THE ECONOMY: ASKING THE RIGHT QUESTIONS

Where the economy is likely to go at any point in time is a crucial input into most important decisions an enterprise makes. This is especially the case now as the economy emerges from arguably the worst conditions since the Great Depression. Enterprises that get the economy right are going to be a lot better off than those who don’t.

It is human nature when making decisions to give short shrift to framing the proper questions and leap quickly to forming an opinion. Perhaps this is because a quick opinion is so much more efficient, though one consequence is that subsequent analysis and consideration tends to be heavily biased in favour of just confirming the initial opinion. A key step in making good decisions is always asking the right questions. This article looks at the questions that matter in deciding just how strong or not our economy will be going forward.

First, inflation or deflation? If you could somehow fast forward to 2015 and peek in to a newspaper, a good use of your time would be a look at the inflation rate. If prices are falling, we are probably in a grim, Japanese-style deflation. If prices are moderately rising, the likelihood is that things have settled down and growth, employment and investment are back on track. If inflation is high and rising, it likely means today’s extraordinary monetary and fiscal stimulus overshot in a price explosion, and that we are back to 1970s stagflation, choosing between economy-stifling tight money to bring the inflation rate down or inflation- stoking, easy money to grow the economy.

The inflation or deflation question has gone mainstream. I am a long-time fan of country music, and know that its stars are willing to take on almost any issue. Still, I never remotely expected Merle Hazard’s piece, “Inflation or Deflation?” It is genius to be able to put a complex economic question into lyrics. A few verses make the point:

Inflation or deflation?
Tell me, if you can
Will we be Zimbabwe
Or will we be Japan?

Credit markets came undone
And still are in distress
Will the dollars in my mattress
Buy much more next year or less?

It’s a desperate situation
When you’re at the zero bound
If a tree falls in a forest
Is it making any sound?

New money makes inflation
If folks who have it spend
But if it only sits there,
Then the misery will not end.

Inflation or deflation?
The choice is looking grim
I wonder what John Maynard Keynes would say
If we asked him.

Second, protectionism or open markets? Protectionism has a long history of being associated with downturns that turn into nightmares. The world economy was in serious trouble after the 1929 stock market crash but what took the bad situation and made it infinitely worse were tax increases and especially the U.S. 1930 Smoot Hawley Tariff Act. Smoot Hawley put a high tariff wall around the U.S. and in the process wrecked world trade, as others responded in kind. The race to the bottom was on. With half of one percent of the world’s population and three percent of world trade, Canada is more vulnerable than most to the world going protectionist.

Politicians know the protectionist history well and yet they also know protectionism has the short-term appeal of giving the voters someone to blame at the ballot box. For a politician in deep trouble over the economy, protectionism may not be without personal benefit.

Once again we stand poised on the knife edge of protectionism. The Doha round of trade negotiations that began eight years ago desperately needs to be kick started to a trade liberalizing conclusion. Bilateral actions in restraint of trade abound between countries. The trade rhetoric is very inflammatory as nations trade insults and barbs about who is cheating more.

If emerging protectionism can be put back in the box before the kind of major action that inevitably triggers a “no way back” cycle of retaliation, the economy will be a big beneficiary. If protectionism prevails and accelerates, things may get very tough, and sooner rather than later.

Third, order or disorder? The global economy is beset by imbalances: the huge U.S. current account deficit versus the huge developing-country current account surpluses: horrific federal government spending deficits in developed countries like the U.S., Canada and Japan; the paradox of developing countries funding developed country stimulus programs; sky-high consumption-to-GDP ratios in developed countries like Canada and the U.S. versus sky-high savings to GDP ratios in developing countries like China; a U.S. debt to GDP ratio that is now grudgingly coming down from historic levels but still has a long way to go before deleveraging has run its needed course; staggering developing-country foreign exchange reserves compared to ours, and so many central-bank policy interest rates in the vicinity of zero versus the three percent norm.

The question is not one of knowing if the imbalances can persist indefinitely, because they cannot. Rather, the question is one of trying to know if the inevitable adjustments will be orderly or disorderly.

Nowhere and at no time is this issue more important than when the subject is the U.S. dollar. The dollar must come down against a number of currencies; the Chinese yuan especially must strengthen. It will not be easy, but economies can probably accommodate major but orderly exchange-rate adjustments with modest disruption and pain. If the process is abrupt and disorderly, look out below. There will be no place to hide. The same can be said for the movement of interest rates from historic lows back to normal. All things considered, we should all be cheering for an orderly transition. On everything.

Fourth, whither commodity prices? If commodity prices are heading up, that would imply recovering consumers and recovering economies, which would be good news for all. The link is China and the rest of the developing world that in this scenario would be buying commodities — putting upward pressure on their prices — to turn into finished goods for export. When commodity prices are strong, Canada wins because we are such a big commodity player. If commodity prices don’t hold up, the likelihood is that the U.S., Canada and most everyone else will still be struggling.

Fifth, whither capacity utilization? Capacity utilization is the percent of available production capacity that is actually being used at a given point in time. In the U.S. and Canada, the number is currently very low by historical standards.

If capacity utilization is rising, it means consumers are buying, which in turn will eventually get executives to start investing in plant, equipment, machinery, etc. again. Investment spending has a multiplier effect on economic activity, which makes it highly desirable. If capacity utilization stays stubbornly low, this does not bode well. Sustainable recovery is unlikely without a big jump in capacity utilization.

Sixth, whither interest rate spreads? Convention in lending markets is to make judgements about conditions based on the spreads or differences between borrowing rates on risky securities and borrowing rates on risk-free securities, usually treasury bills guaranteed by high-quality governments. The smaller the spreads, the more comfortable savers are making their funds available to investors. Narrow spreads, and things are getting better; wider spreads, not so much.

Seventh, whither the U.S.? The U.S. accounts for more than 20 percent of world GDP, with the U.S. consumer alone accounting for 18 percent. China is coming on but for the foreseeable future we can say that where the U.S. goes is more or less where most countries will go, certainly Canada. Exports to the U.S. are about a quarter of our GDP. Get the U.S. right and you are a long way toward knowing how things will unfold.

Asking the right questions is a first step to running a good enterprise. On the economy, it comes down to only a few.