Times change, and so do Canadian expectations...

In a post from last September there was surprise on the part of your blogger as to why the dealing community was so bullish in terms of expectations for the Bank of Canada raising benchmark interest rates this year (2013). Anyone that has followed the musings and scribblings of your humble scribe is aware of his reticence in conceding to the inexorable upward movement of rates as in times past; to wit, as has been argued on a number of occasions, this time --barring a co-ordinated global restructuring and co-operation by the G20-- is different from previous business cycles where rates have risen in a lock step fashion with the business cycle.

But times change, and so do Canadian expectations...

The median end of quarter forecasts see no change in BOC rates from the dealing and analyst community. Indeed, the median and mode forecasts for the BOC benchmark rate in 2014 is 1.00% -- exactly where it is right now. Of course, this does not preclude the possibility of a rate hike in 2014. We live in the real world replete with uncertainty --it can be of either the Knightian or Keynesian brand-- not the imaginary world of rational expectations. But fundamentally, the dealers and analysts are seeing the same data that you and I are seeing:

Source: Box 4 - Bank of Canada Monetary Policy Report

Canadian economic activity was weaker than expected in 2012. On an average annual basis, real GDP grew by 1.8 per cent, compared with the 2.4 per cent projected in the April 2012 Monetary Policy Report The most important contributors to this unexpected weakness were exports and, to a lesser extent, business fixed investment, the effects of which were only partly off set by higher inventory investment and weaker imports (Chart 4-A) Government expenditures and household spending were roughly in line with expectations. [emphasis added]

 

For example, Canadian exports of non-energy commodities to China and other emerging-market economies (EMEs) have become more significant to Canadian trade in recent years EMEs recovered relatively quickly from the global recession, but their economic growth was weaker in 2012 than the Bank had expected Finally, competitiveness challenges may also have played a role, with the Canadian dollar remaining strong and productivity growth weak

Approximately two years ago, the BOC was making the bet that despite consumption tapping out the household sector and the government committing to fiscal retrenchment, a driver for sustained growth to close the output gap would be the business sector coming to the fore and stepping up with capital investment. This hasn't happened.

At the most basic level, notwithstanding headwinds from global dynamics, this is an incipient flow of funds issue. Why would the business sector invest without seeing the concomitant demand domestically. In turn, larger businesses are able to tap capital market to exploit return on otherwise moribund cash.

Marc Lavoie and Mario Seccareccia have framed the dynamic in their presentation "Competitive Pressures in the Banking Sector, Perverse Incentives, and Financial Stability: Understanding the Canadian Experience"

Instead of industry being the net borrower vis-à-vis the banking sector, growing profits and retained earnings associated with fairly flat business investment have slowly transformed (or “rentierized”) the non-financial business sector itself into a net lender that seeks profitable outlets that provide high financial returns for its internal funds (see Fig. 2 below).

On the other hand, households have become net borrowers and have thus become an additional source of revenue for business enterprises from the increasing net spending of the household sector.

Banks have become financial conglomerates engaged in lucrative investment banking by layering their assets, engaging in cross-boundary arbitrage, and loosening credit by permitting the household sector to take on an increasing debt load without a concomitant rise in real personal disposable income. [emphasis added]

Without the rise in real incomes the stock of rising debt will have to be serviced for years to come. The younger demographic cohort needs to service that stock of debt with a flow of income that isn't rising as fast as the real cost of living (that incorporates supply side shocks of rising food, transportation, and childcare costs for those with families).

The older demographic, likes cohorts before them, will not have the same propensity to to consume as they did during their working years and the rise in the dependency ratio is just beginning in Canada.

Outgoing Bank of Canada Governor, Mark Carney, in a characteristically sermon like passage yesterday warned:

We cannot grow indefinitely by relying on Canadian households increasing their borrowing relative to income. Nor can residential investment remain near a record share of GDP, particularly given signs of overbuilding and overvaluation in segments of the real estate market. [emphasis added]

The irony --if one can call it that-- is that the aggressive monetary easing has snookered the small open economy that is Canada into a corner. The underlying fragility of the household sector cannot withstand a 400 basis point rise in interest rates that have been characteristic during past recoveries but neither does the central bank want to encourage more borrowing in light of a policy of easy money in an uneasy world.



Despite C.D. Howe Institute's ministration BOC rates will remain where they are.

The Statistics Canada release this morning stated "The Consumer Price Index (CPI) rose 0.4% in the 12 months to April, following a 1.0% increase in March. Declining gasoline prices were largely responsible for the 0.6 percentage point difference in the 12-month change in the CPI. Price decreases for the purchase of passenger vehicles were also a factor."

The 12-month change in the Consumer Price Index (CPI) and the CPI excluding gasoline

This flies in the face of the Paul Masson's C.D. Howe clarion call for higher Bank of Canada rates when the central bank maintains the official line of maintaining a flexible inflation-targeting framework of core inflation at 2% within a 1-3% operating band.

An open question: where does the C.D. Howe Institute want the BOC rate to be by this time next year? In terms of the great bogey man of inflation, perhaps it is concerned about expectations and with it (inflation) being "always and everywhere a monetary phenomenon" hence that call for a pre-emptive BOC hike.

This misses on a fundamental observation that everyone should see (whether they choose to or not is another question). Over the long term, a tighter monetary policy will not help solve the underlying weakness in the Canadian economy --it is but one part of a toolkit of policy measures. The fact that governments increasingly rely on it is emblematic of a deliberate vacuum in the Canadian political economy debate where the voices of reason have been shoved to the side in favour of shills for vested interests.

As has been outlined on this blog on a number of occasions, we continue to have growth in precarious employment, a lack of real income growth for those below the affluent percentile, an increasing reliance on resource extraction, real estate and the low end service sector for job creation while implicitly knowing that the real estate as a driver of GDP growth during the past decade cannot continue forever. 



Residential investment (aka real estate development) party will be over (BOC MPR April 2013)



We, as a nation, are back to Harold Innis and W.A. Mackintosh's staples Canada with a pinch of race to the bottom globalization: hewers of wood, drawers of water and servers of French fries.

All of the aforementioned factors ultimately affect demand which in turn should be a driver for where output should be but in the traditional neoclassical view output is always supply side driven and the elusive ‘closing of the output gap’ we’ve been hearing about is, in theory, closing faster than a speeding bullet anytime now, or over the coming quarters…… or not.

Slack in the Canadian Economy (BOC MPR April 2013)

Paul Masson's C.D. Howe commentary urging a rise in the Bank of Canada rate is wedded to the rules over discretion role of monetary policy and presumably under a Taylor Rule regime the BOC rate would be ~3.5% (according to back of the envelope calculation)

Taylor Rule Model (Source: Bloomberg)

Professor Masson does make a number of valid points in his paper:

(i) low rates punish households that rely on investment income;

(ii) low rates disproportionately increase the long dated liabilities of pension plans and makes life challenging for insurance companies in particular but financial institutions generally;

(iii) low rates can be a driver for asset price bubbles;

(iv) in the Canadian context low rates have been a cause for 'evergreening' (further leveraging) rather than deleveraging.

While these points are valid, they do remain thoroughly incomplete:

(i) financial repression in addition to inflation is the oldest trick in the book as an alternative to growth to manage debt servicing;

(ii) actuarial deficits are based on a point in time projection and are open to criticism in their methodology but they do not represent a flow that adds to a stock of debt and financial institutions like banks have tractor investments on the asset side of their balance sheet that have shielded them somewhat after the financial crisis but fundamentally lower rates are not good for their net interest margins as they suffer margin compression; (iii) central banks have been deluded into thinking that macroeconomic policy with an inflation targeting framework has been responsible for controlling inflation and the recent run up in assets is the consequence but flow of funds into non productive assets by financial institutions has been going on for the good part of the past 15 years;

(iv) don't forget inequality: pent up demand to consume combined with greater barrier to enter the housing market has created the spike in the debt to income ratio.

Source: Debts and Assets: A Big Focus for Households (Sébastien LaRochelle-Côté, Chief Advisor, Statistics Canada )

Macroeconomics isn't just about science --when authors claim that it is they are being scientistic not scientific. It is also about recognizing the patterns from yesterday, understanding political and societal realities of today and weaving comprehensible narratives incorporating those elements for policy tomorrow.

At the federal level, Finance Minister Flaherty has pledged to slay the deficit by Fall 2015 and implied in this projection is that this will be done through positive growth rather than cuts. But what happens when the household and government sectors deleverage at the same time (as the former will have to do the latter has pledged to do)?

The business sector won’t be investing in fixed capital formation anytime soon, and doesn’t see the demand drivers to increase employment.

Source: Box 3 Factors Weighing on the Outlook for Business Investment (BOC MPR April 2013)

When you combine this with the demographic dilemma of an aging population in Canada and its Western trading partners --think of the Eurozone in particular but also China and eventually the United States-- for which there is no palatable prescription and  you will realize that there is little scope for monetary policy to be anything but accommodative at this time and into the medium term.

Policy makers have snookered themselves; raising rates would pre-emptively cause a severe recession with possible debt deflation consequence as a worst case scenario. This does not preclude the possibility of a rate hike in 2014 --stranger things have happened; think back to John Crowe's tenure as BOC governor-- but if that were to happen then expect a retracing back to 1% thereafter upon realization of the policy error.

Getting a product to market -- what they don't cover in business school

Anyone who has had to sit through lectures on strategy knows of Porter's Five Forces:

See "The Five Forces That Shape Strategy"

Anyone who has specialized in understanding how new technologies get to market know of Geoffrey Moore's Crossing The Chasm:

Furthermore, the famous line from chapter two of Adam Smith's Wealth of Nations states

"It is not from the benevolence of the butcher the brewer, or the baker that we expect our dinner, but from their regard to their own interest. We address ourselves, not to their humanity, but to their self-love, and never talk to them of our own necessities, but of their advantages."

But what happens when the self interest of parties acts as a barrier to technological advancement that can bring a superior product to market? What happens when the self interest of parties is inimical to the safety of the consumer who purchases the said parties' products?

The website Fairwarning (1) exposes such behaviour and today highlighted the complicity of the power tool industry's attempt to stop a company called SawStop from successfully marketing the only saws with skin-sensing technology, in this piece: "After More Than a Decade and Thousands of Disfiguring Injuries, Power Tool Industry Still Resisting Safety Fix"

As Myron Levin and Lilly Fowler write

"The SawStop story is about an industry’s ability to resist a major safety advance that could, by now, have prevented countless disfiguring injuries, but might have been bad for business. It highlights the endless due process that makes it virtually impossible for regulators to enact safety measures over the unified objections of industry."

"The invention involves running a weak electrical current through the saw blade. When a person comes in contact with the blade, the body absorbs part of the signal. An electronic sensor detects the change in current and activates a spring. The spring jams an aluminum wedge between the teeth of the blade, which acts as a brake. The blade also drops below the surface of the table. It all happens in so few milliseconds that, unless the hand is moving unusually fast when it hits the blade, the injury typically is minor.

One of the mysteries is why the power tool industry, with its engineering prowess, didn’t invent SawStop before Gass did. Maybe he was smarter. Or maybe the industry didn’t do it because it didn’t need to."

Read the rest of the story at www.fairwarning.org with the takeaway that (i) self interest isn't necessarily benign in terms of outcomes; it can be dangerous; (ii) invention and innovation often occurs outside the citadel of big business and getting something to market can involve navigating the complex world of powerful lobbies and legal obfuscation ("barriers to entry").

In closing, recall that Ralph Waldo Emerson stated that "If a man has good corn or wood, or boards, or pigs, to sell, or can make better chairs or knives, crucibles or church organs, than anybody else, you will find a broad hard-beaten road to his house, though it be in the woods" -- which is often misquoted as the building a better moustrap story -- but in reality market forces in the 21st century are not so simple.

(1) A shorter version is of the story is available at Mother Jones

Iron Lady's Lasting Legacy: Releasing The Kraken of Global Finance

At this time last month the passing of Margaret Thatcher was met with fulsome tributes from supporters and derisive attacks from detractors -- such was the polarizing nature of the Iron Lady. Thatcher's refusal to compromise, and belief in what she believed [1], was countered with her own contradictions: the ostensible promotion of classical liberal ideals contradicted by support of dictators, most notably Augusto Pinochet, who clamped down on the freedom and democratic choices of citizens [2]. As Richard Dowden wrote in The Guardian "A close aide once told me that she opposed apartheid more on the grounds that it was a sin against economic liberalism rather than a crime against humanity. She also was bitterly against sanctions of any sort – they were a crime against free trade." [emphasis added]

Readers of this blog understand the unapologetic empathy towards all people --particularly the lower classes-- finding their voice in society and having a say in their right to a decent livelihood. In contradiction, Thatcher famously went on to state that (in terms of society):

I think we have been through a period when too many people have been given to understand that when they have a problem it is government’s job to cope with it. ‘I have a problem, I’ll get a grant. I’m homeless, the government must house me.’ They are casting their problems on society. And, you know, there is no such thing as society.[emphasis added]

 The late Baroness' mastery of rhetoric belies an appalling acknowledgement  (or lack therof) of history, the ebb and flow of social relations that underpin economic transactions and the role of power and class in everyday life. Without an adherence to community and finding one's place in society there is no place for individual responsibility --as the individual would not be alive to make that choice; the two are different sides of the same coin and commentary to the contrary is naïvely pernicious.

Government is not the answer to all problems but it isn't necessarily the source of all problems either. The Old Institutionalist Economics framework of Thorstein Veblen, most eloquently forwarded by John Kenneth Galbraith in the modern era, understood the place of power: the power of Big Business, that of Government, and of Labour (or Unions in the 1970s) acting as a counterbalance against each other. More recently, William H. Janeway, who is a private equity veteran not a socialist, made the case for government in The Two Innovation Economies:

In the United States, the government constructed transformational networks (the interstate highway system), massively subsidized their construction (the transcontinental railroads), or played the foundational role in their design and early development (the Internet). Activist states around the world have funded basic science and served as early customers for the novel products that result. For a quarter-century starting in 1950, the US Department of Defense – to cite one crucial example – combined both roles to build the underpinnings of today’s digital economy.

Thatcher's rise to the top came not because the British people appreciated her ideas on economic policy but due to the complete detachment of Britain's public sector unions from the reality that the rest of the British public faced during the severe Winter of Discontent. The mere fact that Britain's old Labour party was seen as weak in the face of union militancy meant that the voting population's choice of Thatcher over James Callaghan was 'a rational choice.'

Sam Gindin, formerly of the CAW and presently a part of York University has framed unions in the following manner in a Jacobin magazine interview:

Unions emerged out of the working class but they are not class organizations. They bring together a subset of workers with a common workplace who look to the union to represent their particular interests. During the postwar period of growth and near full-employment, the wage gains and private welfare state negotiated (pensions, health care) spread to other unionized workers (and a few more universal demands like Social Security spread even more generally). But – and this is the lesson of the past three decades – that period has ended. Sectional unionism, even when militant, was no match for the corporate/state counter-attack of the 80s and 90s.

The capitulation of unions, and the defeat of labour by extension was made possible by the Iron Lady's lasting legacy: releasing the Kraken of Global Finance. The Kraken analogy is apt as the former sea creature has effectively defeated the Leviathan of Big Government in shaping policy that has ultimately shaped society over the past three decades. (Any resemblance of the Kraken below to Matt Tabbi's "great vampire squid wrapped around the face of humanity, relentlessly jamming its blood funnel into anything that smells like money" is entierely deliberate.)

There is no alternative: Release the Kraken

It happened in the City by way of The Big Bang in 1986 and set the stage for the deregulation of policies that had been enforced during the period after The Great Depression:
 From the 1930s to the 1980s, many countries had policies of financial regulation that included many of the following (See Endogenous Money 101 [4]):

• (1) Interest rate ceilings;
• (2) Liquidity ratio requirements;
• (3) Higher bank reserve requirements;
• (4) Capital Controls (that is, restrictions on capital account transactions);
• (5) Restrictions on market entry into the financial sector;
• (6) Credit ceilings or restrictions on the directions of credit allocation;
• (7) Separation of commercial from investment (“speculative”) banks;
• (8) Government ownership or domination of the banks. (Ito 2009: 431–433).

Jayati Ghosh, a professor at the Centre for Economic Studies and Planning at Jawaharlal Nehru University, wrote recently about global finance: capital flows, financialization [3], and the resulting asset inflation ("bubbles" in speculative rather than productive assets) in the developing world

Meanwhile, the other concern is that many developing countries are trying to cope with the continuing ramifications of the global crisis by generating their own bubbles in domestic asset markets. This happens in a variety of ways: stimulus measures that target sectors like real estate and housing; other fiscal concessions granted to encourage more financial saving and investment; liberal rules for extension of consumer finance for purchase of durable goods; financial liberalisation measures that encourage more expansion of the sector; and so on.

These may create temporary mini-booms in certain economies, but these are temporary at best and in the current fragile external environment they may be even more short-lived. And the bursting of those bubbles will be even more painful in the context of the global economic headwinds. At the same time they will also encourage the same tendencies that continue to make developing countries export capital to the North, at the cost of meeting their own citizens’ needs and fulfilling their own development projects.[emphasis added]

It was in relation to a McKinsey Global Institute report on "Financial Globalization: Retreat or reset?" and a PDF of Ghosh's article "Is Global Finance Finally Shrinking?" that is available here

With the financial crisis in the rear view mirror there has been a creeping tendency to believe that all is well and that trend growth is set to return after austerity sets economies back on a self correcting path of growth.

This is unfortunate in both the delusional sense of self correction and the prescriptive sense of an unwelcome lost decade that will certainly be the result in Europe and a possibility elsewhere without a necessary rebalancing globally. 

Orthodox thinking supports the concept of financialization through the argument that it enhances efficiency because markets are best in pricing future economic outcomes and financial speculation --when prices diverge from a fundamental value-- is, as the argument goes, a stabilizing factor. Reality informs us otherwise.  

While we understand that this may be the case in an idealized abstract world justifying general equilibrium, in  the messy real world the opposite is true.

The effects of policies from a generation ago can be papered over but not forever. What we are living with now is the unequalled strength of the Kraken of Global Finance where capital inflows can be fleeting. In effect, we have business cycle that are led by asset bubbles where speculation has driven capitalist boom phases. The flipsisde to this are the ensuing financial crises with busts and central banks scrambling to stop debt deflation. This blog will explore the rich history of deflation theories --as subscribed by Veblen, Schumpeter, Minsky and Fisher-- in future posts.



 

[1] "Hayek's powerful Road to Serfdom, left a permanent mark on my own political character, making me a long-term optimist for free enterprise and liberty"

[2] As Yanis Varoufakis wrote, she sought to impose libertarian values, only to discover that she needed an autocratic state in order to do so (which explains nicely her fondness for, and defence of, General Pinochet).

[3] Financialization means the increasing role of financial motives, financial markets, financial actors and financial institutions in the operation of the domestic and international economies. (Gerald A. Epstein "Introduction: Financialization and the World Economy")
[4] From the blog Social Democracy for the 21st Century: A Post Keynesian Perspective (link: socialdemocracy21stcentury.blogspot.com )

The precarious nature of employment today means more "losers" and fewer "winners" tomorrow

Since the end of The Great Recession the focus has been on the moribund job growth in the United States and the hara kiri policy bloodletting in the Eurozone that will ensure at least a lost decade and probably more for the population in the euro periphery. This has provided shelter for Canadian policymakers with the National Post going so far as to say that "At G20, Flaherty still has his economic bragging rights."

But the game of bragging (when there is nothing to truly brag about) is afoot and for those clinging to the questionable certainty of mean reversion the coming year will be a testing one. Will new Bank of Canada Governor, Stephen Poloz, and the governing council raise rates by this time next year? This blog has gone on record in maintaining the view that barring Promethean internationally co-ordinated policy (which is highly unlikely) Canadians are in for a secular period of low rates with none of the expected rate normalization seen in previous cycles.

Amongst the many reasons for rate hike scepticism, the composition of job growth is most troubling with 4 of 5 new employees finding temporary employment since the recession began in 2008..

Canada: Growth in permanent and temporary workers

Globe and Mail economics reporter Tavia Grant explored this further in her recent piece, "Canada's shift to a nation of temporary workers":

What many employers would call flexible work, others would call precarious. A joint study by McMaster University and the United Way in February found four in 10 people in the Greater Toronto and Hamilton region are in some degree of precarious work (defined as a state of employment that lacks security or benefits) – and that this type of employment has risen by nearly 50 per cent in the past two decades. It also found that people in insecure work tend to earn 46-per-cent less than those in secure positions, and rarely get benefits.

In a previous post there was an cursory exploration of Guy Standing's view of such workers -- insecure, young, and with no bargaining power--  who arguably fit into the framework of his book "The Precariat: The New Dangerous Class" (Some have argued that the idea of the precariat dates back to French sociologist Pierre Bourdieu).

Fitting Standing's class structure into a stylized income segmentation of tax filers in Toronto, one comes to a troubling observation: how do people on such relatively low incomes get by in an increasingly expensive city? Toronto is simply another example of what has happened elsewhere: cities gentrifying and becoming  increasingly expensive for a greater portion of the population.

Precariat et al.

All tax filers in Toronto (median income 2010) = $27,200


 Middle Class

Top 10% Toronto (median income 2010) = $104,600



 Upper Middle Class

Top 5% Toronto (median income 2010) = $135,700


 Proficians

Top 1% Toronto (median income 2010) = $283,400

 Salariat

Top 0.1% Toronto (median income 2010) = $1,024,200


Elite

Top 0.01% Toronto (median income 2010) = $3,898,800

 

With the majority of job growth coming in the form of temporary jobs it begs the question of what will be the future catalyst for growth? The increasingly precarious nature of employment today begets more "losers" and fewer "winners" tomorrow. The marginal propensity to consume for those consigned to temporary work will be higher and conversely the marginal propensity to save lower as will the ability to save up for a down payment. In turn, how will this segment be able do the things that Canadians in generations past took for granted, such as buying a single family residence, due to the barrier to entry of high house prices. Moreover, the rising inequality we see today will manifest itself with pensioners tomorrow that are knee deep in debt and working to make ends meet. This is part of the irresistible forces of the globalization model and technology that has enabled the disappearance of many jobs.

And it will continue. William H. Janeway remains someone who understands the capitalist system for what it is --inherently unstable yet dynamic and full of opportunity-- had this to say recently:

The processes of creative destruction continue to play out.  Five years ago Nokia and Motorola ruled the mobile world, with Blackberry as the leader in the enterprise market.  Where are they now?  Plus the maturation of open source technologies and access to cloud-based computing and storage resources on an as needed basis has radically reduced the cost of development for new start-ups.  Even Apple's extraordinary success is beginning to look transient in the post-Jobs age.

How does one contend with such change when planning for the future? There are no easy answers but the steady dismantling of the social contract embedded since the time of Lester B. Pearson will create ferment, resentment and anger amongst those left behind in a society of fewer "winners" and many more "losers".