By Philip Cross, July 26, 2017
As the Canadian economy slumped under the weight of lower oil prices starting late in 2014, the Bank of Canada relied mostly on a lower exchange rate to revive the economy, encouraging the devaluation with an unexpected cut to its interest rate early in 2015. Altogether, the Canadian dollar sank by 25 per cent between 2014 and 2016 and is now at US$0.77, despite recent firming in oil prices and Canada’s economy. Most economists defend the devaluation of the Canadian dollar as an overall stimulant to the economy.
There are circumstances when a lower exchange rate buoys the economy, but Canada over the last two years shows the down side of relying on devaluation to buttress growth. A lower dollar eventually lifts exports but it also imposes higher import costs on the economy. This is especially true for Canada, which imports one-third of all its goods and services as well as large quantities of capital. These costs were quickly felt and easily identifiable over the past two years. Meanwhile, the stimulus from a lower exchange rate was largely invisible before 2017. The evidence points to the devaluation hampering rather than helping growth over the last two years.
The pain that a lower loonie inflicted on Canadians in 2015 and 2016 is obvious. Everyone who buys fuel for driving or heating pays 25-per-cent more than consumers in the U.S., because Canada automatically pays the U.S. price, adjusted for the exchange rate. In total, this costs Canadian households $3.3 billion a year. Consumers also saw prices go up for travel outside Canada (in response, travel abroad fell by a third since 2014) and a wide range of goods from food to clothing and even a reversal of the trend to lower prices for vehicles and some new tech gadgets. Elsewhere, businesses and governments in Canada paid more for everything from imported inputs and machinery and equipment to servicing the $488 billion of debt denominated in U.S. dollars, which exceeds all their Canadian dollar-denominated debt, according to a new database from Statistics Canada.
Meanwhile, what were the benefits of a lower dollar? As the nearby graph shows, the volume of exports today is only 2.0-per-cent above its level in the third quarter of 2014 when oil prices began to slump. Even this miserable growth owes more to long-planned oil sands plants coming on-stream than to the devaluation; oil export volumes rose 10 per cent, while manufactured goods such as autos increased four per cent. The lower loonie did help export earnings, which convert to more Canadian dollars when repatriated to Canada. However, this barely offset the impact of falling commodity prices, with export prices eking out a one-per-cent gain since mid-2014. This redistributed some of the pain from corporate income to households, but redistributing pain is hardly a stimulus.
Some costs from the lower dollar were not anticipated or even imagined when devaluation began late in 2014. No one foresaw that lowering interest rates and the exchange rate (which reduced the price foreign investors paid for housing in Canada) would trigger the housing bubbles in Vancouver and Toronto. House prices in Vancouver took off suddenly and accelerated in Toronto after the Bank of Canada cut interest rates in January 2015, reinforced by an inflow of people moving to these cities after the attraction of moving to the oil-producing provinces disappeared. The impact of lower interest rates and the exchange rate on housing prices was not anticipated because it did not occur during the devaluations undertaken in the 1970s and 1990s. The evidence-based approach to policy-making is limited to what has happened in the past, while it downplays what could be different in the future.
The fact that exports will eventually pick up in response to the lower dollar misses the key point. The lower dollar was meant to be an immediate salve to the wounded Canadian economy in 2015 and 2016. Instead, growth floundered with the Bank of Canada regularly citing weak exports and business investment as the reason growth continued to disappoint in 2015 and 2016, the very sectors the lower dollar was meant to stimulate. Instead of higher exports, easier monetary policy mostly produced soaring house prices in Vancouver and Toronto in 2015 and 2016.
Economics does a disservice to itself and the public when it claims more precision than it possesses. The idea of trying to stabilize the economy is less than a century old and our knowledge of the macro-economy is embryonic, not encyclopaedic.
Philip Cross is a Munk Senior Fellow at the Macdonald-Laurier Institute.