FINA Committee Meeting

37th PARLIAMENT, 2nd SESSION

Standing Committee on Finance

EVIDENCE

CONTENTS

Wednesday, October 23, 2002

º

1625

The Chair (Mrs. Sue Barnes (London West, Lib.))

Mr. David Dodge (Governor, Bank of Canada)

º

1630

The Chair

Mr. Charlie Penson (Peace River, Canadian Alliance)

Mr. David Dodge

Mr. Charlie Penson

Mr. David Dodge

Mr. Charlie Penson

º

1635

Mr. David Dodge

Mr. Malcolm Knight (Senior Deputy Governor, Chief Operating Officer and Member of the Board of Directors, Bank of Canada)

Mr. Charlie Penson

º

1640

Mr. David Dodge

The Chair

Mr. Pierre Paquette (Joliette, BQ)

M. David Dodge

º

1645

Mr. Pierre Paquette

Mr. David Dodge

º

1650

Mr. Malcolm Knight

Mr. Pierre Paquette

The Chair

Mr. Roy Cullen (Etobicoke North, Lib.)

Mr. David Dodge

º

1655

Mr. Malcolm Knight

»

1700

Mr. Roy Cullen

The Chair

Mr. Roy Cullen

Mr. David Dodge

»

1705

The Chair

Mr. David Dodge

The Chair

Mr. Scott Brison (Kings—Hants, PC)

Mr. David Dodge

Mr. Scott Brison

»

1710

Mr. David Dodge

Mr. Scott Brison

Mr. David Dodge

Mr. Malcolm Knight

»

1715

The Chair

Mr. Tony Valeri (Stoney Creek, Lib.)

Mr. David Dodge

»

1720

Mr. Tony Valeri

Mr. David Dodge

Mr. Tony Valeri

The Chair

Mr. Bryon Wilfert (Oak Ridges, Lib.)

»

1725

Mr. David Dodge

»

1730

Mr. Bryon Wilfert

Mr. David Dodge

Mr. Bryon Wilfert

The Chair

Mr. Bryon Wilfert

Mr. Malcolm Knight

»

1735

Mr. Bryon Wilfert

Mr. Malcolm Knight

The Chair

Mr. Richard Harris (Prince George—Bulkley Valley, Canadian Alliance)

Mr. David Dodge

»

1740

The Chair

»

1745

Mr. Shawn Murphy (Hillsborough, Lib.)

Mr. David Dodge

»

1750

Mr. Malcolm Knight

The Chair

Mr. Pierre Paquette

»

1755

M. Malcolm Knight

Mr. Pierre Paquette

M. David Dodge

Mr. Pierre Paquette

M. David Dodge

Mr. Pierre Paquette

The Chair

Ms. Maria Minna (Beaches—East York, Lib.)

¼

1800

Mr. David Dodge

¼

1805

Ms. Maria Minna

Mr. David Dodge

The Chair

Mr. Pat Martin (Winnipeg Centre, NDP)

¼

1810

Mr. David Dodge

Mr. Pat Martin

Mr. Malcolm Knight

Mr. Pat Martin

Mr. Malcolm Knight

Mr. Pat Martin

Mr. Malcolm Knight

¼

1815

Mr. Pat Martin

Mr. Malcolm Knight

Mr. Pat Martin

Mr. David Dodge

Mr. Pat Martin

Mr. David Dodge

Mr. Pat Martin

The Chair

Mr. David Dodge

The Chair

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CANADA

Standing Committee on Finance

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NUMBER 004

l

2nd SESSION

l

37th PARLIAMENT

---

EVIDENCE

Wednesday, October 23, 2002

[Recorded by Electronic Apparatus]

º  (1625)  

[English]

    The Chair (Mrs. Sue Barnes (London West, Lib.)): Before I commence with the order of the day, I do want to give an apology on behalf of all the members. Sometimes the House has strange and mysterious ways that are correct in their technicality, but I'm sorry you had to wait this amount of time. We got here as fast as we could after the vote.

    The order of the day is pursuant to Standing Order 108(2), and this is consideration of the Bank of Canada's monetary policy report.

    We are very pleased to have the Governor of the Bank of Canada, Mr. David Dodge, with us today. Accompanying Mr. Dodge is Malcolm Knight.

    Welcome to you both. The floor is yours.

    Mr. David Dodge (Governor, Bank of Canada): Good afternoon, Madam Chair. Thank you very much.

    I'll say a couple of words on the report to start with. Before I do, though, I want to say how much we at the bank appreciate the opportunity to come here twice a year, at the time we release our report. We're very cognizant of the need to ensure that Canadians, through their members of Parliament, know what we're doing and try to understand what we're doing, so this is a very important opportunity for us. So I thank you all for taking the time.

    As you know, we released our monetary policy report this morning, discussing economic and financial trends in the context of Canada's inflation control strategy.

[Translation]

    The Canadian economy has been expanding strongly so far this year and is now operating fairly close to its full production capacity. Consumer price inflation has risen above the 2 per cent target and is expected to rise further before year-end because of high oil prices and a number of other relative price movements. What is important for monetary policy is that these one-off influences on specific prices not feed more generally into price and wage inflation.

    The Canadian economy has grown more rapidly than those of all other G7 countries over the past year. Annualized growth exceeded 5 per cent in the first half of 2002—well above the growth of the economy's potential. We estimate that Canada's economy grew at an annual rate of about 4 per cent in the third quarter. Thus, we have seen a significant reduction in the amount of excess supply in the economy so far this year.

[English]

    As we look ahead, global economic, financial, and geopolitical uncertainties are likely to moderate the rate of Canada's economic growth over the next three quarters, thus growth should come in at the bottom of or even slightly below the 3% to 4% range that we had anticipated in our last update. But bear in mind that the output gap is actually very small. Assuming the uncertainties now clouding the outlook do dissipate in the second half of next year, we expect growth to accelerate to above potential at that time, absorbing the small remaining amount of excess supply.

    The bank's core measure of inflation is running above our earlier projections. This rise reflects sharp increases in home and auto insurance premiums and, in Ontario, electricity prices. Core inflation is also being pushed up by strong demand for housing.

    All told, core inflation is expected to peak at about 3% by the end of the year. But as the one-time influences that I just mentioned fade, core inflation is expected to decline in the second half of 2003, provided those one-time factors do not feed through into wage and price inflation more generally.

    We do have to remember that the Canadian economy is now operating not far from capacity. In order to sustain non-inflationary growth, we'll need to continue to remove monetary stimulus before the excess supply in the economy is completely absorbed. The pace and the extent of that action will depend on the balance of domestic and external developments and on their implications for pressures on capacity and inflation.

    Madam Chair, Malcolm and I would now be very pleased to try to take your questions on any of the issues that are raised here, or on any other economic issues you may care to raise.

º  (1630)  

    The Chair: Before I start of the rounds of questioning, I'll just say that we will go the full two hours and extend this meeting. Hopefully everybody will stay as long as they can so that we can get full questioning in, if people wish.

    We'll start a ten-minute round with Mr. Penson.

    Mr. Charlie Penson (Peace River, Canadian Alliance): Yes, thank you, Madam Chair.

    I'd like to welcome the governor, Mr. Dodge, and Mr. Knight to our committee. I know we got started a little bit late here, but a few things were happening in the House today.

    I welcome your economic update. I do want to ask a question, though. Considering that you're concerned about controlling inflation, and you're at the upper end of the range right now, you must consider a number of factors in regard to what's at core inflation. What about government spending itself; how does that reflect? What score would you give that in terms of whether it's inflationary? I know that the numbers show a roughly 6% to 7% increase in spending this year by the federal government over last year, and roughly 10% the year before. How much does that influence the total inflation rate?

    Mr. David Dodge: It's hard to give a precise answer to that. What is really important is the government balance, because of course it's the additional impetus to demand that comes from government that really affects generally the pressure on the economy. At the moment, at the federal level, the fiscal situation is roughly balanced, with a small surplus. So on balance we're not getting pressures from the federal fiscal situation.

    At the provincial level, you get a bit more of a mix as you go across the country. Provinces like British Columbia, that have the largest deficit, are also the ones where the economy is the weakest as well.

    On balance, then, I think one would have to say that here in Canada, governments, federal and provincial, are not contributing to these pressures. That would not be the same story in the United States.

    Mr. Charlie Penson: I gather, from what you're telling us, that's because they're not out in the market borrowing money to run their operations. Is that what you're saying?

    Mr. David Dodge: No. I mean, that is true, but we're removing demands from Canadian households and Canadian corporations, through their taxes, at about the same rate the government is spending out there and creating demand. So on balance, the governments collectively, and the federal government in particular, are not contributing to putting any additional demand pressures on the economy, nor, in the case where we're running big surpluses, reducing the demand pressures on the economy.

    Mr. Charlie Penson: Mr. Dodge, the American economy is struggling. A lot of people are concerned that some factors, such as business investment, are looking fairly negative these days. In fact, there are probably 40- to 50-year lows in terms of the amount of business investment. Businesses must be looking ahead a bit, judging what their markets are going to be.

    I guess I'm wondering, when we have an economy in Canada that's so closely tied to that of the United States, how long we can be out in front of them. I know we're not out in front a whole lot, but it is a full percentage point in our interest rates. If we're going to be moving that further and they are either staying the same or lowering their rates, isn't that something you have to take into account as well?

º  (1635)  

    Mr. David Dodge: Certainly it is. Demand for Canadian goods and services is made up of domestic demand and foreign demand. Domestic demand has been really quite strong, for reasons we can discuss as the afternoon goes on. U.S. demand has not been as strong, but I think it's quite important to remember why that is.

    First, U.S. households have continued to consume quite strongly, and indeed, they've been consuming lots of things we produce in this country, automobiles for one. For housing, where we supply not just lumber, but all sorts of components, furnishings, and so on, consumer demand, household demand, has indeed remained relatively strong. What has been very weak, as you indicated, has been investment demand in the United States, and it is particularly weak among larger enterprises. Mid-sized and smaller enterprises tended to carry on. There are a lot of reasons for that, and maybe I could turn to my colleague, Mr. Knight, to go through a couple of things there.

    But in sum, before we look at that critical area, it is true that U.S. demand has been a little weaker. It is likely to be a bit weaker than we thought it would be when we were here last spring, and that is in large part the reason we think growth in the Canadian economy will be just a little slower over the next three quarters than we thought it was going be last spring.

    Malcolm, maybe you could talk a little bit about the investment side.

    Mr. Malcolm Knight (Senior Deputy Governor, Chief Operating Officer and Member of the Board of Directors, Bank of Canada): I'll just maybe add a couple of points to what the governor has said.

    First, our central projection for the U.S. is that it will grow at about 2.5% during this year and a little bit above 3% during next year. That's not a bad performance, but as you suggested, it's not a strong enough performance that we would expect the U.S. to be pushing against capacity before late next year. It's really capacity pressures, combined with strong earnings growth, that lead to stronger fixed capital formation.

    At the present time, as the governor said, the main engine of demand growth in the U.S. economy has been demand for consumer durables. Initially, at the beginning of the year, there was a big swing from declining inventories to stabilizing and then to rising inventories, and a small pick-up in machinery and equipment investment.

    For the time being, that's what we see as mainly contributing to the growth rate we're talking about, but as the financial head winds we're seeing in the U.S. economy and the world economy gradually begin to dissipate--and we think they will eventually dissipate--that will bring down the premiums on the interest rates firms have to pay relative to interest rates on government securities. It will reduce the cost of capital. At the same time profitability should be strengthening and we should see an improvement in fixed capital formation. But that's a little way out on the horizon at this point.

    Mr. Charlie Penson: I just have one further question, Madam Chair.

    Considering that the growth in both Canada and the United States has been driven by consumer demand in automobiles, the housing sector, and all those things it takes to furnish a new home when you buy one, there must be some measurement of when that demand has been satisfied. I know there was some pent-up demand, especially in Canada, but because our forestry industry is a big part of this and in the automotive sector 80% of what we produce is exported to the United States, I would expect that somebody is measuring this and making a call on when that demand is going to be finished. It seems to me it can't go on forever. There is a point where people have their new house and that need is filled.

º  (1640)  

    Mr. David Dodge: Let me deal first with Canada. We went through a period from about 1991 through to about 1997 when, in fact, we were not meeting the long-run demand for houses in Canada. And so while 220,000 starts is very high, nevertheless, we can foresee some slight slowing. Indeed, unless there is some slight slowing, there are going to be some real pressures in that market. But we can foresee a number of years of above average, above replacement demand for housing in Canada.

    The United States is very interesting. Here I'm going to rely on the analysis the Federal Reserve has done, because they've spent a lot of time on this particular issue. Their analysis is that there is quite a bit of pent-up demand in the United States, largely because total immigration has been quite high, and a lot of the demand immigrants might have brought was not fulfilled in the late 1980s and early 1990s. So there is quite a strong demand at the bottom end, if you will, for the people getting on to the housing ladder. So they may not believe we're in some sort of a bubble here that is going to collapse. Obviously, at the same time, one has to say that this demand is being facilitated by very low longer-term interest rates in the United States, and if those rates start to move up, that demand would moderate. But it's not a case of somehow evaporating.

    Automobiles would be a different story. I guess we all have trouble thinking that Americans can consume 17 million or 17.5 million automobiles a year, year in and year out.

    The Chair: Thank you very much.

[Translation]

    Mr. Paquette, please, you have ten minutes.

    Mr. Pierre Paquette (Joliette, BQ): Thank you, Madam Chair.

    Thank you for your presentation. I think the picture you are painting is relatively optimistic, because what you are basically saying is that the inflationary pressures we are feeling these days are more situational than structural and that likely by next year, we should find ourselves within the Bank of Canada's target inflation range, between 1 and 3 per cent. So we should not expect to see a substantial interest rate hike in the coming months.

    I would like to know whether this is a valid interpretation of what you said.

    M. David Dodge: What we are seeing now is some relative price adjustment, like insurance prices. However, according to our forecast and those of many economists, by next fall or early 2004, we will definitely reach our economy's full capacity and there will be much more generalized pressure on prices. Therefore, it is important to take controlled steps to reduce the amount of liquidity in the system before that pressure materializes. We do not currently consider inflation to be a real problem, because there are some very unique things going on right now, but it could become a real problem in the future, a problem that will have to be avoided.

º  (1645)  

    Mr. Pierre Paquette: You introduced my second question when you said—and this runs through your entire presentation—that in order to sustain non-inflationary growth, we will need to continue to remove monetary stimulus before the excess supply in the economy is completely absorbed, that is, before we reach our full output potential. However, in your presentation, you did not say anything about the possibility of raising our output potential. Obviously, if our output capacity remains at its current level, it is clear that with growth, we will be using more and more of our capacity and inflationary pressure will emerge. But if we increase our output capacity at the same time as growth is occurring, there will be no such pressure. Rising interest rates discourage investment and thus discourage increases in output capacity, thereby indirectly creating inflationary pressure.

    How do you manage to deal with this kind of dilemma, whereby if inflation is a threat, you are tempted to raise interest rates, which discourages increases in output capacity? This has an undesirable side effect—and I would like you to explain that to us—especially since under the circumstances, it seems to me, in terms of financing through the sale of shares, it will be extremely difficult, in the coming months, to convince Canadians and Quebec savers to massively purchase shares to finance future investments, what with the current state of the stock market. In my opinion, there will probably be more borrowing than in the previous period, with rising stock prices that made everyone want to try their luck on the stock market.

    In your answer, I would like you, by way of background, to also deal with the current problem of the stock market's decline.

    Mr. David Dodge: That is an excellent question, but one that is hard to answer in 25 words or less. I am going to start and then turn the floor over to my colleague.

    First, I want to say, as I said last week in Quebec City, that productivity is crucial to the future of Canadians. There are a number of ways to increase productivity. You can have more machinery and equipment. You can use new equipment and high technology. You can manage companies better. Last, and this is very important, you can increase labour capacity. Most policies that encourage these four factors are not our policies. We need to have an investment-friendly macroeconomic climate, and more importantly in the long run, to maintain a low and stable inflation rate. But that is in the long run, and you are quite right to say that currently, what we call the financial headwinds, which are affecting every part of the world, are discouraging investment and creating a somewhat difficult situation.

    I answered the easiest part of your question. I am now going to turn the floor over to my colleague, because dealing with this rather difficult financial situation is a real problem, not only for us in Canada, but in countries the world over.

º  (1650)  

    Mr. Malcolm Knight: With respect to business investments, as the governor said, the foundation of the economy, given the balanced federal and provincial budgets as well as interest rates that are quite low currently--even though we have increased our key policy rate three times--that constitutes a very solid foundation for the economy. Growth is strong, and what encourages businesses to invest is the margin. They will invest if there is no margin of excess capacity and if there is strong profitability. What we are currently seeing is that in terms of profitability, given that demand is growing strongly, especially in sectors that produce consumer goods and housing, there are investment incentives in those sectors and also in the energy sector. So in Canada, I think we have already seen investments in machinery and equipment pick up slightly, and in the coming months, we will see more fixed capital investment.

    When we talk of financial headwinds, and of financial market volatility, it is true that the recent tumble in share prices affects household wealth. As the governor said, the impact is lesser here than in the United States, because the value of shares held by households relative to their overall assets is some 16%, and that is much lower than in the United States. So if you own a lot of shares, you may be uncomfortable, but for most Canadian households, higher employment and disposable income have been more important.

    Mr. Pierre Paquette: Do I still have a little bit of time left? On this committee, the time is far too short. That is not how it was on the Foreign Affairs Committee.

    Thank you for your answers.

[English]

    The Chair: On the bell.

    Mr. Cullen, ten minutes.

    Mr. Roy Cullen (Etobicoke North, Lib.): Thank you, Madam Chair.

    If you look around the world economy, there are some troubling spots, some that are more obvious, Brazil, Argentina, Japan. A group of us were just in Taiwan, and there's a concern there about underperforming loans, and there are other areas of the Far East as well, and other parts of the world. I wondered if you could give us your current prognosis for these trouble spots--maybe there are others as well--and say whether we should be worried about them, or if the prognosis is good, or better or worse than we might anticipate after reading the newspapers.

    I wondered if you could comment, in respect of the U.S. economy, on the extent of consumer debt--we keep hearing stories about the consumer debt climbing in the United States--and whether that poses any sort of additional risks, or where that's likely to go in the future.

    Mr. David Dodge: Maybe I'll start with the second one, and then I'll turn to my colleague, who will give you a bit of a briefing on world conditions.

    It is absolutely true that particularly in the United States, though in Canada too, the indebtedness of households relative to their annual income is higher than it has been for many years. Indeed, it's probably historically high. It is also true that the ability to service that debt is also quite large, because interest rates are relatively low, in particular mortgage rates. It is important, I think, here.

    If you look at the Canadian numbers, we are really quite low in regard to the fraction of household income that is required to service debt, whether it's mortgage debt or standard consumer debt. In the United States it doesn't appear to be quite as low against historic experience, but in part, that's because what's been happening in the United States is that there has been an increasing fraction of households that own their own homes. So if you just divide the population into two parts, homeowners and non-homeowners, homeowners carry much more debt than non-homeowners, but if you look at the ratio of debt to income of homeowners, it hasn't increased nearly as much as the aggregate, nor has it for the non-homeowners, because there have been shifts from the non-homeowning category to the homeowning.

    All that having been said, it gives you the impression that we have no concerns whatsoever. I don't think you should read that. Clearly, at some point households will slow down the rate at which they're taking on debt, and that will be particularly true of consumer debt, credit card debt, and so on, which is influenced over the business cycle quite sharply as rates go up. So at some point, it is true, that will constrain the growth of consumption, but in the United States, where that's going to come first, that's likely not going to happen until rates move up, and rates will move up as the U.S. approaches its capacity.

    So it's worrisome. It's one where you have an amber light. It's certainly not flashing red, it's certainly not solid green, but in the U.S., I would say, it's something to keep an eye on. In Canada, in fact, saving rates have held up reasonably well. Maybe we're in a situation where the green light and the orange light are both on at the same time, but it's not as serious here as it is south of the border.

    Now we'll come to your other question, an extraordinarily interesting one, and I'm going to turn to Malcolm for that.

º  (1655)  

    Mr. Malcolm Knight: As to the world situation, there are certainly a lot of uncertainties at the present time. Clearly, the geopolitical uncertainties, particularly in the Middle East, are a major factor. The uncertainties and volatility in financial markets are also an important related factor that is affecting the world situation. The IMF, in its most recent world economic outlook, has written down its projection for world output growth for next year. If you look at it, though--and the IMF is not the most optimistic organization--the projection for world growth next year is actually over 3%. So it's fairly close to capacity growth. It's partly a result of the continuing strong performance of the People's Republic of China, but clearly, there are significant risks on the horizon there, and you put your finger on some of the trouble spots.

    In the case of Brazil, we have to see what will happen in the election, but there is a clear plan for what the Brazilian government needs to do to adjust its fiscal position, and we hope that program will continue to be followed by the new administration that comes in. If it is followed, they will get from the international community $6 billion in financing during the remainder of this year and another $24 billion next year, and that should very much help the situation.

    Argentina is obviously in a difficult position, with a moratorium on payments, but the situation has stabilized a little. The peso is around 3.8 to 4 to the dollar. Because they have a current account, an export surplus, and they're not paying on their debt, the foreign exchange market has a little better equilibrium, but clearly, it's going to be very important for them to reach agreement with the IMF on a program that gives confidence to international creditors going forward.

    In Japan the key problem--and we've been reading about it in the newspapers for several weeks--is the resolution of the bad loans. It's a problem that's been around for a decade, but it's hard to see how that economy can get moving more rapidly without a clear plan to resolve it. You pointed that out in the case of Taiwan as well, but even in China, which is doing very well and has begun to address the problem of non-performing loans and public sector restructuring, that will be an issue going forward.

    On the other hand, Russia, with IOL prices, is doing better than was expected, and the rest of Southeast Asia is probably doing a little better than at least we had anticipated at the beginning of the year.

    That's a very broad summary. I don't know if that helps.

»  (1700)  

    Mr. Roy Cullen: That's very helpful. Do I have time for a quick question?

    The Chair: A very short one.

    Mr. Roy Cullen: Thank you.

    I'd like to ask a question about capital markets from a couple of different perspectives. One is this crisis of confidence in the markets and corporate governance. I don't imagine you're here to make recommendations on those aspects, but if you look at the United States, which seems to be a non-interventionist type government, maybe the politics is driving some of the legislative solutions they're looking at. It seems to me that in Canada we need to try to find the right balance. The private sector and the regulators are trying to respond in what I think is a reasonable way, but as to whether it's enough, probably it won't be. There is a delicate balance, it seems to me, where you create so much interference in the markets as well that you kind of overkill the problem. You may want to comment on that.

    Second, if we're going to finance this innovative economy, there have been concerns and challenges in the past about making sure we have risk capital pools that will do that, and there have been a number of fiscal measures to try to encourage that formation. Do you have any ways of tracking that, whether we're doing better or worse, or any ideas that might help the committee in moving that agenda forward?

    Mr. David Dodge: Oh boy.

»  (1705)  

    The Chair: In a short time.

    Mr. David Dodge: Let me start with the first part of it. What is critical to all Canadian enterprise, whether big or small, whether it's at the cutting edge or in a mature industry, is that our capital markets work efficiently and provide enterprise with appropriate credit on appropriate terms. We at the bank in particular, of course, worry about bank credit and fixed type credits; equities are not really our side of the game. But clearly, there's a spectrum here.

    I think you are very right to be worried about this issue from the perspective of efficiency of markets. And I think it is true that fears about the quality of the information provided on the balance sheets and income statements of firms makes it much more difficult for capital markets to operate efficiently. Hence it's very important to take steps to restore that trust in the numbers firms report on. The principles of the Sarbanes-Oxley bill in the United States are ones to which we would fully subscribe. The trick is how you actually ensure that those principles are appropriately implemented, and that is really the debate that is going on and will have to continue.

    I would just remind members of your committee that we face a bit of a problem here. I think, on balance, we in this country would be a bit more favourable to the International Accounting Standards, which are much more principles-based and somewhat less regulations-based, than we would to FASB and the U.S. approach. But we do have to remember that our firms need to have access to world capital markets, and the one that's most important to us is New York. So even though we may not be totally comfortable with the precise way the Americans are moving, we do have to remember that access to that market remains important, so it certainly should influence how we deal with the issue.

    The Chair: Thank you.

    We'll go to Mr. Brison, followed by Mr. Valeri, then Mr. Wilfert.

    Mr. Scott Brison (Kings—Hants, PC): Thank you.

    First, U.S. foreign debt at last quarter was a quarter of GDP and the current account deficit 5% of GDP. I think that's the highest level since the Civil War. There are predictions that you'll see the U.S. dollar weaken significantly. We've been hearing that for some time, but it hasn't really happened so significantly that we'd really consider it. Do you think the U.S. dollar will fall in an orderly or a chaotic fashion, and what do you think the impact of that would be on the Canadian exchange? The World Bank is now predicting a 70¢ Canadian dollar by the end of the year, the Conference Board is predicting further weakening. There does seem to be a lack of connection. Even when the U.S. dollar goes down, the Canadian dollar doesn't seem to be gaining anything in turn now. I'm wondering why you see that.

    Mr. David Dodge: We see a very large current account imbalance in the United States, so how does that get corrected? We hope it gets corrected in a relatively smooth manner. There is no reason that cannot happen. There is a risk, obviously, and the risk rises over time that the correction, when it comes, will be rather abrupt and disruptive. To the extent that markets function appropriately--and it goes back to the previous issue--as we see some recovery in Europe, as we see Japan begin to get its act together, as some of the uncertainties in South America perhaps are reduced, then what we could see is demand elsewhere, so opportunities elsewhere look better, and we will begin to get the correction. Part of that correction will be a U.S. dollar that, relative to other currencies, will depreciate a little bit. That's part of the mechanism for the correction to take place. As part of that, because the U.S. runs a considerable current account deficit with Canada, we would expect the U.S. dollar also to depreciate against the Canadian dollar. How fast, when, that I can't tell you.

    Mr. Scott Brison: We have Canadian capital markets that have been, you can't say performing well, but performing less badly than the U.S. capital markets. The Canadian economy, in a general sense, is doing better than the U.S. Yet the Canadian dollar is only a tiny bit higher than it was at the record low. So why is there this lack of connection between the Canadian economy and Canadian capital markets relative to the U.S. and the performance of the Canadian dollar relative to the U.S.? Some would argue that the Canadian dollar is what they consider a marginal currency, that during these times a currency, whether it's the euro or the U.S. dollar, benefits from these uncertainties. What does that say about the future of the Canadian dollar?

»  (1710)  

    Mr. David Dodge: There are several issues embedded here, and I'm not sure I can tackle them all in the complexity and detail they warrant.

    First, an exchange market is a market like anything else. A price is getting set daily that equilibrates, more or less, the capital flows and the current account flows. That's what it is doing, and the market clears, and we don't interfere in that market with capital controls and we don't intervene in that market. What we have observed historically is that financial institutions and investors do carry large positions, and as the currency started to move away from what they thought might be normal, they would kick in, and that tended to stabilize. What we've observed in currency markets, and indeed we observed it in fixed income markets as well and the stock markets, is that there is a tremendous amount of risk aversion out there, so investors, banks, and so on are not stepping in to take those positions, and we are getting much more day-to-day volatility in currency markets, and indeed in all financial markets, at the moment. That will correct itself a bit over time.

    So right now day-to-day flows are dominating. We can thus expect, I think, some greater volatility in the near term than we might have seen historically.

    Mr. Scott Brison: But again, when our economy is performing better and the capital markets are doing less badly, but the dollar still doesn't reflect it, doesn't that bode negatively for the future of the Canadian dollar? When good news is not reflected and we see a continuing ambivalence to the Canadian dollar in the markets, isn't that a negative sign about the sustainability of the Canadian dollar?

    Mr. David Dodge: I don't think so. The market is doing what it's supposed to do, it's equilibrating the flows, but positions are not being taken in the same way going forward. You have to remember that we have a situation in this country where--and it goes back to an earlier question--Canadians are continuing to save, where national savings are indeed meeting the demand, if you will, for national investment. We're not having to rely on foreigners to finance that investment net to the same extent that the Americans are. Given that the American currency has been relatively strong, going back to your first observation, there hasn't been all that much correction yet in the U.S. current account position.

    Mr. Malcolm Knight: Because it's a very important question, could I just add one point? What we ultimately want to get is strong non-inflationary growth of real per capita GDP in Canada. If you look at the period from 1997 to the end of last year, with the revision in U.S. GDP numbers, we've actually had a little stronger growth in real GDP per capita in Canada over that period as a whole than has occurred in the United States. Those gains in income come partly from a slower rise in prices relative to the wages people earn and partly from changes in the exchange rate. But the exchange rate, as the governor said, is also responding to many other factors.

    Over time it is likely that a 5% of GDP current account deficit is large enough that it can't be sustained at the current exchange rate for the United States relative to other currencies, but exactly how that process of adjustment will occur is going to depend on a large number of factors. One of the factors that has been important in the United States in recent years and continues is that the United States has had a very high rate of growth in labour productivity. That improves profitability, induces investment, and induces funds from abroad to move in there. We are seeing now a certain strengthening of our productivity growth, and that should bode well for the Canadian dollar relative to other currencies in the future.

»  (1715)  

    The Chair: Thank you.

    We'll go now to Mr. Valeri for 10 minutes.

    Mr. Tony Valeri (Stoney Creek, Lib.): Thank you.

    Thank you both for coming this afternoon. I think you're bringing some very valid points forward to the committee, and I think it will certainly help us in our thinking as we continue our pre-budget consultation and framing our document.

    I can't resist bringing up the issue of the north-south flows of investment and trade in goods and services and reflect upon the Conference Board of Canada's Canada 2010 document, which points out that increasing North American integration will continue to be a reality for Canada--at least that's what the Conference Board is saying--and that the biggest risk we face, in fact, is just letting it evolve and not doing some thinking well in advance and doing some planning. The Conference Board seems to suggest that minimizing those trade barriers is critical and that further trade liberalization is an important aspect for Canada to think about, including perhaps going to a North American customs union, or at least having that discussion. I'm not suggesting here today we go one way or the other, but I would like to hear your thoughts.

    The goal the Conference Board lays out is one of helping to reduce the risk of investment being redirected out of Canada and into the U.S. or Mexico, arguing that it's the investment flows that are impacting the value of the dollar more than barriers to trade or commodity prices. I'm wondering if you can comment on that, agree or disagree, and perhaps make some suggestions along those lines as to what it is we should be doing or thinking about as this debate continues.

    Mr. David Dodge: Yes, this is an extraordinarily important issue. For many years I have argued the importance of opening Canada's borders and prying open the borders of other countries, and I'm not going to try to answer the whole question. I think the Conference Board has raised some important issues, although there are some things in that report that struck me as being not exactly right. But there is a significant border risk remaining.

    We entered into NAFTA in good faith. We in Canada have had a policy in continuing to open our borders, not just within North America but around the world. That stands us in good stead. But we continue to face a risk in the U.S. Congress, in the U.S. administration, that they will use their anti-dump laws and their countervail laws and move with various restrictions when competition gets very strong for their industries. So I think it is absolutely correct, as you suggest, that we should be taking steps to try to reduce that potential of adverse action, and as we reduce that potential of adverse action, then we don't have a border risk as to whether a plant gets put in Canada or in the United States and we're competing, if you will, on a level playing field.

    But, yes, we should definitely strive to continue to reduce that border risk.

»  (1720)  

    Mr. Tony Valeri: If in fact, as the discussion continues, there is consideration of adoption of policies of deeper integration, could you comment on how the decision to do that would affect whether we keep Canada's floating exchange rate or not? Please comment on that and some of the pitfalls or some of the considerations we should think about as we consider adopting this type of policy.

    Mr. David Dodge: I actually gave a speech on this in Sherbrooke a couple of weeks ago, and I'd be very happy to send it to you.

    First, if we're going to reduce the risk of our producers being shut out, we have to negotiate a tighter arrangement to avoid these capricious actions that Congress might take. We also will have to open our borders more fully for the goods and services where we're not totally open yet. We should do that and we should continue to do that. We should continue to reduce the impediments that we have for trading between provinces, because we still haven't gotten rid of all our own internal impediments. That is extraordinarily important. In some sense that's issue number one.

    With regard to further integration, there's one market we really haven't tackled at all, and that is the labour market. For highly skilled professionals, mobility is a little expensive, but it's not too difficult. For most people, moving back and forth across the border to work is not such an easy proposition. Indeed, we know that real difficulties can arise from time to time, because the structure of our economy is different from the structure of the U.S. economy. Real difficulties can arise from time to time when we have big surpluses of labour or when we have a shortage of skills. So if one is thinking through the logical progression, we would want to move to open that.

    At that point, when you have mobility in all markets--we now have quite good mobility in capital markets--you then would logically come to address the issue of whether it would still make sense to have our own currency and a floating exchange rate, or whether one proceeds to some form of common currency. Logically, though, that comes after you create a true single market for goods and services, a true single market for capital, and a true single market for labour.

    Mr. Tony Valeri: Okay.

    Thank you, Madam Chair.

    The Chair: You still have two minutes.

    Mr. Tony Valeri: That's fine.

    The Chair: Mr. Wilfert, do you want to start your ten-minute round?

    Mr. Bryon Wilfert (Oak Ridges, Lib.): Yes, thank you, Madam Chair. I apologize, because I have to make this fairly short; I have a bill that's just come back into the House.

    Through you, Madam Chair, I thank the governor for being here today. I am going to take a different tack from the one taken by my friend here. It's the same issue but a different approach.

    Mr. Tony Valeri: That's why I thought I'd give you the two extra minutes.

    Mr. Bryon Wilfert: Nice segue.

    But before I get into that--I don't share his enthusiasm--let me ask you a couple of questions.

    Both the IMF and the OECD forecast that Canada will lead all other G-7 nations in economic growth this year and next. Given what we see currently and what may be on the rise, what factors should we be particularly watchful of that may have an impact on these very positive predictions by both the OECD and the IMF?

    Second, the OECD's 2002 publication indicates some significant improvements in the competitiveness of Canada's tax system as measured by the level of total taxes as a percentage of GDP. And in 2000, the Canada-U.S. tax burden gap was narrower than it had been in many years. Perhaps you can comment on the importance of continuing this direction in order to promote and encourage business investment in Canada. Obviously, the issues of productivity and competitiveness come to mind.

    Finally, I have a great deal of concern about the level of foreign ownership in this country, particularly, because of the weaker Canadian dollar, the number of companies in some key sectors that are being bought out. I am increasingly concerned personally about where that is taking this country in terms of our lack of ability to control the economic levers in this country. Economic integration, in my view, ultimately has led to political integration, historically.

    I'm concerned about the NAFTA tribunals and WTO rulings, etc. While we seem to be following the rules, others are not, including the United States, with increasing protectionist activities. Then there's the fear of a common currency. If we go in this direction, in my view we might as well pack up shop. So I am concerned about the level of foreign ownership and the implications of it, both in terms of the bank's ability to conduct economic policy and direction in terms of monetary policy in Canada and this government's ability to in fact do the things that Canadians need in order to compete internationally. That doesn't mean we couldn't compete internationally if we had a level playing field, which I don't believe we have. But that's a personal observation.

    So if you could tackle those three questions in probably five minutes or less, you'll be doing well.

»  (1725)  

    Mr. David Dodge: I'll leave the first question to my colleague and I'll try, in 25 words or less, to deal with the second two.

    What is really important is that over this decade, the governments, federal and provincial, maintain a fiscal balance or run a slight surplus so that by the time we get to the end of the decade, we've reduced the level of public debt in relation to GDP really quite significantly. In so doing, what we've reduced is the burden of interest payments as we go forward into the future, which ought to enable us, again in both levels of government, to deal with the pressures that will come as the baby boom generation, if you will, moves through.

    So it's very important for a long-term social policy, it's very important for structural reasons, and it's very important for the reasons that were raised earlier--to provide a climate that is encouraging to investment.

    Precisely what level of taxes and expenditures you want to operate at is up to you, not us. That is for parliaments and legislatures to decide, not me. But I would encourage that there be a balance.

    Second, with respect to taxation, I think it is very important that we consider efficiency aspects of taxation as well as distributive aspects. And that is difficult, because sometimes they are somewhat in conflict, but if we're going to get high growth, we have to ensure that we carry out our public finances with maximum efficiency at whatever level of expenditures and taxes parliaments decide to deal with.

    On the foreign ownership question, this is a really interesting issue. Actually, it's an issue that we at the bank are starting to do a little work on in conjunction with others, with private academic researchers and researchers in corporations. In The Economist, the analysis would say it doesn't matter who owns it; what matters is how efficiently the firms perform. Basically, the evidence is that the performance of multinationals domestically in Canada has been as good or better than the performance of domestically owned firms.

    On the other hand, you're absolutely correct that if you talk to people, they will say, no, head offices are really important, because it's only when you have head offices that you have all the other industries that go with head offices--the accounting profession, the legal profession, the financial professions, and so on. And these are highly productive people who contribute to income growth.

    The long and short of it is, evidence in this area is extraordinarily weak and hard to come by. Right now we are trying to see if we can't get some hard evidence on this. You can pick circumstances where you've had tremendous growth with very high degrees of foreign ownership--Ireland is a good example--but you can pick other circumstances where head offices really have been quite important as engines of growth. You can find examples to support whatever side you want elsewhere in the world. We're in a bit of a unique situation in that we sit next to the country with the largest proportion of large multinational head offices, and we are really trying to work very hard at this issue.

»  (1730)  

    So I won't give you an answer, because I can't. The evidence is not there to provide an answer either way. I would simply note, however, that in terms of foreign direct investment, there's been roughly a balance over the last three or four years in terms of Canadians acquiring companies and assets in the United States and Americans acquiring companies and assets in Canada. There has been that balance. What really matters here, then, is not just the head office issue but also whether head offices of big firms are more important than head offices of small firms collectively. And I can't give you the answer to that, but it's a very interesting question that we're looking into.

    Mr. Bryon Wilfert: Governor, I just want to say that I'm encouraged that you're looking at it, but I would say that the issues of decision-making are extremely important for jobs. I'm also concerned about the fact there may be a balance, but in terms of the scale, we are obviously... And if there are decisions by a government in fact to loosen or remove certain controls on foreign ownership in certain sectors, we will, in my view, be much more vulnerable than we already are.

    Mr. David Dodge: That may be true. All I'm saying is that we just don't have any evidence.

    Mr. Bryon Wilfert: That may be for another day.

    I guess very quickly, Madam Chair, Mr. Knight can perhaps respond to the first question.

    The Chair: A very short answer, Mr. Knight.

    Mr. Bryon Wilfert: Thank you, and then I'll run.

    Mr. Malcolm Knight: I'll try to be as brief as I can.

    First, to go over the facts on growth this year, definitely we're going to be at the top in the G-7, with growth of 3.5%. The U.S., which is next, is going to be in the order of 2.5%. That's pretty much in the bag, because it's late in the year.

    But for next year, part of the reason that the OECD and the IMF are giving these projections is that their projections for the U.S. seem a little pessimistic to us. The IMF thinks the U.S. is going to grow--year on year--at 2.6% in 2003. If that were true it would be opening up a gap of excess capacity. That's below the consensus forecast, and I think it's a little bit pessimistic. In fact, we think that both Canada and the United States can grow during 2003 in the region of around 3%, which is very good performance.

    The second thing I will say is that one of the wonderful things about being a central banker is that whether times are good or bad, you always have things to worry about.

»  (1735)  

    Mr. Bryon Wilfert: That's not too different from being a politician.

    Mr. Malcolm Knight: I know.

    You asked about the risks. Clearly, on the downside, the risks for the Canadian economy really come from concerns about downside risks in the rest of the world and from the uncertainties that are hanging over the world economy. But those risks are there right now, and currently the Canadian economy is performing very well in the face of them.

    On the other side, there is the risk that since we have very strong growth, even though we expect it to slow, we have very little excess capacity in the economy. We don't think recent price movements are a reflection of increased inflationary pressures except in a few sectors, such as construction, but as growth continues strongly, that could create inflationary pressures. Because it takes time for our policy actions to impact on the economy, we may have to act in order to keep inflation at our target range of 2% going out there a year and a half to two years from now.

    So those are the risks we're looking at, and they're on both sides.

    The Chair: Thank you very much.

    We've completed round one. We'll go to five-minute rounds.

    Go ahead.

    Mr. Richard Harris (Prince George—Bulkley Valley, Canadian Alliance): I'm sure we'd all agree that worrying about things in good times is much more fun than in bad times.

    Governor Dodge, Mr. Knight, I appreciate your comments today.

    I wonder if I could just question you a little bit about the productivity deficit that exists between us and the United States. About a year ago, I think we were talking about around 30%. As a matter of fact, this committee produced a report a couple of years ago. Our mandate was to suggest ways in which the government could increase productivity in this country. To date, two years later, I don't believe we've seen a measurable increase in our productivity.

    I want to ask you a question concerning the difference between our dollars. What impact does this productivity deficit have on the value of our dollar against the U.S. dollar? That's the first question.

    Secondly, there have been some suggestions that things have been put in place to encourage the dollar to stay low not only to simply make us more competitive in the U.S. market for our manufactured goods and our natural resource products, but also to offset this productivity deficit and, as a result of that, of course, sell Canada and our goods and services at a discount through that encouraged low dollar.

    I wonder if you could maybe just comment on those statements and the suggestions that have been made by others.

    Mr. David Dodge: Sure. Let me start with the facts, though, because that's always helpful.

    If we take the last four years, 1997 to 2001, the actual measured labour productivity growth in Canada has been 2% per annum, and in the United States 2.3%. In fact, there has been relatively little difference over that most recent period. That's quite different from the early part of the 1990s, when, as we discussed earlier, we were taking a lot of actions in this country to correct problems that had hung over from the 1980s, indeed, going away back to the 1970s.

    If we take the first half of this year, we've had surprisingly strong productivity growth, around 3% per annum, and the U.S. had a little more than 4%. These are extraordinary numbers, and let me caution you, they will change seven times before the statisticians finalize them about seven years from now. You have to be really careful with these numbers. This is the hardest thing to really tease out from the data.

    It is absolutely true, however, that during the early part of the 1990s, as we strove to correct our fiscal situation, as we struggled to get inflation under control, and as we adjusted to freer trade, we certainly didn't do as well as the United States did.

    Our expectation is that as we move forward over the next five or six years we probably should do a little bit better than the United States. That's not saying it's in the bag; we have to work at it, but we aren't going to be carrying these difficult adjustments that we've had to make, and indeed, we'll be starting to get a payback from those adjustments.

    As we look around the country, I find the restructuring of mid-sized business, in particular, that is going on in order to take advantage of opportunities incredibly encouraging. As labour markets tighten up, as we absorb some of that excess labour that got thrown off as we made those adjustments in the early part of the 1990s, also that ought to contribute to higher productivity growth in this country.

    So I am not pessimistic. That doesn't mean we don't have to work hard, very hard, at it--you as parliamentarians and all of us as managers of private enterprises or public enterprises--to ensure that we are doing what we can to take advantage of the new technologies so we really do get productivity gains and so that Canadians get the benefit of higher real incomes that come from this. I wouldn't say one ought to be discouraged and throw one's hands up. Indeed, it would have been extraordinarily surprising, given the macroeconomic adjustments and the adjustments to trade that had to go on in the early part of the 1990s--it would have been terribly surprising--if we had done as well on the productivity front as the Americans did.

    So I'm not saying relax, but I'm also relatively optimistic that there are real opportunities there to be had, and my expectation is that we will do a little bit better, relatively speaking, over the course of this decade.

»  (1740)  

    Then there's your issue on the dollar. I go back to my earlier answer to Mr. Brison's question. The dollar is an equilibrating mechanism. We were borrowing like mad in the early part of the 1990s from all over the world. We had a current account deficit of roughly 4% of GDP. We now have a current account surplus of 1% to 2% of GDP. We had a tremendous movement as we made those adjustments.

    The exchange rates were part of what was facilitating those adjustments. That's why, I think, you see an organization like the Royal Bank, looking at these medium-term factors that influence exchange rates, saying that the likelihood is that the Canadian dollar will appreciate over the medium term relative to the U.S. dollar, given these changes in flows that are taking place. There's not a mystery thing here; a price does what it's supposed to do in making adjustments. That happens to be one more price in the economy.

    The Chair: Thank you very much.

    I remind everybody these are five-minute rounds.

    Mr. Murphy, go ahead, please.

»  (1745)  

    Mr. Shawn Murphy (Hillsborough, Lib.): Thank you, Madam Chairperson.

    Thank you, Governor Dodge, for being here today.

    I want to pursue an issue regarding the decrease in our capital markets in Canada and how that may be affecting our economy. The first issue is this so-called wealth effect that's out there with the decrease in our capital markets. I take it from the statistics on consumer confidence that this does really not have an effect, or perhaps there isn't such a thing as a wealth effect out there. I'd like your comments on that.

    Equally, if the stock markets go up and the decrease in the wealth effect reverses itself, will that have a stimulus effect in our economy through consumer confidence, and of course disposable income? Tied in with that, do you see any concern with pension plans having a deficit? Is that a risk you see out there because of the decreased returns in our public and private pension plans?

    Also tied in with that, as far as I'm aware, this is the first time we've ever seen a total disconnect between economic growth and our capital markets. I'm not aware of any other situation like that. We have a fairly robust economic growth and our capital markets are decreasing. If you look at other periods in history where the capital markets have gone through quite a slide, which we haven't experienced lately, you see negative economic growth in most instances. Could you comment about what you see happening?

    Anyway, if you could comment on those three issues, I'd appreciate it.

    Mr. David Dodge: I'll try. I'm going to turn to my colleague to talk about the wealth effect on households. I would like to deal with the issue, though, because it has come up several times. It came up in Mr. Paquette's question and it came up earlier in Mr. Penson's question.

    At the present time, one finds very different conditions in different parts of the credit market. Small and medium-sized business at the moment really have very good access to credit, given the fact that there's a lot of uncertainty generally out there. If you compare 2001-02 to 1991-92 or 1981-82, what you see is a credit market that is really functioning very well for mid-sized and smaller businesses outside of the riskiest high technology sectors. But generally those credit conditions are quite good.

    On the other hand, for larger businesses we've never seen the spreads in borrowing rates differ as much as they do at the moment between, let's say, double A rated firms and single B rated firms. I mean, the spreads are huge and they have a number of fallen angels, so that a number of large firms at the moment are facing extraordinarily high interest rates and their ability to invest is indeed quite low, while those that have been perhaps a little more prudent in their operation and preserved their credit rating have a lot of access to credit.

    So we have something that we've not really seen in credit markets very often. Indeed, I think it's true, Malcolm, that the spreads through our corporate borrowing between high investment rated and single B or double B firms are the widest they've been since the 1930s.

    So that is one set of issues. Equity markets act similarly. If we look at the averages, the averages mask huge differences. Some firms have gone from very high valuations to zero over this period, and those clearly affect the averages. When you take something like Nortel, which I guess was very close to 30% of the TSX--it has gone from $120 at its peak to $1--you have a tremendous effect on the average.

    So it is a very mixed situation out there, and of course, because the rates we affect are low and high rates for banks, so they're the low risk at the very shortest end, we have to be very careful that we don't have so much liquidity in that part of the market that it ends up spilling way over and creating real problems going forward. That's why we are going to continue to remove liquidity from that in a timely and measured fashion and before we get to the point where the economy is overheated.

    Now let me turn to Malcolm to talk about the wealth effect. Not being very wealthy, I can't talk about that.

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    Mr. Malcolm Knight: It's certainly true that if you have a household that has been holding equities, as the governor said, there has been a very significant depreciation in equity wealth, and that is continuing even this year. The TSX, even with the gains of the last few weeks, is still some 18% below what it was at the beginning of January.

    When we look at this from the point of view of monetary policy, though, we have to look at all the influences that affect consumption. Two of them that are really important are disposable income growth, which has been very strong in Canada, because of strong employment gains, and interest rates. The low interest rates that came about in 2001 because of a weakness in the economy and the huge uncertainties after September 11 have very much stimulated consumption of consumers' durables, and also a lot of purchases of items related to home ownership.

    Now you come to the wealth effects, and clearly, in the case of equity wealth that has been a negative factor on consumption. But on the other side, household wealth in Canada also depends on ownership of houses and what happens to the value of the housing stock. In Canada the proportion of household wealth that is in housing relative to equities is higher than it is in the United States.

    It's very hard to say how these wealth effects will have an impact, quite frankly. That's one of the things we're going to be looking at very closely, overcoming this. We expect the growth of consumption spending to slow, that's part of our central forecast, but how it slows will depend on how these wealth effects play out, and it's not well known exactly how they work.

[Translation]

    The Chair: Mr. Paquette.

    Mr. Pierre Paquette: Thank you, Madam Chair.

    I have two short questions. First, you said that inflation, in the short run, would not be a real problem, but that it might be by 2004. You also talked about your expectations for the next five or six years.

    I would like to know whether the Bank of Canada conducts studies over periods longer than two or three years, taking into account, or attempting to take into account, structural changes. I am thinking, for example, of the Kyoto Protocol, which may affect not only the behaviour of prices, but also monetary policy.

    Have you, for example, done longer term studies on the aging population, which could entail changes in consumer behaviour, given that consumption patterns vary with age? Clearly, the population structure may affect the behaviour of prices, and thus monetary policy too.

    So I would like to know whether you conduct studies over five- to ten-years periods, perhaps even longer.

»  (1755)  

    M. Malcolm Knight: That is a very, very important question. But a very hard one too. First of all, we have to bear in mind that climate change will have very significant effects on the economy in the long run. So that is something that must be taken into account in the long run.

    With respect to the consequences of the Kyoto Protocol, definitely, if there is an impact on various prices, the price of energy relative to other goods and services, we, at the Bank, will have to take that into account, because we have an inflation rate target that we have to meet over the medium and long term. But for the time being, it is very hard to try to analyze the potential impact of policies that will be adopted to meet Kyoto commitments. That is a longer-term period than the monetary policy horizon.

    When the policies and process for meeting Kyoto commitments become a bit clearer, we will include them in our analyses.

    Mr. Pierre Paquette: I have one last question for Mr. Dodge. I remember when you were deputy minister, you opposed the termination of tax treaties with tax havens like Barbados and Bermuda. I would like to know, now that you are Governor of the Bank of Canada, knowing that 35 billion dollars leaves Canada for these tax havens, whether you have changed your position on this issue.

    M. David Dodge: I think the best thing to do would be to ask the new Deputy Minister of Finance that question.

    Mr. Pierre Paquette: So as Governor of the Bank of Canada, you have no position. That is my understanding.

    M. David Dodge: What is extremely important is that taxes not interrupt effective investment and the smooth flow of capital. There have always been such problems, and we are continuing, with the OECD and other countries, to find ways of avoiding these problems. Now even the Americans, perhaps for other reasons, are interested in dealing with this problem.

    Mr. Pierre Paquette: Surely it is because of money laundering. Apparently one fifth of the money in tax havens is laundered money.

    Thank you very much for your answers.

[English]

    The Chair: Thank you.

    Madam Minna.

    Ms. Maria Minna (Beaches—East York, Lib.): Thank you, Madam Chair.

    One area that has been of interest to me for some time is this. I know that in the U.S., for instance, they have a policy of full employment, which is defined, I think, at about 4% or 3% unemployment. I'm not sure what their unemployment rate is at the moment. In this country unemployment is somewhere around 7%, and there have been interest increases twice now this year. The economy in the U.S. is on the downturn, so somehow I don't see the positive nature of increasing interest rates and how that would affect our unemployment situation.

    My question to you concerns what our policy is. Does the Bank of Canada use the concept of the non-accelerating inflation rate of unemployment, which, as you know, refers to the theory that the unemployment rate can be pushed down only so far before inflation starts to rise, in its conduct of monetary policies? Has your nearer estimate changed much over time, and what is it? I go back to the experiences we had in the 1990s, when interest rates kept rising and unemployment just.... I've listened to many arguments from other colleagues with respect to the fact that as soon as we get to a certain level of inflation, we hike interest rates, and that increases unemployment as well, because it's investment and so on.

¼  (1800)  

    Mr. David Dodge: We certainly have a concept of capacity, and that's capacity from both the labour side and the machinery and equipment side. It is absolutely true that as we look forward, we try to judge just how close to capacity we are or will be and try to adjust rates to have inflation neither go way up or go way down because we're not at full capacity. So the answer is that we do certainly have a concept of capacity, and it does include the labour side.

    I'm sure there is much more to capacity on the labour side than simply thinking about unemployment rates in the way we have thought about them. Levels of employment or employment rates really tell us quite a bit. During the early part of the 1990s unemployment rose, but not as much as it otherwise would have, because the labour force participation rate dropped. What we've seen this last year is much stronger employment growth, almost record employment growth. Labour force participation rates have started to rise and are almost back up to where they were in 1989. That's part of the reason we on the governing council of the bank have said we think probably there's a little more room to manoeuvre before we hit capacity than the straight econometric estimates we have would say. So we certainly look at that.

    It is also true that labour capacity can be improved if labour markets themselves work better and if individuals can move from one job to another more smoothly, move more smoothly from an area that is contracting to one that is expanding. So we also put quite strong emphasis on policies that encourage labour market flexibility, including both formal training and the on-the-job training that has to be done at the level of the firm or enterprise. Obviously, the better the job we do removing impediments in the labour market, the lower one can push unemployment rates before one hits capacity. The Americans, while they certainly don't do all things right, have been more successful, I think, than almost any other country in ensuring flexible labour markets. American enterprise, for all that we may castigate it for some things, has done better than Canadian enterprise in providing on-the-job training, upgrading, and so on.

    So the answer is that we do have a notion of capacity. That notion changes over time. It certainly is influenced by both public policy and policies of firms, and it is influenced by social and structural changes and so on that have an impact on participation rates. It's quite complicated, and boiling it down to a relatively simple number produced by Statistics Canada every month is not terribly helpful.

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    Ms. Maria Minna: Thank you. I just wanted to understand. I know it's not an easy concept. I have just one final comment. I agree with you entirely with respect to the fact that our companies have not done as well as they could in training and retraining their labour force. I think we, as a nation, also have to do a lot more, even beyond what the companies would do. That's an area of labour management, labour retraining, upgrading, and so on. I think it is important.

    If we were, as a country, to set up a policy of full employment, and say we considered that to be as low as 4%, certainly not any higher than 5%, what would we need to do, apart from the flexibility of the labour force and so on? What kinds of indicators would we need to have in place to ensure that inflation didn't also...? Because that's an important....

    Mr. David Dodge: There's no single policy that's going to get you there. You know it as well as anybody. We need policies to facilitate labour mobility across space, policies to facilitate mobility across skills, because we do have problems in that regard, policies that will facilitate the entry of people into the labour force, polices that will encourage continuing upgrading of skills, both on the part of the individual and on the part of the corporation. There's a wide range of things. The better we do in that regard, the lower the rate of unemployment compared with what you would have before you get the capacity. But I really do sound a caution. It also depends a lot on what is going on in the world. If there's a lot of structural change going on or it hits certain industries particularly hard, for periods of time one's bound to have somewhat higher rates of unemployment than if everything is functioning smoothly.

    Ms. Maria Minna: Thank you very much.

    The Chair: Our last questioner of the evening is Mr. Martin.

    Mr. Pat Martin (Winnipeg Centre, NDP): Thank you, Madam Chair. I'm sorry to have been late. I was giving a speech in the House and couldn't get away, but I do appreciate the opportunity.

    Mr. Dodge, I heard you speak at the Canadian Labour Congress executive council meeting; I think it was in January of this year. You were asked about many of the issues Ms. Minna just asked you about in respect of NAIRU as a concept and what full employment is by your definition. As Ms. Minna just told us, in the United States there's a stated policy goal of full employment. That really means maybe 3% or 4%, as there are always some people who cannot or will not be in the workforce. We've been worried--when I say “we”, I'm with the NDP caucus--and I know other colleagues in the labour movement have been worried that the NAIRU rate that seems to have been guiding policy is at 8% or more, and it fails to take into account the hidden unemployment. Given that the EI system now makes it much more difficult to get registered as unemployed, there are fewer and fewer people who are registered as unemployed. If it's 8% officially nation-wide, it may be 12% or 13%. When it hits 8%, the interest rate knob starts to get cranked up again and pulls the rug out from underneath people who want to get back into the workforce.

    My question is along the lines of what Ms. Minna was asking. Is NAIRU a determining factor in your making up your mind when to start cranking up the interest rates? If it is, do you take into account the hidden unemployment problem, the many people who are not registered with Canada Employment Centres because they don't qualify for UIC any more anyway?

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    Mr. David Dodge: I thought I tried to answer that question when I was answering the previous questions. I'm going to let my colleague go at it.

    Mr. Pat Martin: I didn't hear you answer it when you answered Ms. Minna's question.

    Mr. Malcolm Knight: Let me come at in maybe a slightly different way. As you know, we have a policy of achieving a low and stable inflation rate, 2%. Early last year we were worried the economy was turning down and that it would result in a weakening of employment, an increase in the unemployment rate, and the measure we would see there would be that future inflation would be declining below our target range. We have a symmetrical approach to that target, so last year we acted to reduce interest rates and strengthen demand, strengthen employment relative to what it would otherwise be, and therefore continue to hit our target.

    Mr. Pat Martin: It was a great idea.

    Mr. Malcolm Knight: I think that tends to moderate the cycles in output and employment in the economy. So as a result of reducing interest rates by 475 basis points last year, we had an economy in Canada that actually did not have a recession, but had relatively good employment performance in those difficult circumstances. This year, although we've raised interest rates on three occasions, we continue to have low interest rates. What's happened to employment? Employment has risen so far this year by 427,000, an annual rate of approximately 3.8%. That's pretty strong. As the governor said, the improving job opportunities have brought those who were perhaps discouraged workers in weaker economic conditions back into the labour market, and so although we've had very strong employment growth, the measured unemployment rate actually ticked up by a tenth of a percentage point last month.

    Mr. Pat Martin: Because there are more people in the workplace.

    Mr. Malcolm Knight: But when we are looking at how we operate monetary policy, I think we do operate it in a stabilizing way, a policy that gives the best prospect for the long-term growth of employment and non-inflationary conditions.

    Mr. Pat Martin: Would you agree there are enough examples out there now to disprove the concept of this non-accelerating inflation rate of unemployment? In the United States, where they have 3% and 4% and it doesn't spike inflation, why are we still guided by this idea?

    Mr. Malcolm Knight: Well, I think if we got to 3% in the United--

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    Mr. Pat Martin: We're at 4% in Manitoba, and we don't see a spike in inflation locally or domestically. In fact, it's a great thing. We would hate to see interest rates raised because we've hit 3% or 4% unemployment. We should be celebrating when we hit that. If inflation is not going up, maybe that whole NAIRU was a myth and maybe it's been discredited.

    Mr. Malcolm Knight: It's very important to do everything we can to improve the structure of labour markets so we can get the frictional and other types of unemployment down. But given the structure of the labour market, there are pressures that can be created in it that will induce inflation. So we have to operate our policy so we get an equilibrium in the labour market that won't lead to cost and price pressures. But given that intention, which I think is very important in making macroeconomic policy, the structural factors you talk about to improve labour market performance are extremely important.

    Mr. Pat Martin: I have one last question. Until very recently, Arthur Andersen was the auditor of record for the Bank of Canada. When we asked the Minister of Finance if he was willing to change that, because a lot of people have got rid of Arthur Andersen as their auditors in the United States and major corporations, he said he was unwilling to do so, because it was a five-year contract. Arthur Andersen has merged with Deloitte & Touche, I believe, in Canada at least. Can you tell us who is the auditor of record now for the Bank of Canada?

    Mr. David Dodge: As you know, we have two. Deloitte is the second auditor, having replaced Arthur Andersen.

    Mr. Pat Martin: Is it the same people involved, the same principals? Did the merger result in different individuals dealing with the files?

    Mr. David Dodge: Yes.

    Mr. Pat Martin: Thank you.

    The Chair: Thank you very much.

    I again apologize for the delay. The House works in this way sometimes, so I appreciate that both of you have managed your schedule so that you could accommodate the members tonight by staying later than you had originally planned.

    I also thank all the members for staying and for trying to fit their schedules around the House schedule and other meetings.

    Thank you very much, and we'll see you in the springtime.

    Mr. David Dodge: Thank you, Madam Chair.

    The Chair: We are adjourned.