Monday, February 28, 2011

Canada: "But it's different here!!!"

Perhaps you've heard that Canadian debt-to-income ratio is 150%. What this basically means is that for every dollar Canadians earn, on average, we owe $1.50 to somebody else. Canadians, especially homeowners, are living on borrowed time; unlike the consumer deleveraging south of the border, Canadians are continuing to spend. Believing the monetary and fiscal authorities about a global recovery, many have concluded that Canada has escaped the worst of the recession. But despite our continued efforts to violate basic principles of economics, the “invisible hand” will correct itself.

Canada will face another recession. Here's why:

There's goods news and bad news. First, the bad news:

Like their Fed counterparts, the Bank of Canada favours the policy of low interest rates while keeping inflation in check. Unfortunately for us, the official way of measuring inflation is fundamentally wrong while the M3 increases every year. Most of this “new wealth” comes in the form of bank credit, finding its way to consumers and businesses. This artificial expansion of fiduciary media is the basis for the business cycle.

The fiscal department of government has a role to play as well. In this country artificial incentives have favoured real estate and consumer loans. In 2008 the federal government decided to get into the insurance business by purchasing $65 billion worth of mortgages from the banks. By the end of 2009 total government expenditure on chartered banks was $114 billion.

This misdirection of capital and high levels of debt bare much resemblance to the housing bubble in the United States. As Americans learned the hard way, perpetual growth via inflation never lasts. A basic economic principle is that you can't print your way to prosperity. It may seem redundant, but Keynesian economics ignores this basic reality.

When the “double-dip recession” is acknowledged and the “velocity of money” grinds to a halt, Canada will find itself up a creek of feces. Our resource sector will help us weather the storm better than our southern neighbour, but resources alone aren't enough to keep this wealth effect going. Add high commodity and energy prices as well as massive consumer deleveraging – a majority of Canadians are going to be hit hard. Unemployment is likely to come from two major sources: the increasingly stagnant service sector and the burdensome public sector. In the former, sectors of the economy dependent on cheap credit and cheap oil will face severe limitations. Regarding the latter, the rift between taxpayers and tax consumers will become more prominent in the coming years.

If the BoC lowers interest rates to 0% or partakes in “quantitative easing,” they're only going to worsen the problem. The deflationary spiral central banks fear won't actually happen. There will be a severe deflationary depression, but it will not grind economic activity to a halt. Continued inflation will only reduce purchasing power and prolong recovery. Runaway inflation could destroy the currency.

If this recession is met like the last one, then the situation will be made worse by having the government boost “aggregate demand” via stimulus measures. “Shovel-ready” projects and other “government investments” represent resource destruction. The fact that these projects are never accomplished by market forces indicates where consumer preference resides. In addition, taxation itself is an act of wealth destruction as no tax can be passed forward. That is to say, all sales taxes are ultimately income taxes. Taxes are a disincentive for production, savings and investment.

Given their history, the monetary and fiscal authorities of Canada tend to prefer some sort of economic intervention over laissez-faire. What could be a quick severe depression is very likely to become a prolonged stagnation that ends with either economic collapse, revolution or a heavily regulated state. Or all three.

But I said there's good news. So here it is:

The Bank could raise interest rates and the federal government could cut taxes and spending. Ideally, parliament would legalize competing currencies and link the Canadian dollar to gold. However for now we're just deal with the first two policies, as these are more likely to occur than the latter two.

If the Bank decides to raise interest rates it will tighten borrowing across the nation. Higher rates will assist in the reallocation of resources to profitable sectors of the economy. Higher rates also increase incentives for consumers to deleverage and save. A lower standard of living is inevitable as consumption is curtailed and malinvestments are liquidated. However, a hands-off approach by government will increase the prospects of a real recovery.

Higher interest rates will have other noticeable effects in the economy. Predictably, our dollar will rise in relation to the American greenback. While a weak loonie abroad makes our exports look appealing, the negative effects on everyone in the long-run far outweigh any short-term gains. Eventually, a “strong loonie” will lower capital costs, raw material costs, increase purchasing power (for wage-earners too) and help naturally bring down interest rates.

In Economics In One Lesson this is how Henry Hazlitt sums up economic logic:
"The art of economics consists of looking not merely at the immediate but at the longer effects of any act or policy; it consists in tracing the consequences of that policy not merely for one group but for all groups."

If we wish to remain optimistic about the future, it helps to have the right kind of policies now. Austerity in the public sector begins by acknowledging that government can only consume. Therefore all public sector spending represents a form of wealth destruction, despite the value one may take away from these services.

Canadians unable to find employment with the government will need the freedom to exchange private wealth for their services. For example: if an unemployed nurse isn't allowed to practice nursing without being employed by the government monopoly, she will sit idle while demand rises. Despite supply or demand, the shortage of nurses will be a direct result of the government monopoly on health-care. Likewise with other services, from maintaining roads and sewers to police and security - competitive enterprises in the market will help offset austerity in the public sector.

To ensure the future of Canada's social safety net, these services need to be provided by the market of voluntary exchange; where wealth is created. Universal health-care is possible without coercive taxation. Whether these services are provided by charities, insurance companies or direct payment is irrelevant as the market will ultimately reflect consumer preference.

Fortunately, dire circumstances sometimes bring about innovate solutions. When the Soviet Union collapsed the Cuban government had to take steps toward privatization. Despite lacking access to basic resources and strict central control, the Cuban market adjusted agriculture practices to meet local conditions. It is not unreasonable to believe that in absence of government monopoly, voluntary exchange will correct any "market failure."

Regardless of how Canadians face today and tomorrow's problems, the solution will not come from government intervention. Economics ultimately depends on the actions of individuals in the spontaneous order of the free market. Each consumer votes with his or her every dollar. We could restructure using the peaceful, voluntary, free market or we could accept the economic downturn as an inevitable fact of life and impoverish ourselves waiting for an non-existent statist recovery. Whatever road we choose, this period of reallocating resources, wealth, labour (and trading partners) will not be a walk in the park.

But it all starts by accepting the fact that it's not different here. The basic principles of economics apply everywhere.

Tanstaafl Canada.

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