Canada: When is it recession? Global Economic Outlook, Q4 2015

The Canadian economy shrank for two quarters in a row, and journalists immediately declared a recession. But it’s a bit more complicated than that. The slowdown was blamed on slow growth in the United States and the drop in the price of oil.

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Canadians (or at least Canadian economists) have had the unpleasant experience of trying to figure out just what makes a recession. At the beginning of September, Statistics Canada delivered the expected news: The Canadian economy shrank for two quarters in a row.1 Journalists immediately declared that a recession had occurred. But it’s a bit more complicated than that, not least because Canada now has a semiofficial business cycle dating committee.

What makes a recession? This might be the economists’ equivalent of medieval theological debates. The “two-quarter rule” is a good example of oversimplification of a complex subject. Economists don’t actually use this rule. It was originally suggested by US statistician Julius Shiskin in 1974 as one of a number of possible rules of thumb.2 While it was never really accepted within the economics profession, journalists latched onto it because it was simple—even if it is sometimes misleading.

What makes a recession? This might be the economists’ equivalent of medieval theological debates. The “two-quarter rule” is a good example of oversimplification of a complex subject.

In Canada, the C. D. Howe Institute recently created a Business Cycle Council composed of leading Canadian economists to make recession determinations.3 This method allows flexibility in defining downturns, and (perhaps just as important) provides economists with a common understanding of cycles. That way, economists can argue about causes and features of the cycle rather than whether one occurred and what the exact timing was.

In July, the Business Cycle Council determined that data did not show that Canada—as a whole—had experienced a recession.4 Indeed, although GDP fell in two quarters in a row, it didn’t fall by much. GDP in Q2 2015 was just 0.3 percent less than in Q4 2014. And employment between December 2014 and June 2015—while the economy was supposedly in recession—was up about 75,000 jobs. That’s not exactly normal for a business cycle downturn. Meanwhile, Canadian households responded to the bad news by taking on yet more debt, and housing buyers in Toronto and Vancouver seemed determined to push those cities into the ranks of the world’s most expensive. So it’s not really surprising that the two-quarter rule just doesn’t work in this case.

Canada_3The role of oil

Whether or not it was a recession, the slowdown was blamed on—not surprisingly—slow growth in the United States and the drop in the price of oil in late 2014. The US economy can cause a lot of problems for Canada, but its contribution to Canada’s nonrecession was modest. Figure 1 shows that the slowdown was caused primarily by business investment rather than real exports.

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The decline in business investment was led by industrial machinery and equipment (down 15 percent in the first two quarters of 2015) and engineering structures (down 10 percent). Investment in transportation equipment, in contrast, rose during these two quarters. But what gives the game away is the large decline in spending on mineral exploration (46 percent) during this period. The problem for Canada was not so much oil sales as it was a steep drop in investment in new crude production. In this, the Canadian experience was similar to the decline in US GDP in the first quarter. Falling investment in crude production (in the form of a fast decline in oil drilling rigs in use) was a big contributor to the slowdown in the United States. Low prices didn’t stop the oil flowing in North America, but they certainly put a dent in plans to find new oil to pump.

Volatile oil prices pose a significant problem for Canada. The Canadian economy has been reshaped over the past 20 years by a huge bet on oil. Exports of energy products jumped from about 10 percent of all exports in the late 1990s to almost 30 percent by 2014, as shown in figure 2. Four-fifths of Canadian energy exports are petroleum, crude, and refined. Canada bet on selling oil, mainly to the United States. As oil prices rose, the bet looked pretty good. Canada has long been an oil exporter, of course, but the new production comes from more expensive sources, particularly the “tar sands” in Alberta. The International Energy Agency estimates that 25 percent of Alberta’s tar sands production requires a Brent price above $80 per barrel to be profitable (compared with just 4 percent of US “tight oil” production and 8 percent of deepwater production, which are other expensive sources).5 Canada’s bet, then, wasn’t just in producing oil but in producing oil that was some of the most expensive crude in the world.

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Canadian households responded to the bad news by taking on yet more debt, and housing buyers in Toronto and Vancouver seemed determined to push those cities into the ranks of the world’s most expensive.

As long as oil prices remained high, the bet appeared reasonable—at least to people in the energy industry. For Canada’s traditional industrial sector, the increased role of oil brought problems. Between 2001 and 2013, Canadian unit labor costs rose 18 percent more than US unit labor costs. For Canada’s industrial heartland, these increased costs have meant trouble competing with foreign (that is, US) companies. Canadians have become quite worried about the “hollowing out” of Canada’s basic industries, particularly since the new energy industries aren’t located near population centers and employ relatively little labor in any event.

The problem is well known to economists under the name “Dutch disease.” In the 1960s, prospectors found significant natural gas reserves in the Netherlands. As production came on line and was exported to Germany, the Netherlands experienced an inflow of capital that made traditional Dutch manufacturing uncompetitive. In the modern world, this takes the form of rising exchange rates. And the Canadian dollar has, indeed, followed the price of oil, rising between 2009 and 2010 and staying high along with the price of oil for several more years (figure 3).

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The most disturbing thing about Dutch disease is that traditional industry, once lost, may be difficult to revive. The fall in oil prices is likely to put this question to the test in Canada. The falling Canadian dollar should provide a shot in the arm to Canadian industrial competitiveness, but whether Canadian producers will be able to respond remains an open question.

Enter the NDP

The winds from the prairies are bringing more than snow to Ottawa this fall. As of this writing, analysts are assigning a 50 percent probability to the October election resulting in a minority government led by Canada’s New Democratic Party (NDP). When Canadians turn away from their hockey games this winter, they may be watching whether the NDP really means what it says about changing the country. After nine years of Stephen Harper’s Progressive Conservative (PC) party, it could be quite a shock.

Canada’s bet, then, wasn’t just in producing oil but in producing oil that was some of the most expensive crude in the world.

Canada_2The rise of the NDP appears to be more related to a general inclination for change than a sincere desire among the electorate for the avowedly social democratic policies of the NDP. This was made clear by the surprise NDP victory in Alberta’s provincial election in April. The NDP’s strong support of climate change remediation policies and alternative energy plays strongly against Alberta’s economic interest (in oil production, for example). But voters evidently wanted a change after 44 years of the PC running the province.

What would an NDP minority government try to do? The main economic initiatives look like they would be focused in two areas:

  1. Climate change: This is a difficult problem for Canada, both because Canada’s economy depends on exporting fossil fuels (as the nonrecession demonstrated) and because Canadians, like their neighbors to the south, enjoy their large automobiles and houses. The NDP would like to introduce a cap and trade system to price emissions, which is likely to be very controversial.
  2. Taxes: Everybody likes to lower taxes, and all three Canadian parties have plans to do what voters like. But the NDP plans include an offset: higher corporate taxes. This may prove to be very important to the NDP, as without some additional revenue the party is likely to find it impossible to meet other goals.
The rise of the NDP appears to be more related to a general inclination for change than a sincere desire among the electorate for the avowedly social democratic policies of the NDP.

At this point, the NDP has committed itself to a balanced budget—an important consideration since it has a reputation as a party happy to borrow and spend. Canadian voters still remember the budget problems of the 1990s. This had nothing to do with the NDP, which never had enough power to actually determine federal spending before. Many Canadians, however, are very proud of Canada’s more recent fiscal probity, and the NDP prefers not to rock this particular boat. But while the NDP is promising to keep budgets balanced, the Liberals are advocating planned deficit spending to provide a Keynesian boost to the economy. A formal or informal NDP-Liberal alliance might lead to some relaxation of Canada’s budget constraint.

The NDP is by no means assured of a victory, and whoever wins will probably face the unenviable task of running a minority government. This will give the PC and Liberal parties some say in what an NDP government can actually accomplish and is likely to put the brakes on some of the NDP’s more ambitious proposals.6 Absent a surprising election in which one party wins a clear majority, the winter will almost certainly see intense negotiations in Ottawa between the three large parties.