Economic security requires diversification

In my previous post, I discussed the need for an industrial policy.

Canada is in a rather unique situation in that it has a lot of natural resources with a low population. Economists have criticized our previous Prime Minister Stephen Harper because his policies acted to the detriment of manufacturing in Canada.  In theory, this should be an immense advantage. In practice, it has not led to the higher standards of living that it could.

Expanding on that, how can Canada use its existing natural resources to leverage an advantage in manufacturing? Ian Welsh, a brilliant intellectual, has written a very interesting piece.

It is very well written and I am going to quote large sections of it, because Welsh observed better than I could.

 

What happened to the Dutch is that their manufacturing sector collapsed. What Canada’s NDP leader Thomas Mulcair is saying is that Canada is suffering from Dutch Disease. He says we are losing manufacturing jobs due to the higher value on the Canadian dollar caused by all the oil from the oil sands we’re shipping out of the country, which raises value of the Canadian dollar.

Previously I’ve written about the role of natural resources keeping up the Canadian dollar. The problem is that when the Canadian dollar is high, Canadian manufactured goods become less competitive, and the Canadian dollar is heavily driven by the cost of natural resources.

The price of commodities has since fallen since this piece was written in 2015 and the Canadian dollar has taken a tumble from near parity with the US to something in the range $0.70 to $0.80 USD per CAD. It does seem to vary, but the CAD$ has stabilized around that area.

Actually instability of the Canadian dollar has become a source of concern in business circles. I think that in the long run, a $0.70 to $0.75 USD per CAD is a stable target to aim for and I applaud the Bank of Canada for adopting this range.

 

Canada has traditionally had what is known as a “mixed economy.” When it comes to exports, we have both manufacturing and resource sectors, the latter of which oil is just one part. Resources experience boom and bust cycles. There is always another resource bust around the corner. Always. No resource’s prices stay high forever. When resources are doing well, they support our exports.When they’re doing badly, manufacturing takes up the slack.

As with any such oscillating economy, what should be done is that when one is booming, it subsidizes the other. We don’t want manufacturing destroyed during high resource price periods, because there will always be low resource prices in the future. So we tax the high resource prices and we subsidize manufacturing. When resource prices collapse, the manufacturing sector subsidizes the resource sector.

If we allow the manufacturing sector to become badly damaged, it cannot be easily rebuilt when resource prices collapse. Nations built entirely on resources are, and will always be, subject to economic collapse when the resource prices collapse, and, again, they always do–the only question is when.

However, this is has not brought about a big return on Canadian manufacturing. The gains have been limited. Why is that?

Previously, in my post about industrial policy, I wrote about how the weak Canadian dollar would lead to tourism and a boom in manufacturing, something that has happened in Montreal and Quebec. It is also interesting to note that Montreal is experiencing a technology boom. Tourism is already booming in Canada due to our weaker dollar and sometimes at the expense of the US with its stronger currency.

Why? Manufacturing is knowledge intensive and capital intensive, but not labor intensive. The problem is that without years of experience in manufacturing, it is difficult to set up shop. Imagine a sophisticated plant such as a semicondctor fabrication plant or a jet engine manufacturing plant. That facility requires a lot of know how. Without the years of accumulated know how, it becomes extremely difficult to build because the nation must start from ground up. It is also why it is extremely important to subsidize manufacturing, as Welsh astutely observes during times when the Canadian dollar is strong.

It will take years of sustained low dollar to ensure the return of manufacturing. That means enduring years of heavy investment, with losses, low profits, and a lot of uncertainty for the chance of success. It is very hard for the private sector to do. I also think that the Canadian government should play a far more active role than it currently does with industrial policy.

 

Mulcair has also talked about value-add and that’s worth discussing. Shipping raw oil, raw logs, and unprocessed fish means you get the lowest prices possible and less jobs. Value-add means you refine the oil in Canada and sell it. You turn the logs into paper or 2x4s in Canada. You can smoke the salmon in Canada. This provides jobs and the end goods sell for more. It may be that processing “in-house” will increase the price slightly compared to outsourcing the processing to the US or China, but that costs less sales than it would for the equivalent manufactured item.

Why? Because resources are finite. There is only so much oil in the world at any given price point. There are only so many salmon, especially wild salmon. There are only so many trees, especially trees that are good for construction-grade timber.  Other countries will generally buy these resources anyway, because there is nowhere else to get the product. Sales may decline slightly, but profit often increases and so do the number of Canadian jobs.

To me, the tragedy is that more Canadian politicians and Canadian citizens do not recognize this. Oil for example would be more valuable if we exported petrochemicals, had an advanced plastic industry here in Canada, and other advanced petroleum based derivatives.

Other nations, many of whom depend on Canada for their natural resources, may have limited choice but to accept value added products. This is a great source of jobs for Canada. One economic policy that might be encouraged is to subsidize and give incentives for businesses to become far more vertically integrated than they currently are.

 

Once upon a time, the Canadian Maritimes were a resource boom area. They sold fish, but, more importantly, they sold trees which could be made into masts, an incredibly valuable commodity. Today, with pardon to my Maritime brethren, the Maritimes are in semi-permanent depression.

This is the future that Alberta faces. They should want to be taxed, and they should want that money reinvested in other sectors, because those sectors are Alberta’s future long after the oil boom ends. And the massive environmental destruction is incurring massive costs with which future generations will have to contend, long after the boom days are gone.

To me, the alarming similarity between the decline of the Maritimes and Newfoundland (after the collapse of the cod fishery) is striking.

Hard question: What happens to Alberta’s economy if the low price of oil is permanent? What if oil demand declines for good? What would happen to Alberta? Alberta’s oil is more expensive to produce because it is in the form of tar sands, which is heavy oil (bitumen) rather than light sweet crude. It requires extensive refining and is only viable at high prices of oil.  Unless global warming is so severe that we are forced into leaving it all in the ground, Canada should extract the oil, but spend the money wisely.

To give an example of how oil might someday decline, we need to look at the consumers of oil. Note that transportation is 70% of all oil consumption. It is possible for example that the automotive sector may begin to electrify, with a higher and higher percentage of new automobiles becoming electric. That would mean that an ever shrinking existing fleet of gasoline or diesel powered vehicles would be the one of the biggest consumers of oil.

What about in terms of electricity? The cost per kWh of renewable energy sources continues to fall and if the problems with intermittent sources are resolved, then fossil fuels face increasing competition. In that case, they would be come uncompetitive.

Another possibility is that it is not by consumption, but by regulation, perhaps to address the impacts of carbon emissions on global warming. It has been suggested that global warming past 2 degrees could create a self-sustaining feedback loop, leading to a mass extinction comparable to that of the end-Permian extinction. In that case, it may be necessary to make major cuts to carbon emissions.  If that is the case

Would it not have been better for Alberta to invest in education, infrastructure, and its own manufacturing sector that has value added products? Certainly in such a case, the decline of the price of oil and the demand for oil would be harmful, but not as damaging as it is currently. It’s never popular to advocate for higher taxes. In this case, taxes represented delayed gratification or investments rather than short-term consumption, provided that the money is spent investing in the future. Peter Lougheed, who was Alberta’s Premier between 1971 to 1985 certainly recognized this, although I would argue that the Alberta Heritage Fund did not go far enough. Tragically it created a bitter divide – spend now (which is what the Reform Party was advocating for) or invest in the future?

I am not saying Alberta’s economy has no diversification (it certainly does have a mixed economy), but that there was way too little diversification and that the revenues from oil were not wisely invested. As a result, Alberta, and indeed all of Canada is now suffering from the consequences.

 

Canada’s economy has worked, and we have not become Argentina (the country we would have been compared to before WWII) because of our mixed economy. It is worth protecting, and it is necessary to protect, if we want prosperity not now, but ten years, 20 years, or 50 years from now. If we care about our children, or even ourselves 20 years from now, we must deal with the effects that the massive exploitation of the oil sands is having on our economy and our environment.

Dutch disease is just arithmetic. It is real, and it can devastate the future of a country. Non-renewable resources are the epitome of found money, and what you do with found money is invest it in something productive–something that will yield a return, something which will support you once that found money runs out.

This is Canada, and this is our future we’re talking about. If we actually care about the children we claim to love, we’ll acknowledge the simple arithmetic of what a high dollar does, and we’ll act to mitigate the damage.

Welsh concludes that this is about the future of the next generation of Canadians as well. Resources are finite. Can we truly say that one resource is in demand?

If that resource is not in demand, what will the Canadian economy rely on as a source of prosperity?  Think of it this way: Imagine if you inherited a lot of money. Not taxing it and spending it on consumption would be exactly that … consumption. Once it is gone, it is gone. High taxes used to sustain many new businesses, industry, infrastructure, and education, might someday grow that pile of money. Hence, I call it delayed gratification. Certainly not every business that is started will succeed, and indeed start-ups have a high rate of failure, but some will, making you richer in the long run.

Equally so, it makes no sense to be selling natural resources for export, only to be importing back the products of those natural resources. The value added parts, rather than giving Canadians jobs, gives employment to the nations where the goods were made. The more complex the goods, the more expensive the goods will be, which means that potentially high wage jobs have been lost to Canadians and more importantly, Canada will never have had a chance to build up on the technical know how on how to make those products.

Addressing these concerns is what I consider economic security. Canada should follow in that direction because as Welsh notes, our children depend on this.

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