By Stephen Johnston, director of Omnigence Asset Management
Canada has a stagflation problem. It has for years, and we have been ignoring it.
What is stagflation? Stagflation happens when there is below trend growth and above trend inflation that drives stagnant or declining real GDP per capita.
Why should you care? An extended period of stagflation tends to disproportionately harm the middle class via socioeconomic barbell effects. The phrase socioeconomic barbell describes a structure where there is a pronounced and increasing number of members of society at the ends of the economic spectrum: the high and the low income, combined with a diminishing middle class.
Why does Canada have a stagflation problem? Simply put, Canada has for decades violated the three axioms of per capita growth:
- Capital formation drives growth: Economies that inhibit capital formation have declining standards of living. Economies that prohibit capital formation have poverty.
- Savings drive growth: Savings are the sole source of capital in an economy. Canadians have low savings rates and disproportionately spend savings on consumption goods rather than investing in production goods.
- Investment drives growth: To ensure future prosperity, you must produce and invest more than you consume. Canadians consume much more than they produce or invest.
Canada is the second most indebted developed country in the world, and we borrowed largely to consume rather than invest. Borrowing to consume is simply “stealing’ growth from the future.
Canada also runs persistent current account and fiscal deficits and has persistent investment capital outflows.
Canada has high regulatory barriers to investment, poor labor productivity, our already low capital formation is disproportionately skewed to residential real estate (largely a consumption good, the prices of which are at historic over-valuations and driven by historically high levels of debt), we have a structurally weak currency, energy costs as a percent of GDP are rising – the list go on.
With such a complex set of causes, it follows that the solutions will be equally complex. So, while it would be possible to fill hundreds of pages with complex economic, legislative, policy and tax proposals, at a high level the changes required to begin to address stagflation could be quite simple. Focus on three tools – GST, capital gains tax, and income tax — with these it might be possible to create an environment that increases savings and divert them from consumption goods to production goods.
Step 1: Incentivize Domestic Capital Creation – We should consider 1) increasing GST on consumption goods, and decreasing on production goods, 2) allowing accelerated depreciation on production goods, 3) providing tax credits for investments in new machinery, technology, or infrastructure and 4) reducing income taxes. Savings should now tend to move from consumption into production goods.
Step 2: Retain Domestic Capital – We need to make sure that the savings/capital we divert from consumption are retained in the Canadian economy and invested in Canadian production goods. Unfortunately, Canada has consistent capital outflows. To reverse this trend may require 1) an absolute reduction in capital gains taxes and 2) adjusting capital gains for inflation so that investors are not taxed on nominal gains (particularly if Canada is entering a period of above trend inflation).
Step 3: Attract Foreign Capital – We need to build on Steps 1 and 2 to attract additional non-domestic savings/capital. However, Canada is not perceived as being an investment friendly jurisdiction and such perceptions are difficult to change. We may therefore want to consider targeted, high-profile changes to federal and provincial regulatory frameworks to begin to rebuild confidence and just as importantly signal to foreign capital allocators that such changes are likely to persist over the long-term.
We must be realistic that the road will be long and arduous as we are correcting decades of poor policy decisions. Unfortunately, we do not have the luxury of continuing to ignore Canada’s stagflation problem as Aldous Huxley prophetically observed ‘Facts do not cease to exist because they are ignored.’
If insanity is said to be repeating the same actions over and over and expecting a different result, then while the proposal above might not be the solution, the discussions it would trigger are useful because continuing the status quo Canadian approach is the definition of insanity.
About the author
Stephen is a director of Omnigence Asset Management – a multi-strategy alternative asset manger with almost $1 billion in capital across farmland and private equity. Stephen has a BSc. (Genetics, 1987) and a LLB from the University of Alberta (1990) and an MBA (1994) from the London Business School.
