stays up for 12 months. Let’s assume that the oil price just stays at that new number. It’ll take 12 months for the inflation rate to stay up and then it’ll fall back down again because oil has stayed unchanged for that year. But what happens is that the oil is actually an input into lots of things in the economy. And so that oil then starts going into the system and it’s not just oil, it’s actually… I think of it as the three Fs, food, fuel, fertilizer that skyrocketed in price in the early months of 2022. And so those things are all inputs. In fact, we’re still in 2024 buying things off the grocery store shelf that have ingredients in there that were grown using that really expensive fertilizer 18 months ago.
So how long does it take for the system to digest that even though fertilizer prices have come back down, oil prices have come back down, et cetera? The fact is that that gets embedded in the system. So, my guess was that we would take about two years to define the term transitory, 12 months because of the year over year, plus another year worth of transmission through the system. And wouldn’t you know it? So, I think inflation was pushing towards three or around 3% just before the invasion of Ukraine here and a little higher in a couple of other places. But in that sort of 3% zone and everybody’s inflation rate went up by five percentage points right then. And that’s why we think of inflation as peaking at eight or 9%. In the UK it was closer to 10%. It depends on your imports. So that five points is from Putin’s invasion of Ukraine and 24 months later, that five points is gone.
And what is left is around the 3% that we would’ve had as a bulge in inflation after the pandemic without the invasion of Ukraine. So, the interest rate policies of the best central banks have been aimed essentially at pushing down that core part of inflation, that 3 to 3.5%, getting it back down to 2%. And those interest rate changes have had nothing to do with the drop of inflation from 8 or 9% down to 3%. That’s all just been the transitory part due to the accounting around the invasion. So, hope that makes it clearer that there are these two tracks. And the track that only accounts for central banks is the domestic part, which is 3 to 3.5%, and now it’s down to like 2.7%. So that’s progress. We’ve gone from say 3.5% to 2.7% here in Canada. And I have every reason to think the rest of the progress is going to be pretty automatic from here.
So sticky, yes, Jackie but that’s how I understand the way that policy has worked. The real question we have as policymakers would be when inflation goes to 8%… I’ve just told you a story, but a regular person in the grocery store doesn’t know that story. They just see 8%. They’re like, “Oh my goodness.” And so, the question we have is, does that extra five points that came from Putin’s invasion, does any of that stick in our inflation as it goes through? And that’s the part which is expectational. And that’s the part which was the biggest concern to central banks. And so, you had to tighten interest rates to make sure that didn’t happen. And it still could be sticky, to be frank. It could stick in this 2.5 or 3% range.
Peter Tertzakian:
So that’s inflation. And what the consumer does see is their interest on their line of credit, their mortgage, their credit card bill. And we’d recently here… June 5th, the Bank of Canada announced that the rate dropped from 5% to 4.75%. So, it is conjectured to be sticky. It’s certainly sticky in Europe and the US and we can’t be too far out of step with them because otherwise our dollar would go down arguably relative to the other currencies. So, what do you see in terms of a go forward interest rate, which is ultimately what the Safeway lineup talking points are between people?
Stephen Poloz:
Indeed, indeed. Well, it’s important for people to understand that interest rates are not just higher for longer, they’re higher forever because we got used to a very, very low interest rate regime, say, from roughly 2008 all the way up to the pandemic. And then we got to true zero. None of that was normal. And so, what does normal look like? Roughly speaking, interest rates should be ending up somewhere between 2.5 and 3%. Let’s use 3% for sake of argument. It’s easier to talk around, but it could be a little lower than that. And from 3% for a short rate, you might have say 3.5 to 4% for a long rate. So, all the other interest rates kind of stack up along that curve. But you can tell that at the long end of the curve, we’re about… we’re there now.
We’ve been there throughout. It’s all been at the short end where the rates went up and it’s all going to be the short end where rates come down. If inflation continues its downward trek, which I fully expect, unless some bigger outbreak happens in oil markets or something that… we could do this all again, we always know that as a risk, but provided that inflation continues its downward trek is what I would expect. I would expect interest rates to ease… I couldn’t give a timeline on it but say by two points altogether for sake of argument. The United States is clearly lagging that story, but I don’t think for very long. In a few months. That just means that it’d be surprising if the gap between our rates became as much as 1%, but even if it did, it would put downward pressure on the Canadian dollar, but only modest, only by usually around 2%, which is one and a half cents, that kind of thing.
So that’s the kind of ballpark that we’re talking about. And indeed, if interest rates come down in Canada while the US holds still, which happened in June 5, as you say, if that trend continued for a little while and the exchange rate did go down a cent or two, I don’t think that would be that bad of a thing. That would help spread the stimulus from lower interest rates to the rest of the economy through the export sector. And yes, potentially it might add a little wee bit to imported prices, but that’s a pretty modest effect when the exchange rate is only moving by a couple of cents. If it moved a lot, then that will be a different story. But anyway, that’s kind of like… a controlled reentry is what I’d expect to see. And it’ll be fairly gradual because the central banks, all of them will be cross-checking the data very carefully because the last thing they want to do is take a chance and letting inflation get renewed again.
Jackie Forrest:
Right. Okay. Well, that’s, I guess, good information, but maybe a bit sad for those hoping that interest rates are going to come down much further.
Stephen Poloz:
No, that’s really important because if you got used to that rate from three years ago and you think that’s normal, you have another thing coming. It can’t be normal like that. And of course, back in the day we were reminding people that every chance we got and so I’m sorry if people think that it’s going to go all the way back down. The only reason it might be if the Canadian economy got into a serious problem again and Central Bank needed to reduce rates all the way back down in order to cushion a blow, if there was a major shock, a global recession that drew us down, then you might see a new interest rate cycle. But barring that, that won’t happen.
Jackie Forrest:
Well, let’s talk about the longer term from that perspective, Canada’s lagging productivity. So, it might be worth just explaining to our listeners what is the productivity measure.
Stephen Poloz:
The way we measure productivity is we take the total production in the economy and that the measure that we use as economists is GDP, Gross Domestic Product. And we divide that by how many people are working and that gives us output per worker. That number has been historically relatively weak in Canada. We’ve always seemed to have lagged other countries in our productivity growth. And to the point that over the last 20 or so years, we’ve gone from not just a little bit less than the United States to a lot less than the United States, output per worker, and we suffer from a lot of things, always have. We’re a small economy, so it’s kind of a small economy syndrome. Big economies always seem to have more productivity. We have a small company syndrome because we’re a small economy. Most of the new productivity growth in economy comes from when a small company suddenly becomes a big company. That hockey stick phase.
And the more companies like that you have, the more productivity you’ll have. Well, we know well, we have lots of startups in Canada, great startups, but often we each struggle with that growth phase where they become larger. And the United States seems to be much more fertile ground for that. So that’s a big thing about our relativity. We have a relatively large government sector in Canada. Government sector by construction, the productivity growth is zero. It’s just measured by how many people are there and how much they get paid. If we measured, let’s say, hospitals by how many people get better as opposed to by how many people work there or how many beds there are, you see, we’d be able to measure outputs. Some of these things are really hard to measure, so we don’t have any productivity in the government sector or the public sector, let’s say.
And since we have a big public healthcare sector, whereas the United States has a much bigger private healthcare sector, that’s one reason why they always have higher productivity than we have. Where are the other things that… investment’s been weak as we talked before, and productivity generally is seen as coming from new investment or certainly R&D or investment in intellectual property. And we’ve lagged on all of these things. The whys are multitudinous, but there’s no one thing. But there’s so many. Things like high electricity costs in Ontario compared to Michigan. Red Tape, we’re famous for it, processes, environmental impact assessments, taking years, not months. Indigenous reconciliation or consultations. Years, not months. Everything seems to be without a time limit. It’s almost like very well-intentioned stuff. I’m not criticizing it. It’s exactly what we would want to see, but we never put a deadline on it. We argue about it between provinces and the Feds. Look at TMX, look at the Trans Mountain Pipeline, which I know you’re very familiar with.
So that took 12 years and for 12 years, that project is negative productivity because you’re putting money in, money in where all the workers, everything’s going in, but nothing is coming out. Now we’re turning it on, Peter, we’re just turning it on. It’s going to add up to 0.4, even 0.5 percentage points of GDP going forward. That’s a huge increase in our productivity, the instant that pipeline comes on.
Peter Tertzakian:
Yeah, I hear what you’re saying. And as a data science guy, I feel like we can normalize for these effects to really compare and contrast, say Canada versus the US and the UK. Okay. Take out medical, take out government and see where we’re at. I suspect our productivity, if we normalized for the things that you talked about that may be dragging our productivity down, we would still be lower than other countries. That’s conjecture.
Stephen Poloz:
Yes, we would be. No, it’s not a conjecture. That’s correct.
Peter Tertzakian:
Okay. And you were talking about deadlines. And so, we have from your old shop, the Bank of Canada, Carolyn Rogers, senior deputy governor, she said in a speech recently, it’s time to break the glass and response to Canada’s productivity emergency. What do you think is that… I mean, are we at an emergency level even after normalizing for these effects when we contrast Canada to the other G7, G20, G whatever?
Stephen Poloz:
Well, look, if it’s an emergency, I guess suddenly, I guess the patient has been sitting in the waiting room for like 20 years, and so I appreciate that the Bank of Canada has called extra attention to this issue. But the fact of the matter is that it is not even under the purview, or it is nothing that the Bank of Canada can do to actually affect that outcome except to call attention to it and suggest some of the reasons. I’ve mentioned a number of the reasons, and it would take boiling the ocean to get this salt out, right?
Peter Tertzakian:
Yeah. I tend to think, Steven, the root issue is the same as our discussion with the pension plans. Why aren’t the pension plans investing in our own country, which extends to the same set of issues. Why aren’t other foreign investors coming and investing in this country? Because it takes capital to grow companies, startups to growth, to maturity. And my sense, certainly my gut feel is it’s just really decelerated in the last 10 years, and this is why we do have a productivity crisis.
Stephen Poloz:
I agree with you, and it’s true that in the sense that Carolyn Rogers’ excellent speech pointed it out and said the pressure seems to have accelerated. And that’s true. And if you look at the charts on investment spending overall, it’s slowed down significantly relative to the United States in particular, in 2015. That’s when the gap started. The jaws of death started to open up. At the time, you remember we had the collapse in energy pricing, late 2014 or early 2015. So, there’s a big drop in investment in the energy sector that year. But if we take energy out, it’s still true for the rest. So, it’s important to understand it’s true more widely. On that, I will point to a couple of things. One is NAFTA. So, candidate Trump in 2015 first said if he was elected, he would tear up NAFTA. And indeed, he did get elected and he basically did tear up NAFTA and it took four years for us to renegotiate NAFTA.
And throughout that period, Canadian companies definitely geared back. Anybody who cared about or relied on NAFTA geared back their investments. And in fact, a week after NAFTA was renegotiated as the USMCA, President Trump threatened to put tariffs on us yet again, only the ink was barely dry. And so, the uncertainty around trade was very high. And I could just say that has not gone away under the Biden administration. And of course, now it’s back and forth because not only do we have the prospect perhaps of President Trump being reelected, but the fact of the matter is that they set it up with a sunset clause. So, the USMCA needs to be renegotiated.
What have companies been doing in that time? It’s not just reducing investment. They have actively diverted their investment dollar from a Canadian destination to an American destination as a means to build natural hedges against the prospect of more trade volatility with the United States. We cannot survive without that market.
Peter Tertzakian:
No.
Stephen Poloz:
You can get markets all over the place. They’re all going to be small compared to that relationship. And so, if that’s what it takes to preserve our pride of place or our best place on their radar, then I think that’s how companies have been responding. And it means there’s been less investment here and therefore less productivity here.
Jackie Forrest:
Well, and it’s not getting easier. The candidate President Trump is talking about putting a 10% tariff on all US imports, and of course renegotiating the current trade agreement with Canada and Mexico. But I want to talk to you a little bit about the clean economy because the Americans have had these very generous subsidies that weren’t around when we talked to you last time. So they want to incent clean energy and they’ve come out with the Inflation Reduction Act, and it actually makes manufacturing clean energy technology much more profitable in the US. Here in Canada, we’ve tried to respond. We’ve put in investment tax credits. Now they’re currently going through Parliament. I think some of them will actually get through here, maybe even before the summer, more scheduled to get finished by the end of the year. But we haven’t really closed the gap when it comes to manufacturing.
Today, the investment tax credits that are being proposed here in Canada are not as generous. And we have companies actually leaving Canada, moving them to the United States because they’re getting a much better incentive to be down there. Now, are you concerned by that? And then I want to transition to your thoughts on we have tried to close the gap specifically for some of these EV companies. So, there’s been tens of billions of dollars to support EV supply chain, whether it be batteries or making electric cars in Ontario. Is that a good policy in a way to capture some of that manufacturing job loss?
Stephen Poloz:
I know you know how complicated this all is. It’s hard for me to address all this in one quick answer. I’m really not a supporter of those gigantic subsidies, but, and of course there’s always a but, and here it is. We are not operating in a free trade world at all. If we were, then these kinds of things would be massive distortions and it would be, I would say, categorically that’s a mistake. And we shouldn’t do them. We should instead allow the market forces to do their job. But we’re in a managed trade world. So, what that means is that the basic free trade argument is almost naive because we can’t achieve it. I guess we need therefore to choose our battles, to level the field where we can. And that’s what the kind of thinking lies behind some of these big promises around the EV systems.
I mean, that is of course, one clearly articulated goal, which is to electrify or at least partially electrify all the autos on the road. Now, I think that kind of prejudges a lot of technology, things I wouldn’t want to do. What happens to hydrogen vehicles? What happens to when you just want to drive to the cottage and back on the weekend? A hybrid vehicle sounds like a better plan, which runs electric most of the time, but it has gas as a backup. There’s all kinds of things you could get into, but we know there’ll be a large portion of electrification in the vehicle fleet. And battery technology will improve, so we get the range problem fixed. So those are all wonderful things. So, it seems like a fairly confident choice to at least open the door to Canada there. And we’ve got a long, long history in, not just in vehicles, but in the parts systems that create vehicles. Most of the value, by the way, in a vehicle is in the pieces, right? It’s only about six, five or 6% of the value of vehicle is in that final assembly. It’s the pieces.
Jackie Forrest:
Yeah, but there’s a lot less pieces in electric cars actually. That’s one of the concerns, right?
Stephen Poloz:
Well, there are a lot, but there’s still a lot of pieces, right? So, I think that this is good business to be in. And trying to create those ecosystems, I can see that makes sense. It does seem like a really expensive thing. What could you have done otherwise with that money? What sort of subsidies could have been there for other companies. But people are there to make those kinds of choices, not me. But the idea is though, that when you’re doing the blockbuster thing at the front, you’re kind of breaking the ice, or you’re building a bridge that no one else will build, right? And then once it’s there, then stuff can happen more naturally. And I think that’s the phase, which is hard to predict, but I am confident that it’s true, it will occur, and we cannot obviously compete with a country that’s 10 times as big as us on every single front.
Peter Tertzakian:
Right.
Stephen Poloz:
We just can’t. And what we can hope for is that we’ve got a good renegotiation of USMCA so that across the board, our companies can become important suppliers to all that stuff that’s happening in the United States. That is our most likely way forward, and we should make sure we’re in there fighting tooth and nail for the things that we need in that agreement.
Peter Tertzakian:
Yeah. Well, historically, the vital things that the Americans have needed from us is our resources, and especially our energy economy.
Stephen Poloz:
Well, let’s go to that just for a second, Peter, because when NAFTA was first imagined, in fact the FTA, it was about energy security at that time. Energy security was what motivated the Americans to come to the table. For us, it was like we just wanted free access to all the other stuff in their market. Well, now the United States is a net energy exporter, and so it’s not the premise for their interest now. What do you think would be their premise now? I think it might be critical minerals, which is what we need for the electrification of everything. And we’ve got a lot of that stuff. And wouldn’t you know it, at just that critical moment, what are we doing? I think we’re dragging our feet on getting the critical minerals economy up and running. We’re looking at five years and 10 years of permitting and studies and road building and reconciliation conversations.
Peter Tertzakian:
You’re talking about impediments to investment, and that’s when we’ve talked about-
Stephen Poloz:
There you go.
Peter Tertzakian:
… a lot. But I would also offer that the United States is not energy secure in all hydrocarbon products. The oil comes in many different grades and slates, and many of the refineries are very dependent upon our product.
Stephen Poloz:
Oh, I agree with you completely, but I mentioned oil as a basket thing. You’re right, they export the same number of barrels per day as we export to them. It’s not the same barrel. I get that.
Peter Tertzakian:
It’s not the same kind of barrels. I want to key in on your comment about free trade is dead and now we’re in this era of managed trade. The other thing that seems to be dead is balanced budgets. Broadly speaking, budget 2024 here in Canada was a deficit budget, long string of deficit budgets. The government forecasts deficit right out to 2029, which I think is conjectural. RBC wrote a research piece warning that Canada’s AAA credit rating is at risk due to high debt and slow growth economy. Tell us what you are thinking when it comes to running these string of deficits, credit ratings. Are we in trouble on that front too?
Stephen Poloz:
Well, yes. First of all, some would respond that well, we’re doing better than other countries, but it’s not much comfort to me. When you add the provinces in, we’re not doing much better than other countries, and we’ve had a lot of good fiscal opportunities go by. The fact is though, that the government has become larger since the pandemic, and permanently so. Okay? So, this can matter in the following way, although the money put a number beside that. If we go back to the pre pandemic era and compare that to now, the baseline spending of the government, federal government has risen as a share of the economy by about 2.5 percentage points. I know two and a half percent doesn’t sound that large, but that’s the things that have been added on, various things as we’ve gone through the period, like pharma care, dental care, higher military spending, infrastructure is a big draw, and so on.
Well, so those things are boosting that baseline by over two percentage points. And throughout, we haven’t really chosen something to drop in exchange, or even chosen to pay for it. So, it means that’s why the deficits have been so perpetual, and only because this time, it just wouldn’t add up. There wasn’t enough of a windfall from the economic performance to avoid a tax increase. It’s why we’ve gotten ourselves into this conversation around the capital gains inclusion rate. So, I’ll just say this, when the government increases by more than 2% as a share of the economy, the private sector needs to shrink by more than two percentage points as a share of the economy. That’s basic arithmetic around crowding out. And what that means is… What does the transition look like? What that transition looks like is the interest rates will have been higher to some degree than they otherwise would’ve had to go because government spending continued to grow during the time when the economy was at full capacity.
So, the interest rate peak is a little higher, and the result is softer investment spending, and therefore softer productivity growth, the things we’ve been talking about through most of this podcast, for several years, while the private sector shrinks by that two percentage points. Once the shrinkage is done, then from then on, the private sector can grow at the same speed as the overall economy again. And investment would grow, and productivity would grow, and so on. But during the transition, it looks like what you see when you look out the window today. And so, this is… Now, I’m not saying this is a bad or a negative. Some would see it this way, but you could debate it. There seems to be public choices to have dental care, pharma care, higher military spending.
So that crowding out is a real thing. If we had cut back some other things, we could have avoided the crowding out, but what would those things be? Not up to me or you. So that’s all to say that size matters in that context because the crowding out is real. On top of all that, we do have a debt problem, which is kind of sort of stuck. It’s barely declining. It’s the minimalist kind of fiscal sustainability. And of course, that means we’re only one shock away from being fiscally unsustainable. So, we’re not that well prepared for the next big event, in my opinion. So, I think next fiscal cycle, there’s going to have to be some serious adjusting about that long-term trend. Comparing ourselves to really bad countries like the United States fiscally is not helping us.
Jackie Forrest:
Yeah. Yeah, so generally you’re not feeling comfortable with the debt level and hope that there’s some changes there?
Stephen Poloz:
No, the debt to GDP level was around 30% prior to the pandemic. Now it’s over 40%. At the time, we worried it could go to 60% under our worst-case scenario. So lucky us, it only went to about 46 or 47. So in other words, the economy was hit bunch less hard than we imagined it might during the pandemic. Well, that’s good news. But throughout, we’ve taken some of that good news and we’ve applied it to new programs instead of winding things down faster, as we could have. Fiscally, it’s regrettable, but economically, it’s a public debate that we should have. Are we willing to be bigger? Is that what we want, or do we want the government to look for things to cut out in order to pay for those things? That’s just worth discussing, but the math doesn’t change.
Peter Tertzakian:
Well, Stephen, it’s been a fascinating discussion. We’ve got a lot of information from you when we’re in grocery store lineups and talking to people, waiting for the next available checkout till, pension plans, interest rates, Canadian productivity, debt levels, investment, and so on. So thanks again for providing such deep and insightful comments. Great to have you back. I’m sure we’ll have you back again. None of these issues are going away quickly and are always a great topic of discussion. Thanks again, Stephen Poloz for joining us.
Stephen Poloz:
It was my pleasure. Thanks to you both.
Jackie Forrest:
Thank you. And thanks to our listeners. If you enjoyed this podcast, please rate us on the app that you listen to and tell someone else about us.
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