THE YEAR AHEAD: KEY CONCERNS FOR 1988
Maureen Farrow, President, C.D. Howe Institute
December 10, 1987
Chairman: Ronald Goodall, President
The subject of today's address is the year ahead. Predicting the future seems to me to have been and continues to be an obsession with men and women. Many ways of predicting the future have been developed by men and women over the years.
Ancient civilizations in Egypt, Arabia, China and other countries looked to astrologers to study the heavenly bodies and predict the future; sometimes these predictions were documented in a horoscope. The Romans had a religious college of diviners called augurs who interpreted certain signs - thunder and lightning, the feeding of sacred chickens, actions of serpents - and made predictions called auguries. Similar predictions based on the actions of birds were called auspices. Eventually, an array of forecasters or fortunetellers came into being. Some practised chartomancy by divining the future from playing cards. The crystal ball gained popularity as the forecaster peered into the globe, saw forms taking shape and read the future of a client. The interpretation of dreams allowed some to forecast the future; others interpreted tea leaves and coffee grounds left in a cup; others cast pebbles and looked at the lie of the pebbles to achieve the same result.
Economics, sometimes defined as the study of human behaviour in using resources to satisfy wants, also found its origin in ancient times. Greek philosophers regarded agriculture as of prime importance in the economic hierarchy and placed higher values on statesmen and soldiers than on industry and commerce. Profit was a dirty word in those days. The classical economists such as Adam Smith and Thomas Malthus developed ideas on production and population and produced the laws of diminishing returns (which may be evidenced today by the length of this introduction).
Recent economists from John Stuart Mill to John Kenneth Galbraith built on those earlier ideas and have certainly influenced policies of business and government. Notwithstanding these advances in economic theory and the ability of the economists, I suspect many in this room today read their horoscope in today's newspaper before leaving the breakfast table! My own horoscope for today is particularly interesting: "Libra - Watch what you say today. You could blurt out a friend's secret. Avoid buying extravagant Christmas presents. A friend gives you the benefit of her experience. Show appreciation:"
It is our particular good fortune to have a distinguished economist, Mrs. Maureen Farrow, with us today. Mrs. Farrow was born and raised in England. She received an honours degree in economics from Hull University and undertook postgraduate work at the London Business School. In 20 years of professional experience, she has specialized in applied economics and industrial market research. In particular, Mrs. Farrow has acquired an in-depth expertise in financial markets, consumer products, retailing, construction, real estate, and metals and minerals.
The prestigious C.D. Howe Institute is one of her responsibilities. This institute is an independent research institution which monitors fiscal, trade and monetary policies and contributes critiques and policy advice. Mrs. Farrow continues as a partner with the Coopers & Lybrand Consulting Group. She is a member of the Social Sciences and Humanities Research Council of Canada, past president of the Canadian Association of Business Economists and a member of a number of professional associations. For the past four years, Mrs. Farrow has been a judge of the National Business Writing Awards.
Mrs. Farrow is married and has one son.
Ladies and gentlemen, may I present Maureen Farrow, President of the C.D. Howe Institute, who will address us on "The Year Ahead: Key Concerns for 1988:"
It is a great pleasure to be addressing The Empire Club. And before this audience I think it is most appropriate that I should open with a quotation from Winston Churchill: "No one can guarantee success in war, but only deserve it." We at C.D. Howe Institute believe that 1988 will be a difficult year from a policy perspective, and that there is a danger that Canada will be diverted from the right course. We believe that if Canada is to deserve success, the federal government must ensure that it does not get distracted from its current policies.
In addressing this danger, I want to talk first about the economic environment I foresee for the next year. Then I will `, discuss the pressures the government will be under from the election timetable. Finally, I will talk about the policy implications of these forces coming together.
I should say at the outset that economic and political events seem to be conspiring to make it extremely difficult for Canada to do the right thing from the country's long-term economic perspective.
The Economic Environment. Let me start by drawing a picture of the state of the world economy prior to the October crash. Industrial production data show that for the six major industrialized countries - the United States, Japan, West Germany, the United Kingdom, France, and Canada - the expansion that started in late 1982 continued through 1987. In fact, over the summer months, an acceleration became evident. Most countries are reporting growth in industrial output that exceeds earlier expectations, and the expansion is in exactly those sectors and regions that were struggling in 1985 and 1986. For instance, domestic demand is rising in West Germany and Japan, and even in the United States there is an improvement in the volume of exports. Resource prices are rising, and this has encouraged renewed activity in the oil and gas and mining sectors, which had been bypassed by the prosperity of 1985 and 1986. The most encouraging sign of all is that, to date, the expansion has continued largely without any evidence of a renewed outbreak of inflation.
Canada Continues to Perform Strongly. Against this world setting, Canada continued to perform strongly in 1987 right up to the fourth quarter. In the first half of the year, economic activity (measured by real GNP) expanded at annual rates in excess of 6 per cent and in the third quarter by a respectable 4.3 per cent. Canada has, in fact, experienced one of the strongest growth rates among the OECD countries. A welcome characteristic of Canada's economic performance this year is that all regions of the country have started to enjoy what had previously been a central Canadian economic experience.
However, the numbers for the country as a whole have begun to show some moderation in the fourth quarter. The slowdown is largely in the consumer sector, and in particular, in housing and car sales. It was expected that, as the Canadian economy came to the end of its fifth year of expansion, some slowdown would occur. Prior to Black Monday, most economic forecasters expected that economic growth in 1988 would be slower than in 1987.
Black Monday and the Concerns for 1988. Since October 19, people have been wondering if we are at the edge of a precipice and if, in the next few months, we will fall into a 1929-style recession. My belief is that the stock market correction reflected an overvalued and speculative market. The correction in fact was just returning equity values back to the real world. But October 19 must also be regarded as a moment in time that crystallized a number of key pressing international concerns. These are: international trade imbalances; • the U.S. budget deficit; and exchange-rate volatility.
Global Imbalances. Over the past year, concerns have focused on the merchandise trade and current account imbalances among the major industrialized countries. The U.S. trade deficit has continued to deteriorate, while Japan and Germany have recorded surpluses. The size of the U.S. trade deficit has meant that the United States has shifted from being the world's largest creditor in 1980 to becoming the world's largest debtor by 1986. The United States now requires about $150 billion a year of capital inflows to finance its trade deficit.
Prior to the summer of this year, most of the capital inflows were being supported from the international private sector. However, as the U.S. dollar has continued to fall, there is evidence of increased unwillingness by the international private sector to support U.S. capital requirements, and the void has had to be filled increasingly by the central banks. Put simply, the issue is how to reduce the U.S. current account deficit on the one hand, while reducing the Japanese and West German current account surpluses on the other hand.
Attention right now is also focused on the size of the U.S. budget deficit. Financial markets continue to call for a substantial reduction in that deficit. However, meaningful reduction requires either tax increases and/or spending cuts mainly in social and defence programs. And President Reagan has ruled out both of these methods.
The compromise solution that came out of the economic summit following Black Monday has been the $30 billion deficit reduction package, which, when looked at closely, is more like a $21 billion package. This, of course, is less than Gramm-Rudman. Evidence to date shows us that patience in the financial markets is wearing thin as the United States demonstrates its inability to solve its budgetary deficit problems. My opinion is that compromise will continue through 1988 and that there will not be a meaningful resolution to the U.S. deficit problem until a new administration takes office in 1989.
The 1988 Economic Direction. In summary, the world economy is slowing and decisive economic leadership from the United States is unlikely in 1988. When I look ahead to 1988, my belief is that without decisive leadership, there are several directions that the world economy can take.
The optimistic scenario is that the economy will continue to perform as it is now doing, and the United States will continue to muddle through the presidential election year, for the time being allaying the concerns of the financial markets about its budget deficit but leaving resolution of the problems to 1989 and a new president.
However, I think it will be difficult to navigate successfully through 1988 in this manner. I believe that the pressure points I have already discussed will re-emerge. With a lack of commitment to implement a meaningful deficit reduction package in the United States, Europe, led by West Germany, could lose patience and decide not to support the capital inflows that the United States requires. The inevitable slowdown that we anticipated as we enter the sixth year of the business cycle will then occur.
A second key factor that will shape economic activity in 1988 is the psychology of consumers and business leaders as they make their plans to spend and invest in this uncertain environment. One can argue, to a large extent, that the consumer is not directly affected by the stock market crash because few people are directly involved in the stock market. Nevertheless, Black Monday may have an indirect effect on consumers and the corporate sector because memories of the 1981-82 recession are not buried that deep.
I believe that Canadian consumers and corporations will carefully evaluate their expenditure plans for the next six months and act conservatively in order to protect their current positions and not take undue risks. In fact, at this moment, I believe many corporations in North America are postponing capital commitments. And this delay and postponement will flatten out economic activity in 1988 as projects are stalled. This supports my view that 1988 will see continued softness.
In a nutshell, I believe the Canadian economy is already showing signs of a slowdown, and that the slowdown will now become more firmly entrenched. The risk is that this modest correction could turn into something more severe late in 1988 or 1989.
The Election Environment. Let me now turn to the pressures that the federal government will come under from its election timetable. The government is now well over halfway through its term. And an election must be called by the fall of 1989. Possible dates that come to mind are the early summer or fall of 1988 or 1989. At this moment, economic and political scenarios suggest that there may be attractions to calling an election in the fall of 1988. This timing would follow the June summit and would allow an election after the enactment of a free trade deal but prior to its taking effect on January 1, 1989.
My concern is that an election occurring only nine months from now will run the risk of crowding out and hampering sound implementation of basically sound policies that are now in the pipeline.
Critical Policy Areas. In conclusion, I will examine the critical policy initiatives that are likely to be affected by the convergence of economic and political forces. These are free trade, tax reform, and deficit reduction.
First, free trade. Once the agreement is signed on January 2, 1988,I believe the government should adopt a positive stance and move ahead by tabling and passing the agreement in the House. Given my view on how 1988 could unfold, not to do so would just compound the uncertainties for the Canadian business community.
Second, the tax reform package. I urge the government to proceed with stage one, paying attention to some of the recommendations of the parliamentary committees that have recently reported. In particular, adjustments to reduce the negative impact of stage one on middle-income families with children are called for. There appear to be technical problems with the Blenkarn Committee's recommendations of a minimum tax on financial institutions, so some other means of making the package revenue neutral may be required.
It is also important that the government act on stage two and replace the federal sales tax with a broad-based consumption tax. If the current round of discussions with the provinces fails to solve the issues surrounding the introduction of a national sales tax, then I believe the government should go it alone. It is important that the government make a decision on stage two-which is generally recognized as the most important half of the tax reform package-as soon as possible and announce the detailed plan before the next election.
Third, there are growing concerns over the federal deficit. The deficit has shown an improvement over the past few years and the current fiscal plan has the deficit moving gradually lower. However, a number of forces could combine in 1988 to direct deficit reduction off course. These forces are as follows:
0 Shocks from the international imbalances will result in a weaker economic situation for Canada. This means there is the possibility revenues will fall and expenditures will increase, and the deficit will rise.
• The chances are that, after the recommendations of the parliamentary committees are incorporated, stage one of tax reform will be negative from a revenue perspective.
• As the election gets closer, the government may be tempted to embark on expensive new programs and consequently, expenditures will rise. Already, we are aware of increases associated with the child-care program, increased agricultural support, and defence requirements.
These possibilities worry me, as the total Canadian deficit is already one of the largest among the major industrialized countries. As a percentage of GNP, it now stands at 4.1 per cent compared to 2.0 per cent in the United States. A fact that is often missed is that, in the United States, the state governments are in surplus. In Canada, provincial governments have been building up sizable deficits. By 1986, these deficits amounted to $8.4 billion. This comparison sends shivers down my spine. Attention is currently focused on the United States, but it could shift to Canada's deficit. Then, the issue of financing the deficit will come into play.
Summary. Let me summarize. First of all, the stock market crash and the U.S. impasse on deficit reduction indicate that 1988 will be a year of volatility. The implication for Canada is that the economy, which is already beginning to slow down, could slow down even further. Political events in Canada lead me to believe that an election may be called in late 1988. Combined, these economic and political events imply that the government should proceed speedily with policy implementation on free trade and stage one of tax reform, and reach a solution and a plan for stage two of tax reform. It should not embark on major new expensive initiatives. This will allow it to complete the basically sound policy agenda it has put in place. The government must also keep a watchful eye on the economy and on what a negative turn in the economy could mean to its deficit-reduction plan. It cannot afford to waste money or risk being shifted from its deficit-reduction path.
The February 1988 budget will present an opportunity for the Finance Minister to take stock of the economic scene and to take additional steps to bring down the budget deficit.
In conclusion, I would like to send the following message to Ottawa. In 1941, Winston Churchill said in a radio broadcast to President Roosevelt, "Give us the tools and we will finish the job." I believe these are the words of a man committed to following through. And this is the time when the Canadian government should avoid all other distractions and concentrate on following through and delivering on its current policy initiatives.
Thank you for your attention.
The appreciation of the audience was expressed by Anthony van Straubenzee, a Director of The Club.