Here's a dangerous prediction: dollar will get stronger
JAY BRYAN
The Gazette
As any honest forecaster will tell you, it is dangerous to make predictions, particularly about the future.
This has been doubly true for predictions about the value of the Canadian dollar. As recently as this spring, some economists predicted it was headed for higher ground, when it was actually (as we know in hindsight) strolling blithely toward a cliff.
All this raises an important question for Canadians: what the heck does determine our dollar's value, anyway?
The conventional answer to this question - commodity prices - is rather discouraging, because it suggests that the dollar's slump stems more from the very structure of our resource-oriented economy than from anything that it is within the power of government to fix.
Happily, though, some economists are now leaning toward a different explanation, one that suggests the past few years' spending restraints and deficit-cutting by governments should soon begin to contribute to a stronger dollar and therefore to slightly more prosperity for Canadians.
One of the country's most prominent economists, John McCallum of the Royal Bank, outlined the more pessimistic view six months ago in a widely quoted research study.
McCallum, formerly chairman of McGill University's economics department, concluded that most of the Canadian dollar's drop over the past 25 years - a period that has taken it from $1 U.S. to the current 65.52 cents - could be explained by the drop in world prices of resource-based commodities like lumber, pulp, copper, nickel, gold and aluminum.
Another, smaller, part of the decline was explained by higher inflation in Canada during the 1970s and 1980s, since inflation obviously erodes the value of a currency.
Since commodities accounted for about 40 per cent of Canada's export earnings last year, it certainly makes sense that slumping earnings from such products would hurt the dollar. Ultimately, the dollar's value is set by supply and demand, and exports contribute to demand because exporters convert their foreign earnings into Canadian dollars. Lower earnings mean less demand for dollars.
This commodity-centred view of the dollar's value wasn't universal, however. Economist Michael Walker of the Fraser Institute, a free-marketeering think-tank in Vancouver, put forward the theory that it was big government that explained most of the dollar's change in value.
Going all the way back to 1950, he concluded that differences in the relative size of government spending in Canada and the U.S., once adjusted for short-term interest-rate differences, explained fully 71 per cent of the changes in the Canada-U.S. currency exchange rate. Walker chose 1950 as his base year because that's the last time the size of government relative to the whole economy was about the same in Canada and the U.S.
Walker's logic works this way: more government spending means higher taxes, and higher taxes hurt the economy's ability to grow. When income taxes are high, some talented people who can command high salaries move to the U.S. Others find it more attractive to devise tax-avoidance strategies or simply to toil less than to do productive work. And when taxes reduce the return on capital, some flee to other countries, which also reduces economic output.
So who is right? Is the loony being sunk by the global economic forces that pushed down commodity prices or by government behaviour?
Well, probably both, but the government's behaviour may well be more important. Although McCallum has expressed some reservations about Walker's model, he has also revised his own thinking.
In a paper made public yesterday, McCallum now says that the size of government debt in Canada has played a major part in the loony's long-term decline.
So, while he's been skeptical of the idea that big government is in itself a cause of the dollar's drop, he accepts that if big government is financed by borrowed money, it can indeed harm the currency.
In his latest analysis, McCallum calculates that of the dollar's 34-cent drop since 1973, 10 cents is due to commodity prices, 10 cents to the increasing size of Canada's government debt compared with its U.S. equivalent and 10 cents to the higher inflation in Canada during most of this period. (The remaining 4 cents can be attributed mostly to the fact that McCallum, like a number of other economists, believes markets have overdone their sell-off of the dollar.)
We ran these theories past a third economist, Mark Chandler of Goldman Sachs Canada, who would have earned a place in the forecasters' hall of fame, if there were such a place, by making the contrarian prediction two years ago, in a paper done for the C.D. Howe Research Institute, that the dollar was headed down to 68 cents, not up to heaven.
Chandler thinks that McCallum and Walker are headed in the right general direction, because either big government or big debts would tend to create pressure for Canada to borrow on foreign markets once domestic bond markets are tapped out. It is this accumulated foreign borrowing that directly creates pressure on the dollar.
By last year, for instance, Canada had a $30-billion outflow of interest payments. As all these Canadian dollars were sold to provide foreign borrowers with their home currency, they tended to depress the dollar's value.
Balanced budgets, of course, mean no new foreign debt, and Canada's inflation rate has been better than that of the U.S. for five years, so the prognosis is for improvement. As well, Chandler notes that commodity prices have rebounded about 10 per cent from their low point last month, and the cheap dollar can be expected to stimulate net exports. His current prediction: a 70-cent dollar within 12 months.
montrealgazette.com |
