Canada needs an industrial policy

What is an industrial policy?

An industrial policy is a long-term effort, on the part of government to encourage the long term development of manufacturing and other related sectors.

Frankly, I think that it is tragic that this has to be explained because so few people know  what an industrial policy is, that it is not regarded as an essential part of Canada, much like the Canadian universal healthcare system.

The loss of Canadian manufacturing is a severe crisis for Canada that is often unacknowledged outside of the communities immediately affected. Alternatively, it is at times portrayed as unsustainable due to the high wages in the Western world, or perhaps due to the rise of automation. There are serious questions about those claims, particularly when other nations enjoy a trade surplus.

Why is this even important?

Manufacturing is extremely important because it offers the possibility of high valued added industries within one’s own nation. It has the opportunity to produce many high skill careers and the opportunity to further research and development.

Loss of manufacturing jobs in turn weakens the opportunity to create new high paying jobs, a knowledge base for research, and further weakens the earning power of the middle class. While manufacturing is not a cure-all, having it significantly improves a nation’s economic power. I firmly believe that the reason why economies such as South Korea and China have risen, while Japan and Germany have remained on top is because of their strength in manufacturing. For similar reasons, the Anglo economies have not fared as well due to the loss of manufacturing. That is not to say that those nations have a perfect economy (far from it), just

Over the past few decades, Canada’s job quality has been falling.

“The good news is that those at the lowest end of the wage spectrum are seeing relatively healthy wage gains — not due to bargaining power but mostly due to policy changes regarding minimum wages,” Tal says in the report.

“But the group closer to the middle of the wage spectrum have seen sub-par growth throughout the entire cycle.”

The deterioration in job quality has been steady over the past 10 years, the report said, with the number of part-time jobs rising to 20 per cent of all jobs during the 2008-2009 recession. It’s barely fallen since then, with more than 19 per cent of jobs part-time.

While jobs with above average pay continue to have high pay, and pay continues high in sectors such as logging, mining, electronics and transportation, that’s not where the new jobs are, Tal says.

Instead, they are in service and retail sectors, which pay less than the average wage.

This is an incredibly serious crisis. It needs a lot more attention than it currently receives. Without good quality jobs, Canada’s living standards will fall, as Canadians are forced into precarious employment that does not pay middle class wages. Furthermore, this will lead to lower tax receipts and fewer programs for the future.

According to Morgan Stanley economists Ellen Zentner and Paula Campbell, Canada fares extremely poorly in terms high numbers of low paying jobs compared to the rest of the OECD.

As you can see from the above graph, Canada is not doing very well at all compared to the rest of the OECD in creating high quality jobs. I think that it is very possible that manufacturing, while it cannot solve the problem entirely, could play a big role in helping mitigate the problem.

It would be very interesting to see why Belgium has done so well in preventing low wage work. Equally important would be seeing if similar pilot programs could be implemented here in Canada.

This is an extremely important problem that needs to be addressed in the long run for Canada’s long term prosperity. I think that if Canada is to remain a middle class nation, it is going to need to build up high quality, stable jobs that pay middle class wages. The alternative is a low wage nation, where the majority of people struggle to get by, while a small elite soak up all of the gains. I’m confident that the majority of Canadians would agree with me that is at odds with what Canada should stand for.

Losing manufacturing jobs will not improve the “Creative Economy”, but rather make it worse

It is often said that the outsourcing of manufacturing will lead to a creative economy, namely one where arts, culture, services, and research & development (R&D) take over manufacturing. In this definition, manufacturing is looked down upon as dirty, low skill, and a necessary evil.

In reality, manufacturing is itself a source of research and development. For the US, sending jobs from the US to China decreased research and development:

The firm data allow us to embed the patent analysis in a wider context of other indicators for the activities of firms. Importantly, we find that import competition not only reduced patenting but also firms’ R&D expenditures. Import-competing firms further experienced declines in global sales, employment, capital stock, and stock market value. They were more likely to suffer a decline in operating profits.

The innovation activity of US firms did not merely shift from the US to other countries. We estimate similar negative effects of import competition on patents by US firms’ domestic employees and by their foreign employees. Instead, our results are most consistent with the notion that the rapid and large increase in competition squeezed firms’ profitability and forced them to downsize along many margins, including innovation. Consistent with that interpretation, we find that the adverse impact of import competition on patent output was concentrated in firms that were already initially more indebted and less profitable.

The decline of innovation in the face of Chinese import competition suggest that R&D and manufacturing tend to be complements rather than substitutes. That is, when faced with rapidly intensifying rivalry in the manufacturing stage of industry production, firms tend not to substitute effort from production to R&D. While politicians’ ‘obsession’ with manufacturing is primarily due to the sizable employment losses in the sector during recent decades, an accompanying reduction in innovation may well affect economic growth in the longer term.

This is the opposite of what one would expect.  A creative economy dominated by research and development would expect an increase in R&D as China gained American manufacturing jobs. In other words, increasing imports causes a decline in both R&D expenditures in monetary terms and the numbers of patents. The cause is that too much competition led to a decline in contribution margins, leading to less money available for R&D expenses.

Source: Maas (2017). Relationship between patents and China imports. In theory if outsourcing led to a “creative economy”, the amount of patents should increase, but the opposite is happening.

The article also notes that R&D and manufacturing are complements not substitutes. In other words, in order to accelerate a creative economy, the best option is to invest in the manufacturing sector, and limit imports, which in turn will increase research and development spending. This will accelerate the transition of a “creative” economy.

Keep in mind that Canada has also been running trade deficits. There is no reason to believe that this would be any different for Canada. The lesson is that running trade deficits inhibits innovation rather than fosters it. Manufacturing is a prerequisite for scientific development, not something mutually exclusive.

Over-dependency on oil has been economically damaging

While I am not saying that Canada should abandon oil entirely, I am advocating for a far more diverse economy.  They are not mutually exclusive.

Since approximately 2015, the Canadian dollar has dropped against the USD due to the low price of oil and the continued weak performance of the Canadian economy. There has been no real recovery for Canadians and compounding the problem, Canada has been deep in a real estate bubble, particularly in the cities of Toronto and Vancouver.

The risk of becoming dependent on one natural resource are:

  1. Commodity prices are not stable. While they are high, they can lead to a crowding out of other investments, but while they are weak, because existing alternatives have largely been abandoned, a nation without a diverse set of industries is going to be harmed disproportionately.
  2. That commodity could someday be abandoned. In the case of oil, there are risks such as the emergence of renewable energy, decreases in the demand for oil through new technologies like electric vehicles, and so on.
  3. If a nation’s currency is heavily tied to that one sector, it can heavily swing with that sector, which can affect the stability of the currency and the competitiveness of other sectors. An example, if oil prices are high and Canada has a strong currency, this could make tourism less attractive for Canada because  the Canadian dollar is heavily correlated to the price of oil and therefore stronger. It is more expensive for tourists to come to Canada.
  4. Loss of technical expertise in manufacturing, agriculture, and other important sectors of the economy. Manufacturing is continuous, that is, previous generations of learning built on each other.
  5. Likewise, if there is one sector down, while another sector is up, a nation can potentially mitigate the impacts of the down sector by investing in the up sector.
  6. It can lead to an indirect crowding out of other sectors that in the short run, may seem less attractive. An example, as people become more reliant on oil, secondary services that focus on that one industry can have a disproportionate effect.

Again, none of this means that Canada should not produce oil. It just means that it is very risky to have all the eggs in one basket. So what does that mean? Diversify.

Source: Is the Canadian Dollar a Petrocurrency?, University of British Columbia

Look at the image above. That is an incredibly strong correlation between the Canadian dollar and the price of oil. Actually, if that chart extended into 2015 and 2016, it would show the Canadian dollar dropping to a low of just $0.67USD/CAD around Q1 of 2016. It is rather unusual for a developed nation’s currency to become so tied to the price of a commodity. The article from UBC argues that so long as oil remains a high percentage of total exports, the Canadian dollar will remain highly correlated with the price of oil. While oil according to the article made up 25% of the pie of Canadian exports, I’d would argue that that Canada needs to focus on exporting additional value added goods to reduce that slice of the pie. That will not necessarily come at the expense of oil, but rather complement it. Canada should also be looking into producing other high value added petroleum based products, such as advanced plastics, finished products made of petroleum, and other manufactured goods.

So how is this damaging? Earlier, I gave an example of the tourism industry. Imagine if the price of oil were to rise tomorrow. There would be several problems.

  • As the Canadian dollar is heavily tied to the price of oil, it means that the Canadian dollar suddenly becomes stronger. That means that hotel costs for foreigners, food, and all other costs become more expensive.
  • Airline tickets will also go up as a result of the increases in the costs of oil, making it more expensive to fly to Canada.
  • Tourism by other Canadians becomes less attractive. As the Canadian dollar strengthens relative to other currencies, going abroad becomes cheaper because hotel and other costs in other nations becomes relatively lower than in Canada.
  • Many industries such as hotels have high fixed costs and low variable costs, compounding this problem of lower tourism to Canada.

As you can see, this would quickly compound. Airline travel is important as outside of the northern US (and even for parts of the US far from the Canadian border), Canada’s geographical isolation makes it difficult for foreigners to go to Canada without airline tickets, which is very sensitive to the price of oil.

It is an example of how a simple thing can multiply into something unexpected. Keep in mind that fuel costs are one of the largest costs in the airlines industry. The airlines industry is an area with extremely intensive price competition.

This can also work in reverse. The weakening Canadian dollar caused by dropping oil prices at the end of 2014 led to a decline in travel from Canadians going to the US.  By contrast, if you read the article, more Americans, Mexicans, and other international travelers visited Canada.  This has had harmful effects for some regions of Southern US. Not everywhere, but keep in mind that these are industries with high fixed costs and low variable costs, so even a slight drop can be a challenge. Notice in this case that the strong US Dollar has had an effect on the region of the United States furthest away from Canada because Canadians leave to the US for the winter.

This also has a very important effect on manufacturing because with manufactured goods, the foreign exchange is important because it affects the value of the goods sold abroad. An example, if the Canadian dollar is trading at complete parity, a good may sell at $100 USD in the US, but  if the Canadian dollar is at $0.75 USD per CAD, assuming all expenses of that good were in Canada, that could be as low as $75 USD in the US. By contrast, the same American made good may remain at $100 USD, provided they have the same costs.  This becomes a big advantage in manufacturing too.

I would also argue that this is a good argument for a weak currency.

So how does this affect manufacturing? Why does Canada need an industrial policy then?

Manufacturing, and I will explore this in greater depth in a later post, is a very knowledge intensive line of work. It is not, contrary to the image provided by its critics, an army of low skilled workers. It requires highly trained workers and the possibility for high wage earning.  They also offer the opportunities for high exporting, which improves Canada’s trading position.

If it were not, factories would not be very capital intensive to build, they would not need engineers, technologies such as materials science would not be extremely important, workers would not need very specialized training, and so on. The problem is that with an economy too dependent on one natural resource, there are the following effects:

  1. A crowding out effect where money will go to the highest short-term returns for investors, which might be contrary to the interests of the long term for society as a whole.
  2. Talent will go disproportionately to one field, where they can command the highest salaries. While it’s not bad for people to go into one field, if that one field declines, that could disproportionately damage the economy.
  3. Exports will become less stable because the Canadian dollar would be tied to the value of the price of one commodity. For reasons similar to the tourism scenario I gave earlier, that means very unstable trade balances due to the cost of that commodity. The lack of stability also makes it very difficult to invest in manufacturing because investors hate risks and high volatility, demanding higher interest rates, making it uncompetitive to invest in Canada.
  4. Other nations who do invest more in their manufacturing (paradoxically not having the resources could be an indirect blessing in disguise because it forces investment in value added areas) or knowledge economy could have a leg up.

Samsung’s Austin Fab cost $260 million USD to build and employs 3000. Those 3000 people are making the DRAM chips that make our modern chips function. Inside is a sophisticated plant full of robotics – a far cry from an assembly line (which is actually a higher skill job than what most people think). This is not a low skill job. Samsung intends to invest an astonishing $14 billion USD in South Korea on a massive 10nm Semiconductor Foundry. What will that do for South Korea? It will play a role in helping South Korea lead the world. Canada needs to make similar investments.

Would you rather see Canada have just one segment or invest in multiple segments to ensure that the risks of any decline in a single sector are mitigated? Particularly in the case of non-renewable resources, this is a big question. With resources such as agriculture, with sustainable use of soil, water, and other key resources, it is renewable. Not so much with petroleum as it once consisted of organisms that died tens of millions of years ago. Once it is completed extracted then burned in a combustion engine, it is gone, and what is left is just water vapor along with carbon dioxide. It is not renewable. What happens to Canada if it is does not invest in alternatives when the non-renewable sources are exhausted?

An alarming example is the impact on what happened to Newfoundland in the mid 1990s after the collapse of the province’s cod fishery banks. While there has been a partial recovery in shellfish and due to oil off the coast of Newfoundland and Labrador, there was never a complete recovery. We need to learn from the past mistakes so that we do not repeat them. Part of the problem specific to the fisheries is sustainable fisheries management. However another part is diversification. Newfoundland was heavily dependent on the cod fisheries and as a result, suffered severely when the fisheries collapsed.

Much like the technology sector, manufacturing is a way out. It provides the opportunity for a real “knowledge based” economy. Here are some hard questions?

  • If robots are taking over manufacturing, then would it not make sense to ensure that Canada is a world leader in building robots?
  • If the robots are not taking over manufacturing, then why not invest in manufacturing in Canada? Clearly there are developed nations with strong manufacturing sectors still, such as Germany, Japan, South Korea, etc, and they do pay developed world salaries. Keep in mind, manufacturing is capital intensive more than labor intensive, requiring high skill work.
  • When the natural resources run out, especially the non-renewable ones, how can Canada afford to keep on buying other nation’s goods? What will it pay with?  It would have to run debt, that has limits too. In the long run, a large trade deficit is unsustainable. Canada would need something of equal value to be able to trade back to other nations.

To me, it is clear that Canada must diversify to ensure its future. Canada does have a growing technology sector, but it must ensure that the future remains growing. To do this:

  1. Invest in infrastructure aggressively to ensure Canada has the best infrastructure in the world. This is difficult for Canada because of its low population density, harsh climate, and because the population is scattered, although largely concentrated in the South near the US border.
  2. The percentage of research and development spending as a total of GDP should be the highest in the world.  Too many Canadians who major in these areas cannot find work, so investments in R&D will have the advantage of reducing unemployment and improving innovation.
  3. Build close partnerships with universities and manufacturing so that manufacturing can bring the latest that basic research has to offer into marketable products quickly.
  4. Provide special relief for manufacturing, such as affordable costs of electricity and other subsidies. Asian nations frequently do this.
  5. Student debt relief and affordable tuition would help provide the next generation of Canadians better universities. Continuing to court more international students and highly educated individuals in areas that Canada has shortages in (ex: in medicine) could also be helpful to help.
  6. Publicly owned corporations and public banks could provide vital financing. I’ve previously written about how this could be helpful for infrastructure. I think that this could also help establish manufacturing sectors too.
  7. Increase worker training. Canadian employers currently do not train their workers as much as they should.
  8. Invest in a special bank to loan funds for the purchase of Made in Canada products. Export Development Canada already does this function, but it needs to be expanded considerably. Cheap financing is important for many potential buyers.
  9. Give special discounts to allow Canadian companies to purchase top quality capital goods to improve future products.
  10. Controversially, I will add, undervalue the Canadian dollar. Admirably the Bank of Canada has kept the Canadian dollar relatively low. It must stay that way should oil prices go up again.

I will expand on these in later posts sometime in the future. This is a decades long project. It will not yield gains overnight. There will be setbacks and companies that do fail. Manufacturing is very competitive. The costs are high, as are the benefits. Notice that I mentioned South Korea? They spent decades investing in their manufacturing, in their nation, and in their people. That is why they are so prosperous. They followed the model first pioneered by Japan. Between 1950 and 1990, Japan saw some of the greatest economic growth in human history, propelling them from the devastation of WWII to a modern developed nation that in some regards, surpasses even many Western nations. Even today, despite its difficulties, Japan has a powerful export sector. Actually, as Eamonn Fingleton notes, Japan may be in much better shape than we think it is.

Manufacturing is very competitive across the world. That means that to win at manufacturing, Canadian products will have to be as good as the competition and price competitive for the quality they offer. Otherwise, Canada will not have a chance of competing. That is why I strong stress the emphasis on capital investment, scientific research, worker training, and other productivity enhancements at all costs. Canada could never compete with the developing world on labour costs, so it’s only advantage is product quality and value for money.

Another big consideration is that manufacturing builds on the previous generation. It evolves. Look at the DRAM plant above. Each new DRAM plant takes the technical knowledge of the previous semiconductor process and then builds on that to make ever smaller transistors that can be packed more densely, giving us more RAM for our computers. It works that way for all manufacturing too. Automobiles, aircraft, etc, you name it. If a nation gets out of the manufacturing sector, getting back into the manufacturing sector will be very difficult because it would mean starting from square one. The only way would be extremely expensive research, or to buy the technical expertise of other nations, which they may not be willing to sell for fear of creating future competitors.

Jet engines, like computers build on the last generation. Part of the reason why they are more efficient is because the next generation leads to higher inlet temperatures, making them more fuel efficient. One of the biggest challenges though is making jet turbine blades that can withstand the extreme temperatures and pressures. General Electric, a major jet engine maker, has expanded operations in Manitoba and Quebec. Sources: University of Virginia Engineering and CFM International.

I think that it is clear that unless major investments in manufacturing are made, our current generation and our children will suffer from a declining standard of living. In the US, the bottom 80% are regressing into a developing nation. Canada is in deep danger of following that path. Unless Canada makes a serious effort at investing in the future, in manufacturing, and creating an industrial policy it will follow. Remember that low wage graph I linked earlier? That’s Canada right now. Let’s make Canada into something we can be proud of.

Conclusions

Having an industrial policy is absolutely critical to the prosperity of Canadians. It may very well be that the earning power of Canadians has declined around the time that such important policies have been abandoned.

Canada has become too dependent on one sector and alarmingly, has become a nation of low wage earners. In order to change that, investments in manufacturing through an industrial policy and productivity must be made. Manufacturing has the opportunity to build high exports, increase wages, and should any single sector fail, diversification will help mitigate the Canadian economy from the worst impacts. While oil in and of itself is not bad, over-dependence on one sector of the economy is a huge problem. Should that sector fail, as the fall in oil prices has demonstrated, the impacts could be widespread, not just because of that one sector, but because it could destabilize the Canadian dollar.

To counter this, Canada needs to make a huge investment towards its future. If we do not, Canadians risk falling behind the rest of the world or worse, regressing into a developing nation status. If it does, then Canada could very well build a nation that is the envy of the world. Let’s make investments so that we are the envy of the world.

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