A picture of Canadian money.
A picture of Canadian money. Credit: Rick / Flickr Credit: Rick / Flickr

The following commentary is based on remarks made on September 29 to the Senate Standing Committee on Banking, Commerce and the Economy. A video recording of his full appearance (including questions and discussion) is available here. Jim Stanford is Economist and Director of the Centre for Future Work, based in Vancouver.

Canada is entering a fragile, dangerous moment in its economic history.

Evidence is accumulating that the country is poised on the brink of a significant, potentially lengthy economic downturn. It may have already started. Employment in Canada has already fallen for three consecutive months, from May through August (losing a cumulative total of over 110,000 jobs). That has never happened before in history, without a recession. Other indicators of contraction abound.

This negative outlook is all the more disappointing because it comes on the heels of what should go down as one of the most successful policy interventions in history: the macroeconomic rescue mission which responded to the initial COVID-19 pandemic.

In essence, we are snatching defeat from the jaws of victory.

Some of the factors behind the current weakness arise from global developments (such as the war in Ukraine, or the unprecedented events in the UK). But to a large extent, the looming macroeconomic crisis is self-inflicted: a predictable and avoidable result of the inappropriate application of textbook monetary policy to a situation (global pandemic) that was never described in any economic textbook.

As we know, the economic contraction associated with the imposition of health restrictions to stop COVID spread in 2020 led to the fastest, deepest downturn in Canadian GDP and employment ever. But the rapid and powerful fiscal and monetary interventions undertaken by Canada’s government, and most others around the world, prevented that shock from turning into a sustained recession – or, more likely, depression.

Output and employment rebounded faster than almost any economists, myself included, predicted. That was thanks to the spending power provided by extraordinary personal income supports, the stability in employment relations facilitated by wage subsidies, and above all by Canada’s relatively successful public health effort to limit contagion, illness, and death. 

Canada’s health response was second best in the G7, measured by excess deaths per capita. After all, the economy is composed of human beings – people who get out of bed in the morning, and go off to work, produce, generate incomes, and pay taxes. So keeping humans healthy is the first and primary prerequisite for economic success. And Canada’s public health response, while imperfect, was impressive. It saved tens of thousands of lives, and it positioned the economy for a successful rebound.

The fact that Canada’s economy could so quickly regain pre-COVID levels of employment and output is an astounding victory that economists will be studying for decades to come.

Some now claim that Canadian policy-makers overdid that rescue effort: because total household income rose during the pandemic, for example, with income supports more than offsetting the decline in employment income during the initial COVID recession. I reject that argument. Those policy interventions, and the subsequent recovery of GDP and pre-tax-and-subsidy incomes, are not mutually independent. The interventions explain why the economy did not contract further and for longer. Without those interventions, household incomes would be much lower today, and the supposed “excess stimulus” would have disappeared. 

The same goes for arguments that the Bank of Canada overshot the mark with its monetary stimulus. The economy recovered more strongly and quickly than expected at the beginning of the pandemic. But that was not an “error” in forecasting – it was the result of the fiscal and monetary rescue effort. It’s not just that the Bank of Canada could not have foreseen that rapid rebound in GDP and employment and spending. (It couldn’t be expected to.) More important, the Bank’s own actions helped achieve that stronger-than-expected rebound.

If both fiscal and monetary policy had been less aggressive in 2020, as those with 20:20 hindsight now recommend, then this vibrant recovery (which seems to indicate that less supports were needed) wouldn’t have occurred.

There should be no surprise that these unprecedented events should still be causing further disruptions and challenges. Chief among them, of course, is the acceleration in inflation over the last year.

Demagogues like Pierre Poilievre claim that this inflation is the personal responsibility of the Prime Minister, or the result of the Bank of Canada “printing money”. This is outright, crude misinformation.

The acceleration in inflation is a worldwide phenomenon. It clearly reflects unique pressure points arising from the pandemic. These include:

  • Disruptions in supply chains resulting from COVID shutdowns and related factors (in strategic sectors like semiconductors, automobiles, building materials, and more).
  • Related disruptions in transportation and shipping, also tied to health restrictions on travel and border crossings, which caused large but temporary jumps in shipping and logistics costs.
  • A shift in the allocation of consumer spending away from services (consumption of which was restricted due to health restrictions) and toward goods, spurring initial price shocks in several key merchandise categories.
  • Energy price shocks nominally sparked by the Russian invasion of Ukraine, but actually produced by the speculative, financialized behaviour of energy futures markets. World oil supply has increased since the invasion, not been curtailed – but speculative world markets have nevertheless produced large price increases which are reflected in Canadian prices (even for energy produced, refined, and consumed here).

It must be stressed there is no connection between the size of government deficits and inflation. Some countries with larger deficits have experienced slower inflation (like Japan), and some with smaller deficits have experienced higher inflation (like Germany). This is a global phenomenon.

To be sure, inflation is a concern: one of many macroeconomic challenges in the current environment. Others include creating and sustaining decent employment, addressing inequality, and preventing and adapting to climate change. Inflation is not the only concern we face, nor the most important.

But it’s not inflation, but rather the response to inflation, that is now threatening another economic crisis. Central banks around the world, bruised by unjustified criticism that they “overdid” monetary stimulus during the initial months of the pandemic, and/or were “too slow” to respond to inflation as it emerged, have now rediscovered orthodox true religion.

To try to salvage their reputations as inflation-fighters, they are determinedly but inappropriately applying textbook remedies to post-COVID inflation. They are using the sledgehammer of higher interest rates, applied indiscriminately across all sectors, to suppress domestic demand, increase labour market slack, and hopefully reduce price pressures.

The Bank of Canada claims that current inflation is caused by excess domestic demand. This argument is wrong and self-justifying. Many indicators were already visible in second-quarter 2022 GDP data that domestic demand in Canada is not unsustainable at all – and in fact is already softening in several key areas (including residential investment, consumer durables, and government services and investments). The second quarter also featured the biggest accumulation of inventory in Canadian history, a sure sign demand is weakening; in fact, without that inventory build, GDP growth would have already turned negative.

The parallel argument that inflation results from an overheated domestic labour market, “labour shortages,” and rising labour costs is also inconsistent with the actual evidence. Nominal wage increases have lagged far behind inflation, real wages have fallen over three per cent (with more erosion in store), and the labour share of GDP has declined by over two percentage points since the pandemic. None of these indicators are consistent with the hypothesis of a “wage-price spiral” that so worries the central bankers. These outcomes are opposite to what occurred in the 1970s – the history which central bankers invoke to justify their present-day actions.

One thing that is clear in the economic data is that profit margins for Canadian businesses have widened throughout the current inflationary episode. After-tax corporate profits have increased, reaching their largest share of GDP ever in the second quarter (almost 20 per cent), up by almost five percentage points since the pandemic. This is strong evidence of “profit-price inflation,” not “wage-price inflation.” Nevertheless, the emphasis of monetary policy continues to be on suppressing the incomes and spending power of ordinary working people. This is ineffective, and unfair.

Despite this empirical evidence, the rote application of decades-old textbook remedies to the novel challenge of post-pandemic recovery continues. The Bank of Canada’s actions are mirrored around the world by severe and rapid tightening by other central banks – although it should be noted that the Bank of Canada’s response has been among the most severe of any central bank (more aggressive than central banks in Europe, the U.K., Asia, and Australia).

We are only beginning to see the damage from these actions. Falling asset prices (for equities, other financial assets, and real estate) are one immediate consequence. Rising debt service charges (mortgage payments for many households will soon double, or worse) are biting deeply into consumer spending. Interest-sensitive spending by both consumers and businesses is already slowing.

Will all this pain bring inflation back to earth? Since present inflation does not result mostly from domestic demand factors, there will be no quick payoff from these painful measures in the form of lower inflation. Some short-term moderation of inflation can be expected from the reversal of some of the global factors that started the problem in the first place – such as recent declines in shipping costs, agricultural commodity prices, and some energy costs. But those are not the result of interest rate hikes; they would have happened anyway. Meanwhile, unintended side-effects of higher interest rates push some components of the CPI bundle higher, not lower: including rents and all-in costs of home ownership (which rise, even though property prices are now falling, because of soaring interest expenses).

As events in the U.K. have proven, the global interest rate shock will also produce knock-on effects on financial stability that are unpredictable and potentially very destructive. Some global financial institutions (such as Credit Suisse and Deutsche Bank) are already facing crises of confidence as severe as those that sparked the 2008-09 crisis. Because of inscrutable interconnections between indebtedness, leveraged investment strategies, and asset prices, cascading financial failures among both financial institutions and ordinary households are likely in the volatile months ahead – risking a broader and contagious crisis of confidence.

The backdrop to these worrisome macroeconomic and financial developments is a rise in divisive, anti-democratic sentiment and movements in many parts of the world. The outcome of the recent election in Italy is just the most recent manifestation of that trend. Pain and dislocation resulting from a self-inflicted recession will create a ripe environment for the expansion of those sentiments. We know we are not immune to the risk of anti-democratic and even violent right-wing extremism here in Canada.

This assessment is grim, but grounded in a realistic analysis of current conditions and policy settings. Worse yet, the Bank of Canada (and other central banks) have forewarned that they will not be deterred from continuing to tighten monetary conditions even if the economy slips into recession, until such time as inflation retreats to its target rate (likely years from now). In this light, the recession we are heading into will be neither short nor shallow – because central banks will keep their feet on the brake pedals long after the recession has started.

It is not too late for policy-makers to change this disastrous course. And even if they ignore their critics, as central bankers are prone to do, and continue marching us into a needless recession, it is important that progressives present a clear explanation for the coming crisis, and how it could have been avoided. This will help insulate Canadians against the scapegoating and populism of right-wing forces, who will blame taxes, public health measures, and government spending for the mess – rather than pinning the blame on anti-worker macroeconomic policies, and the financial and business elites who have benefited from them for decades.

Rising inflation is a problem for workers and low-income households, no doubt about it. But we must reject any “cure” that is worse than the disease. A more progressive and balanced anti-inflation strategy would consider the full range of factors causing current inflation, rather than assuming it is rooted in overheated domestic demand and labour market conditions. 

Policy should focus on addressing those true causes of inflation. Supply chain problems and infrastructure bottlenecks should be relieved by investing in new capacity and infrastructure – something that is discouraged, not encouraged, by higher interest rates. Price controls and excess profits taxes on key inflationary sectors (especially energy and housing) can directly moderate price pressures. Reducing fees for public services (such as early child education, public transit, and ancillary health care costs including dental costs) can also incrementally reduce inflation.

Policy must also aim to protect Canadians against the effects of inflation until its true causes are addressed. Income support programs need to be enhanced: especially unindexed provincial welfare programs. Targeted measures like the GST credit and the Canada Housing Benefit should be expanded. These measures can be paid for with excess profit taxes and other levies aimed at those who have profited from inflation.

Workers need the freedom and power to negotiate wage increases that keep up with inflation. This does not in itself “lock in” inflation: combined with productivity growth, nominal wages that merely keep up with inflation are in fact disinflationary (since unit labour costs rise less rapidly than prices). And some day, the current unusually large profit margins captured by business will have to come back to earth – by forcing companies to absorb some of the impact of higher labour and input costs, rather than passing them on (and then some) to consumers as has been the case in the last year.

As the economy slips into recession (as seems virtually inevitable), fiscal policy will need to ramp up again to support jobs, incomes, and spending power. Right now, despite Poilievre’s loud complaints about overspending, fiscal policy is in fact sharply contractionary: federal program spending in the current fiscal year, for example, is shrinking by $50 billion, on the heels of a $130 billion reduction last year. With recession imminent, there is plenty of economic and fiscal room for government to address a long list of pressing priorities: strengthening our fraying health care system, expanding other vital human and caring services (like the ECE roll-out), and accelerating the green energy transition (which would also help insulate us from the gyrations of world oil markets).

A final conclusion is that we will simply have to endure current inflation, until some of its more transitory causal factors abate in coming years (as is already occurring). Mid-single-digit inflation need not be an economic catastrophe, so long as Canadians (particularly low-income and working Canadians) are protected from its worst effects.

Patience, compassion, and a more nuanced and multi-dimensional understanding of both the causes of inflation, and its most promising solutions, can help Canada traverse the coming, dangerous months. We could then cement the historic economic victories attained earlier in the pandemic – instead of squandering them on the altar of orthodox monetary policy. On the other hand, sending the economy into a painful, avoidable, unequal, destabilizing, and self-inflicted recession, all in the name of protecting the “reputation” of an inflation target that was arbitrary and one-sided in the first place, would constitute a self-defeating policy mistake of the highest order.

Jim Stanford

Jim Stanford is economist and director of the Centre for Future Work, and divides his time between Vancouver and Sydney. He has a PhD in economics from the New School for Social Research in New York,...