As Canada is going to be feeling the negative effects of the U.S. recession, and its extraordinary policy response, for some time, Canadian policymakers should be focusing on ways to make our economy more diverse, productive and competitive, argues TD Bank chief economist Don Drummond.

In a speech hosted by the Lawrence National Centre for Policy and Management in Toronto on Monday, Drummond noted that the U.S. influence on Canada will change over the next 10 years. “I argue that the U.S. economic woes will not be restricted to the current recession. There will be recovery, in good part due to the extraordinary monetary and fiscal stimulus. But the root causes of the U.S. trouble, such as inadequate savings, will plague their economy for a long time,” he said.

For now, government spending is bolstering demand, but once recovery takes hold, that stimulus will have to be withdrawn. “At best that will temporarily depress their rate of growth. At worst they will fail at the endeavour,” he said, noting that the U.S. political structure, “with the strong voice it gives to local interests, doesn’t do spending restraint particularly well.” Drummond noted it’s hard to imagine the U.S. cleaning up its balance sheet as effectively as Canada did in the 1990s.

Moreover, he predicts that the U.S. financial sector’s woes will linger for a long time too. “U.S. banks not only need to recapitalize on a gross basis, but they will need to return the public capital injections and essentially replace the “shadow banking” system that has largely disappeared,” he says, adding that the processes of recapitalization, deleveraging and re-intermediation will constrain overall economic growth for a long period.

As the U.S. economy lumbers along at a lower rate, the U.S. dollar is likely to weaken, and interest rates will have to rise. “None of this bodes well for Canada,” he warned. “The modest growth will restrict demand for our goods and services. A trend depreciation of the U.S. dollar may be reflected in a trend appreciation of the Canadian currency. And U.S. bond premiums could spill over to some extent to Canadian premiums.”

In response, Canadian policymakers should try to diversify trade, he counseled. But they must also recognize that the U.S. will remain our biggest trading partner, and, as such, “We must assure the greatest Canadian benefit from whatever U.S. demand there is.”

“That will necessitate effective trading rules and a better flow of goods and services across the border,” he said, adding that the U.S. financial sector weakness could also present an opportunity. “There is no shame in Canada exploiting some of the weaknesses in the U.S. economy,” Drummond stressed. “The Canadian financial services industry could, for example, find opportunities to make major inroads into the U.S. market.”

There are plenty of U.S. banks for sale, he notes, and while they are largely worthless right now, if the government manages to clear some of the toxic assets from bank balance sheets, and the U.S. housing market recovers, they could present an opportunity for Canadian firms.

Additionally, Canada must bolster its own productivity and competitiveness, Drummond said. “A more productive Canadian economy would put us in better shape to compete with the U.S. It would also present a larger potential export market for the U.S. so there could be mutual benefits,” he noted.

To that end, he suggests that policymakers should address high marginal effective tax rates on personal income, make more effective use of under-represented groups in the workforce including recent immigrants and people from the aboriginal communities, ensure equitable access to learning for lower-income families, and rethink our pension systems.

“It is unlikely the U.S. economy is going to give an automatic lift to Canada’s over the foreseeable future. But there are still opportunities for Canada and we must make the arrangements with the U.S. that will maximize those,” he concluded. “Canada must also build upon the recent positive policy moves at all levels of government to build a stronger economy here. That will make us a more formidable competitor. But it will also present a larger market to the U.S.”

IE