FINA Committee Meeting

STANDING COMMITTEE ON FINANCE

COMITÉ PERMANENT DES FINANCES

EVIDENCE

[Recorded by Electronic Apparatus]

Thursday, May 10, 2001

• 0911

[English]

The Chair (Mr. Maurizio Bevilacqua (Vaughan—King—Aurora, Lib.)): I would like to call the meeting to order and welcome everyone here this morning.

This is one of the many round tables that the finance committee will be holding on a number of issues, but today's going be an interesting one as we address the state of the Canadian economy, present and future.

I want to take this opportunity to welcome Professor Herbert Grubel, professor of economics from Simon Fraser University; Professor Thomas A. Wilson, director, policy and economic analysis program, University of Toronto; Dr. Thomas J. Courchene, economist, department of law, Queen's University; Dr. Mario Fortin, professor of economics from the University of Sherbrooke; and Mr. David Robinson, director of public policy and communications from the Canadian Association of University Teachers.

Many of you have appeared in front of this committee, so you know how it operates. You make your initial remarks. We'll hear from the witnesses first and then we'll engage in a question and answer session.

We will begin with Dr. Courchene. Welcome.

Yes, Mr. Loubier.

[Translation]

Mr. Yvan Loubier (Saint-Hyacinthe—Bagot, BQ): You forgot to mention that Mr. Grubel was formerly a member of the House of Commons, and that for four years, he took part in the proceedings of the committee on finance where, being an economist, he did a wonderful job, in his own way of course, since he is no socialist. He's no centrist either. We did not always agree, but he did good work here on the finance committee. He is certainly no stranger to the committee.

[English]

The Chair: I was going to give a more elaborate introduction after, but thank you, Mr. Loubier. I appreciate that.

Dr. Courchene.

Dr. Thomas J. Courchene (Individual Presentation): Excuse me, can I ask the committee how lengthy or short you want my opening statement to be?

The Chair: Seven to ten minutes would be fine.

Dr. Thomas Courchene: Okay. Thank you very much.

It's a privilege and very much a pleasure for me to appear before the House of Commons Standing Committee on Finance. I want to begin my comments by expressing my appreciation for the work of this standing committee.

As part of my research in terms of my recent book I had occasion to look back at Paul Martin's 1999 economic update and then his February 2000 budget. What immediately strikes one is the quite dramatic shift towards meaningful tax cuts from the economic update to the formal budget. And an important catalyst in terms of both the urgency and the substance was this standing committee's December 1999 report, Budget 2000: New Era...New Plan.

So my first comment is, well done, and we look forward to further contributions from this committee. Unaccustomed as I am in terms of tossing laurels in the direction of policy makers, especially federal policy makers, let me nonetheless take this occasion to add one more.

I recently participated in a G-7 conference that focused on debt, deficits, and unfunded pension liabilities of the G-7 nations. In terms of deficits and unfunded pension liabilities, Canada has made remarkable progress relative to the rest of the G-7 nations. To be sure, the Americans can make this claim as well in terms of deficits, but much of their progress is due to the emergence of a peace dividend and not to the types of cuts the finance department had to go through here.

And while we lag behind the G-7 nations in terms of debt, it is nonetheless the case that our debt-to-GDP ratio has declined by 12.3 percentage points as a percentage of GDP over the last five years. That's the largest decline in the G-7 nations.

• 0915

Finally, Canada is back in the fiscal stabilization game with the incredibly timely and significant tax cuts and spending increases ushered in earlier this year in precisely the timeframe in which the economy is slowing. So plaudits on all accounts to the committee.

Now let me argue that there are some challenges remaining. I was requested to talk a bit about some of the longer-term challenges that Finance Canada will face and Canada will face. I'll begin with my mission statement on what it must mean or should mean to be a Canadian in the 21 century.

First, on the human capital future for Canadians, in my book entitled A State of Minds: Toward a Human Capital Future for Canadians, I focus on the implications of globalization and information for citizens, for markets, for governments, and ultimately for Canadian policy. With the imperatives of fostering both economic competitiveness and social cohesion remaining uppermost, this led me to the following mission statement for Canada in the 21st century.

Nobody's about to set this mission statement to music. Nonetheless, I think it has some value. It is to design a sustainable, socially inclusive, and internationally competitive infrastructure that ensures equality and equal opportunity for all Canadians to develop, to enhance, and to employ in Canada their skills and human capital, thereby enabling them to become full citizens in the information era Canadian and global societies.

On the economic front, what this requires, it seems to me, is the necessity to ensure that our marginal tax rates on mobile factors are competitive with those south of the border. This is so we can retain our human capital.

We have made some important progress toward this in the 2000 budget, and some further progress in the 2000 economic statement, but there's much more to do, especially since George Bush has now implemented the U.S. tax cut.

On the social cohesion front, the challenge is to upgrade skills and human capital for the lower portions of the skill ladder. Among the policies I recommend here are a human capital bill of rights for our kids and a wholesale reorganization of the bureaucracy to ensure that citizens and their human capital needs and aspirations are at the policy centre.

What is relevant in the context of this hearing and in terms of what my colleagues are likely to say is that I would put priority on the tax cuts to mobile factors and on some of the spending policies to deliver human capital to equalize the opportunity for human capital development and for information empowerment. I'd put those priorities over, for example, debt targets. In fact, I'm wholly satisfied with the finance department's existing approach to debt control, namely, its enhanced debt reduction plan. In my view, getting the debt-to-GDP ratio down, as we're doing, is satisfactory. I know that others will not be of that view.

The second area I want to focus on, and this gets to the more long-term stuff, is that Canada is going to start facing a financial strain on the federation in terms of vertical balance and horizontal balance. On the vertical side, provinces are one small recession away from being back in a fiscal mess. On the horizontal side, we have the Atlantic region lobbying for much greater equalization. Alberta, on the other hand, is basking in its role as a tax haven, and if the recent budget is any indication, it's a big spender.

So we have both the horizontal tensions and vertical tensions, and let me just focus on one issue in all of this. In my view, Ottawa's 2000 budget approached tax reduction from a social policy perspective rather than from a competitiveness perspective. Most of the cuts were geared to low- and middle-income Canadians. This may be great social policy, but it falls short in terms of addressing international competitiveness.

To be fair, the October statement went further and it did focus on decreasing the high tax rates on mobile factors. Nonetheless, the message that Ottawa is implicitly sending to the provinces is the following. If you want to have overall personal and corporate tax rates more competitive with those in the United States, then you cut your tax rates. On the corporate side, Ontario has done that and Alberta has followed suit. On the personal tax front, Alberta has accomplished this by its 10.5% single tax rate, and no other province has been able to follow suit here.

This is the wrong policy on Ottawa's part. Ottawa is abandoning its leadership role if it turns over the responsibility for ensuring competitive tax rates for mobile factors to the provinces. Unless Ottawa moves forcefully here, we're going to have a major brain-drain problem, both across provinces and in terms of the north-south. I have more to say on that, but I will just leave it at this for the time being.

• 0920

The third area, and even more distant in the future, is that the new dynamic motors of the 21st century economy are increasingly global city regions. These city regions are emerging as dynamic export platforms, the creative centres of human capital and research, and the key competitive nodes in the global network of economic activity. And they're also on the front line of implementing many of federal government policies. More to the point, Montreal, Toronto and Vancouver find themselves going head-to-head competitively with U.S. global city regions. But unlike these U.S. city regions, which have direct access to Washington and Washington infrastructure money, Canadian cities are constitutionalists, they are these creatures of the provinces, and they can't be dealt with directly by Ottawa. The obvious solution here is for the provinces to provide the needed infrastructure moneys to the cities or to transfer greater taxing powers to them. But should neither of these things occur, the cities will begin to collectively cooperate and approach Ottawa and lobby for direct access to infrastructure and other funds.

But it may be too late already, because the City of Toronto has recently bought into the concept of a charter city, replete with demands for powers, for flexible financing, and for representation in existing fora, like federal-provincial committees. The models here are probably the German city provinces, like Hamburg, Bremen, and Berlin. But while this initially relates to the provinces, it won't take long to work up its way to Ottawa and to Finance.

This is related to the earlier human capital mission statement, because these cities are where the repository of much of Canada's human capital will be. And with knowledge at the cutting edge of competitiveness, it does not take much of a stretch to see that the Standing Committee on Finance must at some point grapple with this issue, namely, ensuring that Canada's global city regions are internationally competitive. So that's an area I would recommend you look at a little more carefully.

The fourth area—and it's an old chestnut with me, and I think with Herb Grubel as well—is with the North American currency union. I only have two comments to make on this. First, it's intriguing that Don Drummond of the TD Bank, who is a frequent visitor here I'm sure, and Governor David Dodge both mused out loud in recent days about the fact that in some not too distant future we may end up using the U.S. dollar. But this is the very reason why Rick Harris and I decided to write our piece on a North American monetary union, because we believe that a North American currency modelled on the euro lines is a far better alternative, because it is institution and policy preserving, including ensuring the existence of the Bank of Canada—far better than simply using the U.S. dollar.

The response we've had is, in my view, rather flippant and irresponsible, namely, that the Americans would never agree to the notion of a North American monetary union. Well, where would we be if Canada just said Americans will never agree to a North American free trade agreement or a Canada-U.S. free trade agreement? I happen to believe that the Americans will agree, partly because next January, when the euro comes in, it's going to start displacing U.S. dollars across eastern Europe, across Russia, and even in parts of South America. But that's not the point. The point is that what one believes should not affect the type of research one does.

I remember attending a conference in Washington, D.C., on currency integration where we were broken into groups and they asked us the following question, to focus on the following issue. The statement was, “We now have a North American monetary union. How did it occur? Work backwards.” I can go into the details of what happened there, but basically, it was that after a lot of dollarization, the Fed got worried, because there were so many externalities, political and economic coordination outside, that they started to have informal sessions with the various countries. Anyway, this informal thing became formalized, and they ended up with some version of a North American monetary union.

The point is that I think there is ample scope to focus on various issues within this. What are the needed infrastructure issues that it might be important to have in readiness? What is the nature of the lender of last resort issues? The committee doesn't have to take a stand on whether or not these are good ideas, but we should just make sure we understand the nature of the beast. In this process, there are plenty of Europeans who had a lot of contact with doing the infrastructure, and they should be invited here.

The final point, the final crystal ball focusing, is on the whole relationship between Ottawa and the Canadian federation. In the concluding part of my book, A State of Minds, I wrestled with the notion that something strange has happened in Canada, because the electoral currency, the stuff that sells to citizens, is no longer the old Ottawa stuff—it's no longer resources, it's no longer megaprojects, it's no longer that stuff of nationalism that used to be out there. It's more human capital, information empowerment, social policy, those sorts of things. And Ottawa is going to want to play in this game, because that's what competitiveness is about in the 21st century. That's what social cohesion is about, and that's what individual and nation building is all about. But by and large these fall under provincial jurisdiction.

• 0925

There's no way to avoid a federal-provincial battle here. If the social union framework agreement did not already exist, we would have to create it to help us facilitate this. I'm not sure that this committee should play a role in sorting out who should do what. But I am sure that along with this change in electoral politics and alongside the emergence of human capital, the whole informatics revolution has dramatically reduced the transaction and coordination costs, and therefore dramatically altered the nature of organization in the private sector. Now certainly this must apply to the public sector as well.

So we're going to talk about a new model of government partnering. It's going to partner with many private and civil society institutions to deliver services, and indeed it's not clear that Ottawa should be in any of these service delivery services. As we focus on “e-the people”—the new catchword—whether it's e-delivery or e-coordination or e-contact with society, we have to rethink the whole role of government as provider within the system. This committee and the finance department are the key fiscal and obviously policy-central agencies in the government. I think it would be well to contemplate having a proactive role in the evolution of government organization and in the evolution, therefore, of the institutional organization of our federation.

I think I probably went on a bit long. These are my thoughts of what the committee should be focusing on in terms of preparing for 2010, let's say.

The Chair: Thank you very much, Professor Courchene.

We'll now move to our former member of the finance committee, Professor Grubel.

Professor Herbert Grubel (Professor Emeritus, Department of Economics, Simon Fraser University): Mr. Chairman, as I came in here I couldn't help but notice what a different atmosphere it is today from what it was in 1993 when I sat in one of your chairs. At that time there was almost a sense of panic—certainly great alarm—over whether this country was going to go bankrupt. We had deficits of unprecedented magnitude. We had all of the leading parties saying it's no problem, we'll grow out of our debt. That's one of the reasons I agreed to stand for office, because I couldn't believe that this was the attitude that would bring us out of what I thought was a really serious problem.

Well, today, of course, we are in a much happier situation. We have to discuss what to do with the fiscal surplus. It is in many ways a much easier thing to do than what we had to do in 1993, 1994, and 1995. I congratulate the Minister of Finance and the Prime Minister, who left him the free rein to do all the politically hard things that were necessary to bring us to this happy state.

In this spirit, my brief starts off by naming a number of distinguished economists in Canada who have in recent times set out in various publications and speeches agendas for change—what should be done in the future. Since I happen to agree with all of them, what I'm doing here is presenting in rough outline what I think Canada should do. I have three topics that I cover: the first is paying down the debt; secondly, resist spending increases; and thirdly, initiate major tax reform.

Much has been said at this committee and elsewhere about the need to pay down the debt. You will undoubtedly hear more about it during today's meeting. The arguments for paying down the debt are very simple. It is unfair to leave future generations with a high tax burden to service the debt, especially since the baby boom generation, which incurred it and blew it on consumption, is about to leave productive employment and retire.

• 0930

The very high per capita debt service charges faced by working Canadians in a few years will require even higher taxes per working person than they do now, and thus decrease the incentives to work, save, make investments, and take risks, all of which are essential for better economic performance.

Turning to the second topic, the economics literature contains strong evidence that economic growth is a function of the level of taxation—I emphasize the level of taxation—which in the longer run must equal spending. In one of my published studies I present empirical evidence in support of this theory. Starting at low levels of taxation as a percentage of national income, in Canada's history increases in taxation were associated with higher rates of economic growth, as a correspondingly higher spending raised the efficiency of the economy. However, beyond a certain optimum level, higher government spending reduced growth and efficiency through the distortions caused by the required taxes and even some of the spending.

My study shows that the optimum level of spending is reached at 33% of national income. I should also note that the lower taxes and spending has the additional benefit of increasing the freedom of choice and self-reliance of Canadians, which are important benefits, in my view, in addition to the greater economic growth.

We're still some amount above this optimum, although I congratulate the federal government in particular for moving in recent years towards this optimum level by historically slow increases in program spending and creating an environment conducive to the observed economic growth.

Many observers, including myself, are worried that spending restraints, which got us to this place, are ending. This spending in the future will not be driven by the need for productivity-enhancing government programs, but by the most serious systemic failure of popular democracies—the buying of votes from special interest groups. Do I dare mention here the changes in the EI benefits for residents of the Atlantic provinces, half a billion dollars to the arts community, untold millions to the aerospace industries in Montreal?

If I were on the campaign trail, dear members, I would attempt to muster the backing for spending restraint from the average voter by pointing to the fact that presently governments in Canada—all governments combined—are spending $50,000 a year per family of four. Think about it. Excluding debt payments, the amount of program spending is $40,000 per family of four. For most Canadian families this is hard to believe for people at your level of income. These sums are probably higher than what they get after taxes for discretionary spending.

The government is spending more in your name than is left over for your discretionary spending. Yet you hear it here all the time. People are coming to say that what we need is more spending, and if you don't spend it, the implicit threat is we won't vote for you. You all shrivel up and go home and say, God, how am I going to get these guys back into the fold? I think it's a sad thing, but I'll have a few comments on how to solve this.

Let me now turn to the issue of tax reform—a subject dear to my heart since my work at the Fraser Institute has driven me in this direction. In a short while there will be two books concerned with the cost and benefits of capital gains taxation.

I've just finalized plans for a conference in October in Toronto where Tom Wilson will be a contributor—making Canada more competitive and richer through lower taxes, but also better taxes. The first part of the conference will feature experts discussing efficiency—improving changes in different taxes. In the second part, other experts will present papers discussing the experience of other jurisdictions with lower and better taxes, such as Ireland, Michigan, and Alberta. I hope you can attend this one-day session, which also features, as luncheon speakers, the heads of the two leading think-tanks in Canada—Michael Walker of the Fraser Institute and Jack Mintz of the C.D. Howe Institute.

• 0935

The design of tax policy is very difficult, mainly because it involves trade-offs between efficiency and equity as well as the pursuit of other economic and social objectives, which ultimately have to be made by politicians. However, technological developments and other changes in the economy continuously change the nature of these trade-offs and our understanding of the costs and benefits of alternative policies.

I believe that strong new evidence has now emerged that you and your colleagues should be aware of. It suggests that Canada would be well served by a major program of tax reform. The time for such reform is now. It has never been better in the presence of the surplus. It is facilitated politically when fiscal surpluses can be used so that after the reforms all Canadians can be given a lower tax burden. If you just give away the surplus now without changing the structure you will miss a great opportunity politically to do what is right for Canada.

Let me summarize briefly the conclusions that most of the above-mentioned economists reached in the recent publications on the subject of tax reform.

First, the progressivity of the personal income tax has to be flattened by both lowering the top marginal tax rate and increasing the income level at which it kicks in. Some people will tell you that in the United States, if you live in New York you pay the same as you do when you live in Toronto, but it isn't really true, because in the United States you start getting the highest tax rate only after you've earned at least $200,000, and we get it at $60,000. That is a totally neglected aspect of our structure.

The remedy of this situation requires cooperation between the federal and provincial governments, though even in the absence of such policies the lead of the federal government is essential. Individual provinces that are out of line are certain to be feeling the adverse consequences of their actions and will be forced to fall in line.

It should be noted that the brain drain is sensitive to these tax incentives. My colleague, Don DeVoretz, recently had a wonderful paper in Policy Options in which he showed that in fact young people are extremely sensitive to differences in taxes, after-tax income.

Secondly, taxes on capital need to be lowered to increase the attractiveness of Canada for foreign investors. All experts agree that capital taxes payable regardless of profits are the most damaging by far. Most of these, of course, are provincial. Most agree on the need for lower taxes for the corporate income. Some recommend capital gains taxes at rates equal to or ideally lower than those in the United States.

My own preference for a priority policy is for the simple and full integration of personal and business income taxes. This policy would assure the elimination of the double taxation of profits, which is incomplete and unnecessarily complicated under the present system of dividend tax credits and topping up.

Many people who fill out their income tax forms, even sophisticated people, will think, my gosh, here's my dividend income and now I have to calculate 150% of that and put it into my income tax as income. Little do they understand that later on somewhere down the line in an obscure calculation it will be taken out again. Why not do it openly and clearly?

It also turns out that if you have a fully integrated tax like that.... I had at my conference in Vancouver last summer the person who is now the finance minister of Mexico, and his contribution to the volume that's coming out is how he used this fully integrated system to obtain a systematically very effective elimination of capital gains tax on securities that would represent claims on these corporations. It worked extremely well.

More generally, I would suggest that taxes on business should be neutral and not used to encourage some industries relative to others.

The recommendations of the Mintz committee report should be implemented promptly, however politically hard it will be for you.

• 0940

Thirdly, most economists agree that economic growth is encouraged by taxes that fall on consumption rather than savings and investment. Some recommended, for this reason, that the RRSP system should be made more generous. Kesselman and Poschmann have argued in a paper by the C.D. Howe Institute that there is great merit to the introduction of tax pre-paid savings plans, which have favourable implications for current fiscal revenues while retaining the basic beneficial effects of the present RRSP system.

There are more and more calls for increases in the rates and the broadening of the base for the GST, which taxes consumption, and a matching reduction in the rates of personal and business income taxes.

I know the Liberal government will have some swallowing to do before they go out and say let's increase and reform the GST, but it would be very much in the country's interest.

Let me conclude my brief discussion with one of the main economic goals announced in the last throne speech: raising Canadian productivity. The Department of Industry recently conducted a survey to find out how Canadians felt this goal could be attained. I was interviewed. My answers relevant to this committee's work may be summarized very simply: Do not take new policy initiatives, especially those that involve picking winners in the productivity race and cost money. Instead, have the government get out of the way of investors and entrepreneurs and let them do their job of enhancing productivity.

Second, getting out of the way means the elimination of some important existing policies that prevent the shift of labour and capital from declining employment into growing and more productive use. These are: high taxes on work and income, which discourage work and investment, especially in new industries and technologies so dear to the heart of Canada's ministers of industry; second, the elimination of subsidies designed to prop up declining industries, which is a very unproductive activity; third, reducing the incentives given to people to remain in regions that no longer have resources that can be sold profitably in the world markets and that are too far removed from markets to permit the creation of profitable employment in manufacturing or service; finally, adopting a hard fix for the exchange rate, which will eliminate the present indirect subsidies to capital and labour provided by a secularly declining exchange rate. These falling exchange rates have slowed the move of capital and labour out of declining and into more productive, growing industries.

Tomorrow at 2:30 p.m. I will be going into the lion's den, the research department at the Bank of Canada, and will try to defend this position that Tom and my colleague, Rick Harris, and I have taken publicly that in fact we would be served very much by a hard fix in our exchange rate, a credible fix between the Canadian dollar and the U.S. dollar, leaving for future discussion how exactly it needs to be achieved.

Let me conclude, finally, with some more philosophical insights.

The unpleasant but unavoidable trade-off is that more compassion today means less economic growth for the future. Evidence from around the world, and especially the United States during the last decade, shows that this trade-off is quantitatively significant. Politicians like you have to decide what to do in the light of the information and ideas just sketched by me and several fellow witnesses. I fully appreciate the dilemma you face. Compassion for present voters will get you re-elected, because the votes are, in large numbers, by people with an income below average. Those are the ones who get the benefits and get the breaks. But compassion for future generations who will benefit from these tax reforms means less compassion today, and they are unable to vote for you. You risk electoral defeat.

• 0945

I hope you will have the courage to give more weight to the interest of future generations than has been done in the past by paying off the debt quickly, keeping increases in spending to a minimum, and changing the tax system to encourage economic growth. I wish you good luck in your attempts to do so.

The Chair: Thank you very much, Professor Grubel.

We'll now hear from Professor Wilson.

Professor Thomas A. Wilson (Individual Presentation): It's a pleasure to be before this committee again. I think the last time I was at a round table in December 1999, where we were discussing some of the tax reform issues.

I've given out a handout, which is our forecast from March, because one of the questions we were asked to address was how the economic environment has changed quantitatively since the economic and fiscal update of last fall, and has the government's approach to economic prudence been sufficient to protect the fiscal position of the government?

I guess, in addressing that first question, it's clear that the near-term economic outlook deteriorated considerably now relative to last fall. Our own growth forecast for the current year is for real growth of only 2.7%, whereas last fall we were predicting in the order of 3.5%. This is pretty well consistent across all economic forecasters. The consensus forecast for Canada, if we average all forecasters who participate in this published consensus economics document, is about 2.4%. So we're slightly above average in terms of growth.

I take it that the question on the fiscal position is whether or not the federal government would get into a deficit position again. There, I think, the answer is clear in the context of either the consensus forecast or our own forecast. The prudence factor and the contingency reserve do serve to keep the government out of the deficit zone. Now that, of course, may not be sufficient if a more serious, prolonged recession were to occur. I'll address that one in a minute.

The consensus view of Canada in 2001 is for a rebound in the second half. That's related to similar forecasts south of the border. In other words, the view is that the American economy will either have a so-called V-shaped rebound from close to recession in the first half, or perhaps a U-shape, but with a relatively small bottom to the U. Of course, if that occurs south of the border, that's good new for us, and that tends to drive Canadian forecasts.

There are some risks, of course. I guess the principal risk is a continued weakness in the United States and a further deterioration of equity values. There are a lot of people saying the U.S. stock market remains overvalued by any sort of historical measure of earnings to price or dividends to price. And, of course, the U.S. dollar looks very overvalued, and the U.S. is running a very large current account deficit. So there are questions of sustainability there.

There are also risks overseas. For the Japanese economy, the consensus view there is for a muddling along at a very low growth rate, but if they were to go into recession as well we would then have weaknesses in two of the three large economies that drive the Asia-Pacific region, the other one being China. But Japan weak and the U.S. weak—that could have implications for southeast Asia and the Asia-Pacific countries generally.

• 0950

Our own forecast for next year is for relatively robust growth—4.0%. We're on the high end of the consensus. Then we have growth basically at about potential after that. This, again, is driven in part by what's happening in the U.S. The U.S. consensus view is for growth in 2002 to be back slightly above 3%.

The other question we were asked is what has changed over the past five to ten years in terms of the economic environment, and what does it mean for the government's approach to economic management? I guess the two things that are, in a sense, obvious and common.... Herb has already commented on one of them. One is the turnaround in the fiscal situation. We went from wrestling with a chronic deficit problem eight years ago to now having this growing potential surplus...I was going to say problem, but potential opportunity. That's one very dramatic change.

The other change is the establishment of a low-inflation environment, which is now widely accepted by market participants. In 1993, even though the Bank of Canada and the government had agreed on inflation reduction targets, the credibility of that policy was not yet established in financial markets. If you looked at real-return bonds and nominal-return bonds—long-term bonds—people weren't expecting in the long term that the inflation rate was going to come down to 2%.

Now, if you look at long-term markets, clearly the expected inflation is in the target range. The markets now are saying yes, this is a credible policy; we're accepting it. I think that is also influencing wage bargains and so on. People are just not going to expect that the Bank of Canada would allow inflation to accelerate again, so they're going to plan within this stable, low-inflation framework.

That's important in terms of what will happen to the fiscal situation in a recession. If you go back over most of the recessions in the post-war period, they were triggered by financial crunches or by energy price hikes, which then often led to financial crunches and interest rates going up. When the economy went into recession, you had this double whammy on the federal fiscal position—rising interest payments, which of course had an immediate impact on the short-term debt and then with a lag on the longer-term debt, and a declining economy which of course pushed tax revenues down and unemployment insurance payments up. So that was a kind of a double hit, meaning a big increase in the debts when recessions occurred.

The kind of slowdown we're looking at today and the possibility of even greater weakness are the opposite. What we're looking at now is a kind of a demand weakness arising from perhaps overinvestment and consumers getting overstretched in the United States, and now the Federal Reserve is bringing interest rates down to try to mitigate the impact of that decline in aggregate demand.

So the impact on fiscal positions both south of the border and here, if we go into recession or have an even weaker picture than I presented, is that, yes, the deficit will get larger because the tax revenues will weaken, and we'll pay out more in EI. On the other hand, interest payments are going to go down on the debt. So that's an offset. We won't get as big a hit on the deficit as we did in the past.

I just caution you against looking at what happened to the fiscal position, say, in the recessions of 1981-82 and 1990-92 and try to rerun it today. It's going to be very different simply because we're in this low-inflation environment where there's room for the monetary authorities to provide monetary stimulus when they see a weakening of demand.

So those are the two big things, and they're due to policy. This is due to policies monetary and fiscal.

What else has changed? This is more uncertain. I think the big question is whether we're in a new era of productivity growth. By that, I don't mean going back to the extremely high productivity growth performances of the early post-war period but rather something better than what occurred in the 1980s and the first part of the 1990s.

This is, of course, the issue of whether productivity growth is higher on a sustainable basis because of the development of the so-called new economy—the growth of computers, computer manufacturing, the implementation of computers, communications, related software, and so on. There's some evidence in the States. It's not settled yet, but I would say more economists say yes, there's a medium-term pickup in productivity growth there that's significant, although some still argue that it's transitory and it isn't going to last.

• 0955

In Canada the evidence is more fragmentary. We're lagging behind the United States in this respect, and we don't have as large a computer manufacturing sector. So even if we replicate what they've done, the aggregate impact will be smaller. Nevertheless, we take the view that this will lead to some higher productivity growth, again, not back to the very high rates of the earlier post-war period, but somewhat better—labour productivity running about 2% per year when we measure it as output per employee in the private sector.

As to policy issues coming out of this, one thing is that the focus on getting the deficit under control led to the attitude, we're going to avoid a deficit, come hell or high water—I believe someone said that—and we're oriented towards that. The risk now is that we could run pro-cyclical policies. This time, so far, you have run an excellent anti- or contra-cyclical policy, by virtue of the timing of the tax cut at the beginning of this year. It couldn't have been better. But looking down the road, I think you should be cautioned against postponing future tax cuts simply because you see the economy weakening and that might threaten to push the federal budget into a small deficit position. I think you should at least stay the course with your five-year tax reduction plan. Indeed, economic weakness is a justification for bringing forward future tax cuts that might be planned anyway. I think we see a modest example of that in the Ontario budget. I feel that had the Ontario economy been as strong as we forecast last summer, we would have seen more significant tax cuts than we did see because of the weakness in the economy.

What I think we should be doing is planning perhaps for even larger surpluses in the medium term—I tend to be on Herb's side of this question. Plan to have a larger surplus when the economy is strong, that gives us a bit more of a cushion, when the economy is weak, to not go into a deficit position. But in a situation of severe weakness, I think there's room to manoeuvre now. I think we could be running some small deficits, as long as it's clear they're going to be transitory and our medium-term fiscal plan is sound.

The other issue that comes out of this new environment is the question as to what we do with the fiscal dividend. We've gone from being focused on deficits to asking how we spend or use up in some way the fiscal dividend. The risk here is that we can lose the discipline. We had discipline in expenditure controls and in expenditure reviews when the deficit was a problem. We could lose that discipline now. I think it's just as important to carefully review spending programs. I'm not saying you shouldn't have some new programs or increase spending in some areas, but it's important to do it without assuming we've got this big dividend, so we need money here, we spend there, not looking at whether we should take it away from somewhere else.

There's also the risk of using it up through piecemeal tax reductions. I totally agree with Herb that this situation with a growing fiscal dividend, over the medium term, not the long term, gives us the opportunity to implement tax reforms, rather than simply saying let's have a general tax cut. Let's ask where we want to have taxes cut and how we want to redesign the tax structure.

I agree that one thing you could do is implement the Mintz committee reforms quickly. You've got some room to, in a sense, compensate the losers as part of more general tax reductions.

On the personal income tax side, I agree with Herb that we should be looking at ways to reduce the burden on savings. I think the proposed tax prepaid savings vehicles the recent C.D. Howe study recommended are something that should be seriously looked at. They exist south of the border in the so-called Roth IRAs. The reason I think you should look at them seriously is that they're of particular benefit to low-income people.

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Right now our system provides negative incentives for lower-income families to save, because of the interaction of income taxes and the clawbacks of social benefits. So a lot of low-income families face high marginal rates post-retirement, higher than they do now. It doesn't make sense for them to put money in RRSPs, when a lot of it is just going to lead to clawbacks of some of their benefits. Provided you define that the tax-exempt income from these new savings vehicles does not enter the calculation of the clawback, this will give low-income families a very effective saving instrument, which could stimulate their providing for the future, because they know they're going to get the benefit, it isn't just going to get clawed back.

I would put, more generally, the issue of personal income tax and transfer payment systems high on the agenda, along with the integration of corporate and personal taxes. I fully agree with Herb that this is a wonderful time to think about finally implementing one of the major recommendations of the Carter royal commission, full integration of corporate and personal income taxes. A modest start on that would be to increase the dividend tax credit, in order to bring the marginal rate on dividends down to the new lower rate on capital gains. A year ago the tax rate on capital gains was higher than dividends, and many of us argued that this made no sense, to bring it down, but now the rate on capital gains is below dividends, and that can create all sorts of tax planning opportunities, tax complexities. Let's initially get that rate down again to equality, and then move further along the road towards full integration.

I think, on the PIT clawback issue, this again is an area that requires full federal-provincial cooperation, because the provinces have their own social programs that get clawed back on the basis of income. You can sometimes have stacking of these clawbacks, leading to extremely high marginal rates. In fact, I was appalled, when I did a study of the proposed senior benefit, to find out just how high some of these marginal rates are. The highest,effective marginal rates are faced by very poor Canadian pensioners, in some cases 75%, in other cases even 100%, and that's without taking into account things like benefits and kind. So I would urge addressing that in a major way.

Let me just turn briefly to the longer-term issues. When we look ahead, what might be coming up? There's one thing my colleague David Foot calls the predictable surprise, demographics. We know the population is aging. Ten years from now the leading edge of the baby boom hits normal retirement. But the average age for retirement of males right now is 62 years. So that means seven years from now a lot of them are going to be taking early retirement. And over the course of the following years more and more of them are going to be retired and, of course, older. This has implications for health spending. It has implications for what's going to happen to aggregate participation rates. It has implications for what's going to happen to tax revenues. I think what we'll see, maybe not within seven or ten years, but shortly thereafter, is that the growth of the potential fiscal dividend will be reversed, and we could see the dividend shrink, disappear, and be replaced by a growing potential deficit problem. We can, of course, help mitigate that if we pay down a lot of the debt over the next ten years.

There are a lot of issues to be addressed there, such as whether we want to have the early retirement incentives that are built into the CPP, whether we want to change the age limits on RRSP and RPP payouts, and so on.

The other longer-term issue is the implications of the new economy. Is it going to go on? We have the information technology revolution well under way, there is biotech, and more. These are what some people call the unkunks, the unknown unknowns. These are the things where we don't know really what's going to happen. They could be big. Our view would be that the trend in productivity growth probably is going to be somewhat higher. That should be taken into account in fiscal planning, pension planning, and so on. And one implication of this is that there's going to be increasing importance of the role of human capital in the future.

As to policy implications, I agree, don't pick winners, try to set a framework conducive to economic growth. That doesn't mean you might not increase spending, but you look at how the spending is going to contribute to growth. If we can improve the efficiency of the health care delivery system, that's a plus. That will leave revenues to use for other things. Education, training, infrastructure are areas that probably have positive effects on economic growth and should be reviewed carefully. And of course there is the redesign of the tax system along the lines Herb indicated in his handout.

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I have a few other things, but I think I've gone over time. Thank you.

The Chair: Thank you very much, Professor Wilson.

We'll now hear from Professor Fortin.

[Translation]

Mr. Mario Fortin (Professor, Department of economics, University of Sherbrooke, appearing as an individual): Good morning and thank you for this opportunity to appear before the committee. My comments today will focus on two topics, the present state of the Canadian economy and its prospects for growth.

Since last fall, the U.S. economy has slowed down considerably and this decline has, in turn, affected Canada. This downturn in the U.S. economy was fostered by the Federal Reserve's restrictive monetary policy and developed sooner than expected because of two things that occurred last year; an increase in the price of oil and the collapse of high technology stocks. Since that surprisingly rapid downturn, the U.S. has modified its monetary policy, which, four months ago, became much more expansive.

The advanced composite indicators of most industrialized nations show a marked drop. Historically, these indicators have managed to accurately capture the economic trends in those countries, but the recent drop is principally due to a decline in the stock market. In Canada, for example, it is the only advanced economic indicator to have dropped, along with the second component, the American indicator, which is included in ours. The eight other indicators have not yet dropped. When several components do not follow the overall indicator, the probability of its pointing to a recession is lower. Therefore, right now the probability that we will have a recession seams rather low.

There are several reasons why we may expect the downturn to be less severe in Canada that it was in the United States.

First of all, throughout the 90s, automobile sales in Canada were relatively weak while they were very strong in the United States. This means that the Canadian fleet is aging and will need to be replaced.

Secondly, tax cuts—as indicated in a previous presentation— have been introduced in a very timely way to boost the purchasing power of Canadian households just as the downturn began.

Thirdly, Canada produces relatively fewer high technology goods, the sector most affected by the downturn.

The fourth factor that is presently working to Canada's advantage is the fact that energy prices are relatively high. This is very bad for the United States as they import much of their energy, but this factor is, by at large, neutral or slightly positive as far as Canada is concerned, especially for Alberta and Saskatchewan, though mostly for Alberta.

The fifth point is that the drop in stock indexes have had a proportionally much greater impact on American households as they have much larger stock investments than do Canadians. The effects of stock losses have therefore been less severe in Canada.

That being said, a number of negative factors need to be mentioned.

First of all, the increase in the U.S. price of gasoline could persuade American households to buy smaller cars at a time when the Canadian automobile industry is more focused on the larger models. This could cause the Canadian automobile industry more harm that expected.

Secondly, according to current scenarios, Ontario should be more affected by the U.S. downturn than other areas of Canada. Employment trends in various Canadian regions show that the number of job openings has dropped in the last four months pretty much everywhere, though the data shown in table 1 of my brief do not include the latest figures. Yesterday's figures show that the number of job openings has continued to drop in all areas of Canada except Alberta and Saskatchewan. Indeed, in Alberta, there has been a sharp rise.

There has been a definite drop in the number of job openings. This is important indication of employment trends in Canada as it provides fairly reliable evidence of what unemployment figures will be four or six months away. At the present time, the drop in the number of job openings is relatively small, though it has affected most regions of the country. It is as yet too early to predict a rise in unemployment, but it does indicate that the downturn has had an impact on the Canadian economy.

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Should we expect a recession or a recovery in the second semester? I agree with what is a fairly general consensus: that the loosening of the monetary reins decided several months ago will begin to show results, with the usual 9 to 12 month lag, so that the second semester should see a rather strong upsurge in demand. It is quite likely, then, that what we are going through presently does not mark the beginning of a recession; it is simply a slackening in a growth pattern that should pick up again by the end of the year.

I would like, secondly, to draw your attention to our country's economic outlook. Let me go back to a point that was just made by Mr. Wilson concerning demographics. The economic expansion expected in coming years will be tempered by a slower rate of population growth.

I have shown a table outlining population growth in Canada, according to Statistics Canada, for the 25 to 54 age category. This is the age category that has the highest level of activity. You can see that starting next year we will have a rapid drop in the growth rate of this segment of the population. If the level of activity for the 55 to 64 age category does not rise within the next few years, we should expect a rather more rapid drop in the growth of our production potential than was indicated a few minutes ago. What could make up for this demographic tapering is the possibility that the larger investments of the last few years might have a favorable impact on productivity levels. I believe it would be wise to include in our long term financial forecasts the possibility that a slower rate of growth in the working age population might, within the next few years, lower our potential growth by approximately half a percentage point.

As my last point, I would like to stress that in the last 20 years, the growth of Canada's GDP, in real terms, has amounted to only 2.6% per year. I believe that a growth rate of 3% per year over the next decade seems unduly optimistic, considering the past 20 years, where the population was still growing by 1.5% per year.

Considering the present economic environment, I feel that the government should stay the course and not modify its fiscal policy. Whatever stabilization measures are required should be taken not by the Canadian government but by the Bank of Canada since the government should not let the current economic outlook bring about a change in its fiscal policy. That being said, I do believe that the long-term forecasts concerning government revenues should factor in an element of prudence. When estimating the fiscal dividends of economic growth, I believe it would be wise to base our predictions on an expected rate of growth slightly lower than the one indicated in the last budget.

Thank you.

[English]

The Chair: Thank you, Professor Fortin.

Mr. Robinson.

Mr. David Robinson (Director of Public Policy and Communications, Canadian Association of University Teachers): Thank you, Mr. Chair.

I just want to focus on a couple things: first, to talk about the current state of the economy; and secondly, to look at some of the questions that were highlighted in terms of what's changed and what we might expect over the next while.

As other people have said, I think it's very clear that the slowdown in the U.S. economy has now spilled over the border. The only question that's outstanding right now is how severe and protracted the sluggishness in the U.S. will be.

There's still a great deal of confusion and uncertainty about where the U.S. economy is heading. We see different kinds of indicators coming. But it does appear that the U.S. has, for now at least, avoided an all-out recession that some forecasters were predicting not too long ago.

Growth in the first quarter of 2001 was about double what had been expected, at 2%. The big American spending spree continues to lead the way, as consumer expenditures rose at an annualized pace of 3.1%. But I think that points to the potential risk in the U.S. economy, as well. That is, U.S. consumer spending is being almost entirely driven by credit expansion at this point.

Personal disposable income rose by just 0.5% in the first quarter, so it wasn't enough to offset the extra dollars that American consumers were spending. The personal savings rate in the U.S. has now sunk even deeper into negative territory. The debt service burden of households, which is the amount of personal income needed just to pay the charges on outstanding debts, is at its highest level since 1986.

• 1015

In terms of the U.S. labour market, we have seen a ratcheting up of unemployment, particularly from its low in September when it hit 3.9%. It's up to 4.5% in April. I know some people have interpreted this as re-echoing the recession call, but this is likely a lag of the slowdown in the fourth quarter now showing up in terms of the labour market. However, I don't think we'll see much improvement in the U.S. labour market during the second quarter, as the 2% growth in the first quarter is probably too low to keep the unemployment rate from falling.

Overall, then, in the U.S., the rising financial instability in the household sector, the continuing high trade deficits, and the weakness or sluggishness in the labour market will likely provide the U.S. Federal Reserve with more impetus to introduce further rate reductions. Lower interest rates on consumer credit will help lower the cost of borrowing and should help deflate the value of the U.S. dollar, and these lower rates, we hope, will be matched by the Bank of Canada.

In Canada, of course, the main risk that remains is what happens in the U.S. economy. It's clear, as we heard from other people, that real GDP growth will not meet the expectations that were set out in the economic statement in October. These are now being revised downward to the mid-range of 2%. This will reduce projected government revenues, but as Professor Wilson pointed out, lower than expected interest rates will partially offset that. With the figures I've been hearing, we're looking at a $500 million to $700 million hit to the overall government balance book there.

In fact, given the contingency reserve and the prudence reserve, there's more than enough available to offset any dangers of moving into negative territory. Of course, hindsight is 20-20, or some have even said 40-40, so now the government can claim that its prudent fiscal policy has paid off. That's a little bit like hoping each year that the Maple Leafs are going to win the Stanley Cup. Eventually you might be right, but not this year. Maybe that's not a good example.

Looking at the question of how the economic environment has changed qualitatively, I think other people have spoken to the issues of the improved government finances, but one of the interesting things is just where we are now. Not long ago, in fact, six months ago, people were still talking about a so-called new economic order. We had some brave economists, who are nameless now, even pronouncing that the business cycle was a thing of the past, that innovation and high-tech were going to vault productivity ever higher, that growth rates would continue to rise without any threat of inflation. I think the current slowdown makes all that look like a bit of a bad joke. So there have been some continuities that I think we often forget about.

We talk about the changes in the economic picture, but there have been some continuities. One of the things that has changed, however—and this comes from evidence from the United States—is that economies can tolerate slightly higher rates of inflation and slightly lower unemployment rates, in fact significantly lower unemployment rates in the case of the U.S., without feeling any serious problems. I think last year what happened was that the Federal Reserve moved quite aggressively to cool down the economy—in fact, in hindsight, probably even too aggressively. But I think there may be a lesson here for the Bank of Canada.

I'd like to address the question the committee raised in terms of how we can enhance the standard of living of Canadians in the long term. I'll focus on the long term, and at the risk of grossly oversimplifying things, because I only have a few minutes, I'd emphasize that there are three things we can do over the long term that can make us richer as a country. I'm not talking about richer as individuals, but richer as a country, and hopefully that would trickle down eventually. We can put more people to work, look at increasing our participation rate in the labour force, which is still relatively weak and hasn't caught up to the American levels; we can produce more output per worker, as people have mentioned, increase our labour productivity; and we can improve our terms of trade by cashing in on higher export prices.

If you look over the past decade at what factors were at work to explain the decline in the standard of living that we experienced throughout the 1990s, up until the end of the 1990s anyway, the dominant factor by a wide margin has been, until very recently, the weak labour market. Productivity performance actually had relatively little to do with the problems we had in the early 1990s. The deterioration in terms of trade was not really a factor either.

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I think the first thing we can do is focus on creating better macroeconomic conditions to facilitate something closer to full employment. If anything, as I mentioned, the recent U.S. experience has shown that unemployment rates can fall further than central bankers—or some central bankers—think without triggering inflation. The U.S. Federal Reserve has been far more tolerant of inflationary pressures and far more willing to push the envelope in terms of full employment than the Bank of Canada has through the last decade, although the bank to its credit has softened its stance somewhat recently.

Now, what about improving productivity? Some are tempted by a cursory glance at the poor aggregate manufacturing productivity numbers compared to the U.S. to characterize Canadian manufacturers as hiding behind this undervalued dollar, and that's their main competitive advantage. Yet when you disaggregate the data, you find that with a couple of notable, albeit very important, exceptions, productivity in the Canadian manufacturing industries has been growing faster than in the U.S. The two exceptions are the electrical equipment and industrial machinery sectors, which are important sectors, and, I think, things that we need to look at to see why we're lagging behind there.

I think that the two most important things we can do over the long run to improve productivity are to invest in education, and basic research and development. These are indeed long-term investments. The benefits of rising levels of education, for instance, among the workforce are very slow to materialize, since each year a new generation of graduates entering the labour force makes up just 2% of the active labour market population. So it takes a long time before they enter the labour market and can contribute to rising productivity levels. It's a slow process.

I think the second point to make is that it's one thing to educate young people, but it's also another to create the economic environment in which they're able to use their skills to work. And so I think here that we need to look at coordinating our fiscal and monetary policies.

On the issue of human capital, to conclude—one of the advantages of going last is that all the people have said what you wanted to say—I think it's also important to recognize that just by educating people.... This may sound a bit like heresy coming from someone who represents university teachers. It's one thing to educate people, but we also have to look at access to education. I think this requires broader social policy initiatives as well. We are seeing recently an increasing divide in participation rates among socio-economic classes. That inequality to access is being driven by inequalities in the marketplace. So I think that in order to address educational equality, we also have to look at broader issues of economic equality as well.

That's where I'll end. Thank you.

The Chair: Thank you very much, Mr. Robinson.

We'll now proceed to the question and answer session. We'll have a seven-minute round.

Is it okay, Mr. Loubier, if Mr. Brison goes first?

Mr. Yvan Loubier: I have the same problem.

The Chair: You have the same problem?

Mr. Ken Epp (Elk Island, Canadian Alliance): I don't have that problem. So, on future considerations, if these guys will henceforth always be nice to me, I will concede to them.

The Chair: Mr. Loubier.

[Translation]

Mr. Yvan Loubier: Thank you, Mr. Chairman. Gentlemen, welcome to the committee on finance.

As in the past, I very much appreciate meeting with you and having the benefit of your counsel and your expertise. I appreciate in particular your analysis of the importance of human capital.

In several regions of Quebec, the rate of demographic growth is very obvious. Certain regions are experiencing an incredible manpower shortage and this is particularly true in Montérégie, in the central part of the province. We have had to call upon workers from areas experiencing a slight manpower surplus. It is an unprecedented situation and we must address this problem. There is a great deal of investment going on, but we lack the manpower we need to realize the full economic potential of these investments. I was, however, rather surprised. As much as I respect your judgment, I was rather surprised to see you praise Mr. Martin so highly. Love is blind, but I was expecting, from such distinguished academics, a degree of criticism concerning, for example, some of the inflated forecasts Mr. Martin has made during his years in office. Let me be more specific.

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When you make forecasting errors, which is what he calls them, on points which, according to him, no one had foreseen, and, only a few months later... The last instance is when Mr. Martin, within a four or five month period, overestimated our budgetary surplus by 160%. I am a little bit concerned about that. Last year, he predicted, for fiscal 2000-2001, a budget surplus of only $4 billion, which he increased to $7 billion in October when he brought down his mini-budget. And yet the figures for the first eleven months of the year show a surplus of over $20 billion. Even taking into account the March expenditures, the tax cuts introduced in January and the money spent on Genome Canada and other agencies, we still end up, for fiscal 2000-2001, with a net surplus of over $17 billion.

I did not once hear you criticize these forecasting spreads. I understand the need for prudence but, coming from rational, sober-minded academics such as yourselves, it is no longer simple prudence. Someone ought to be telling Mr. Martin that he should be giving us the true figures and since it turns out that he has not, in the last three years, told us the truth about the size of the surplus, he has undermined the credibility of the very process underlying next week's budget presentation. No one believes his projections anymore and, furthermore, it is a totally undemocratic way of going about things. When we end up not knowing the true state of our finances and when not even academics and straight- thinking economists expose what is happening, there is a problem. We are undermining the credibility of the whole budgetary process and not one voice was raised if not to criticize at least to discuss this aspect of the matter.

As far as the rest in concerned, I share your point of view, especially considering the drop in the rate of demographic growth. This is, to my mind, an important aspect of the issue considering its impact on competitiveness, something close to the heart of our chairman.

Would you tell us more about the various forecasts? I would also like you to tell me what you anticipate the net amount of the surplus would be as of the 31st of March. Was the surplus of the last fiscal year $4 billion, as Mr. Martin announced in February, $7 billion as Mr. Martin announced in October or some other figure? I would appreciate your comments on this point.

[English]

Prof. Thomas Wilson: I'm sorry I didn't comment on that, and thank you for raising the question and talking about Mr. Martin and the large surplus that will come about.

With the year-end adjustments, I think it may be more like $15 billion or $14 billion. Still, it's much larger, but that primarily reflects the extraordinary strength of the economy in the year 2000—the very high growth that wasn't anticipated, the strength of corporate profits, and so on.

My view on this is that when we have unexpected strength, it's debt reduction that takes the residual. That's when we should pay down a lot of debt. This is the automatic fiscal stabilizers at work. I thought this was a big improvement this year over previous years, when there was a tendency to backload spending in order to say the surplus is over target, so there's room in here to load on some spending. I think not doing it was fine and was appropriate, given the business cycle.

If, on the other hand, it had been a case where the economy was weakening, and then we wind up with a larger surplus than anticipated, then I think we have to go back and ask, well, what went wrong? There's obviously something wrong with your fiscal forecast.

The Chair: Are there any further comments?

Dr. Thomas Courchene: Yes.

Your ex post point is very well taken. The problem is that initially in 1995 it was important that we make the “hell or high water” claim come true in getting the deficits down. Therefore the finance department introduced an interesting process by using both prudence and the contingency reserve, which I, at least, supported.

What has happened, as Tom said, is that the growth has been larger than expected, but the problem there is not so much a finance department problem. It's the consensus forecast problem, because the finance department is working off the consensus forecast. So if the consensus forecast is wrong—

[Translation]

Mr. Yvan Loubier: Allow me to comment.

I agree that a forecast can be off by 3 or 4%. At the beginning of my career as an economist, I was myself involved in forecasting. A 3 or 4% disparity over the course of a year, is not bad. It can be considered a perfectly normal margin of error. What is hard to accept, however, is a deliberate forecasting error of 130% over a four and half or five month period.

• 1030

You must admit that there was an incredible discrepancy between what Mr. Martin stated last year, what he stated six months ago and what he will shortly be stating when he releases the figures for the last fiscal year. This has been going on since 1995. I agree that extra surpluses are a good thing since they enable you to do more. I am not arguing against that. I am arguing against the fact that Mr. Martin took us for fools when he told us that there would hardly be any surplus at all this year, by concealing the truth from us, while he intended, all along, to allocate more money to pay down the national debt. As Mr. Wilson stated, any unexpected surplus goes to pay down the debt.

Instead of saying outright that he expected, for the coming year, a $17 billion surplus and that he wanted to allocate $10 billion to pay down the debt... That is called honesty and everyone would understand. You might disagree with him but at least you would understand what his policy is. That is obviously not the case. What we are getting is both sly and hypocritical.

By considering that this was simple prudence on his part, you are going along with what Mr. Martin is doing when he stands before the House. And he will do it again this afternoon or tomorrow when he has to answer questions on this very matter. He will stand up in the House, and quoting as authority Mr. Courchene, Mr. Wilson and Mr. Robinson, he will say that that is what economists are saying. When I take him to task for making a 130 or even a 300% error in his forecasts for this year, he quotes you as authority. Will we ever see the day when you appear before the committee and say that Mr. Martin is going a bit too far, that you agree that he does have some leeway in the matter and that it is his right to err on the side of caution, but that there is a limit to the freedom he has to produce figures such as those he has been producing these last four years? It is your duty to speak up. You are appearing before the committee to state the true figures. Mr. Wilson spoke of a $14 billion surplus this year. That is the first time that I have heard quoted a figure that is slightly closer to reality than those that Mr. Martin has previously mentioned. That is what I would like you to tell us.

Mr. Courchene, I consider you to be the best macroeconomist in North America. I have had the opportunity to study the books you have written on macroeconomics and the banking system. But I would like you to be more precise in this matter and I would like your colleagues to do the same. You spoke of prudence. I do not call that prudence. I call that deception. Do not go along with Mr. Martin on this.

[English]

Dr. Thomas Courchene: I don't believe I'm playing into Mr. Martin's hands.

I have two points to make on this, and then I'll turn it over to Tom. I think Tom is more a forecaster and better able to answer this than I am.

The deficit is a residual of sorts. The forecasts are typically made on GDP growth, on interest rates, and on expenditures and revenues. Small errors in those can give you huge errors in the residual, and the deficit's a very difficult number to predict. When you talk about 300% errors, that sounds like somebody made a huge error, but it doesn't take much of a spurt in economic growth larger than was forecast to give you that. So that's the first point. The errors are not that much on what is being forecast, namely GDP growth.

Secondly, I return to my earlier point, which is that the finance department gathers and takes an average of the forecasts in the private sector and uses this as the basis for its estimates. It does apply prudence and also some contingency reserve to that, but these private forecasts are wrong. It turns out to be underestimates in Canada, in the United States, and all over the place in this upswing.

Unless we go back to the old system, where the finance department just has its own internal forecasting.... We're relying on objective material. It's put forth in a forum like this. I think the forecasters come before the House of Commons committees. They make their forecast—their average—and that feeds into the finance department.

I think the right thing for you to do is to take this question of yours and pose it to the forecasters. Ask, how come you've been wrong all these years?

Tom is a forecaster, so I'll turn it over to him.

[Translation]

Mr. Yvan Loubier: Could we wait a moment before going on to Mr. Wilson. We have been drawing up forecasts since 1996. These are based on the rate of GDP growth, on what the major Canadian banks are doing, on the work of forecasting institutes etc. but we adjust our calculation of GDP growth according to what is out there, to the growth rate of government revenues. For the last seven years, the growth of federal revenues has outpaced the growth in the GDP. Adjustments are made in our calculations. In the course of the year, we take into account income, expenditures and new information. We are continually adjusting our projections. In my own party, I am part of a tiny research team working on this with relatively unsophisticated software.

• 1035

Last year, when Mr. Martin predicted a $4 billion surplus for fiscal 2000-2001, we, using the same objective parameters, came up with a $21 billion surplus. If you take into account the tax cuts announced last October, just before the election campaign, the new money provided Genome Canada and the March expenditures, you end up with surplus of approximately $17 billion.

How come our small research team, three people working with a portable computer on the basis of objective data and the rate of growth as calculated by the major Canadian banks and forecasting institutes, can come up with precise calculations that are very close to the actual figures. We have done that every year since 1996 while Mr. Martin has been making the most incredible forecasting errors? Forecasters cannot be right all the time and I fully agree with Mr. Courchene that forecasting errors do occur, but how can I accept a forecast that is off by 130% or even, as it is this year, by 300%.

This year, Mr. Courchene, we have revised our forecasts for the next five years by taking into account the weakness of the economic outlook. But even with the lower growth figures...

When I look at the headlines such as those appearing in today's National Post, which state that Mr. Drummond foresees a deficit within the next three years, I believe someone is putting us on. With the super cautious forecasts he made last week, he is setting us up for more of that very game Mr. Martin has been playing with us since 1996. You cannot fool the people all the time.

[English]

The Chair: Thank you, Mr. Loubier.

Professor Courchene.

Dr. Thomas Courchene: With respect, I think that Tom Wilson, or someone else, is far better to take a shot at this. I tried my best and you're not satisfied with it, so I think I'll turn it over to somebody else.

Prof. Thomas Wilson: I just want to second your basic point, Tom, which was that it is the residual, so to take a percentage of error on something like the deficit, or the current account, or inventories, where you're subtracting something from another, like inventory change...you can get large percentage errors. If you look at people's forecasts of those things, they often have large percentage errors, because you're taking two big numbers, spending and revenues, to get the residuals. I think you should look at the percentage of errors in the forecasts of the two components.

I can just say that part of the overrun was due to the fact that the consensus forecast for 2000 was off and the economy was very strong. It wasn't just the economy; profits were extremely strong. In our data here, after-tax profits were up 28%, year over year for 2000. I don't think that was predicted in the consensus, even in the middle of the year.

So that would be one. If you're saying you'd take the same kinds of data that are in the consensus forecast and then crank out your own fiscal forecast that was proven to be more accurate than theirs, I think what you want to do is compare your methodology with the people in Finance who do the fiscal forecast based on the economic forecast.

The Chair: Mr. Brison.

Mr. Scott Brison (Kings—Hants, PC): Thank you to all of you for your interventions this morning, and thank you, Mr. Chair, and also Mr. Epp, for allowing Mr. Loubier and I to precede his intervention.

On the issue of the Canadian dollar, the Bank of Canada in recent years has pursued a high dollar monetary policy. Inflation targets in Canada have been about a point lower than those of the Federal Reserve in the U.S. Yet our dollar has dropped precipitously. It has dropped further than one would expect based on just the secular decline notion or trend.

The government won't talk about the dollar. It won't talk about the notion of dollarization. It won't talk about some of the prescriptives to actually use fiscal policy to strengthen the dollar in terms of aggressively addressing the capital tax issues, or more aggressively addressing debt issues, or regulatory issues in the context of productivity. We have a government that won't talk about the dollar, that seems to accept its decline, although it wouldn't state that, and that seems to accept the notion that it's declining rapidly under its leadership.

• 1040

In the last couple of weeks I've had two different people—erudite individuals from the world of economics—who've told me that they believe the government in fact accepts the decline of the dollar and is not willing to politically take the action—the fiscal policies—to strengthen the dollar. In fact, it may want to actually see the dollar atrophy to a point where Canadians start asking themselves the hard question of why even bother having a dollar if we have this embarrassing limp looney as our exchange rate.

So I'd appreciate your feedback on that notion, because from a political perspective the notion of losing our monetary policy independence and losing the Canadian dollar is a very divisive issue. Is the government just trying to create the economic conditions such that Canadians start asking the questions themselves on a more widespread basis and make the ultimate decision easier for the political powers?

Prof. Herbert Grubel: Well, Scott, I think you have raised an interesting question. But I am not really a psychologist. In order to be able to comment on motives, you have to delve into complex structures of peoples' ideas and where they come from and what they want to do. I would prefer not to comment on this, except to say to you and everybody here that we have a problem in Canada.

In the last decade, the gap between per capita income in Canada and the United States has gone from 88% to 80%. There is a trend here, at a time when we were doing the right thing on inflation. Everybody said that would help increase productivity. We've done the right thing in terms of balancing the budget and creating confidence in Canada. We have done a lot of things on taxes—not a lot of things; we have done some. There should be something more done. I think it raises a question: what causes all of this?

I'll be going to the Bank of Canada tomorrow to give a seminar on that subject to share my ideas on this. I think it is a very subtle dynamic process, which is responsible for the decline in the dollar. If I may, I would like to just briefly sketch it.

There's no doubt of the econometric forecasts made by the Bank of Canada, David Laidler, and my friend over here that there is a high correlation in the fall of the dollar whenever commodity prices in the world go down. But somehow commodity prices are not what we teach is a determinant of the exchange rate. The determinant of the exchange rate—I've been teaching for years and published in textbooks—is, number one, what has happened to inflation? What happened to the price level?

If you look 30 years back, you will see that the cumulative rate of inflation in Canada and the United States was virtually identical—one percentage point difference. So it couldn't have been the inflation.

What about the other thing that is supposed to determine it—terms of trade? Why pick on the rate at which we exchange our commodities for the products that we import? Why not look at the rate at which we exchange all of our production against the rest of the world's production? If you look at the last 30 years, the overall terms of trade for Canada have improved. So this is not a very good explanation either of why the exchange rate has depreciated.

What I am left with is a dynamic story, which Mr. McCallum does not have in his model, and that is the following. Let me just briefly sketch it.

You get a decline in the demand for commodities, prices fall, the exchange rate falls—clearly demand and supply. We then let the exchange rate go down to help re-equilibrate that sector of the economy—an increasingly smaller sector. The biggest sector in the economy is medicare. So what happens is, if everything was in equilibrium at the time that commodity prices fell, you disequilibrate the rest of the economy by definition. One manifestation of that disequilibrium is that profits, which were previously normal, go up.

• 1045

Look at the automobile industry. They sell their products in terms of U.S. dollars. Now when you get higher profits in the automobile industry, we have strong unions there that are very happy to see profits go up. So they go and say, now is the time for you to share with us your happy state. They raise their wages. But their productivity hasn't matched the increase in the wages they're paid. The proof of that is in the next period when the commodity prices recover. The exchange rate in the models that are being used in the Bank of Canada should go back to its old level. But what happens? Well, the recovery of the exchange rate is cut well short before that, because the automobile industry and all the other industries that have increased their wages are not productive or profitable any more. Their exports are reduced.

This is the sort of a cycle that we used to see in Italy. That cycle ended in Italy when they joined the Germans, and the Bank of Italy could no longer change the exchange rate. So we must look at these mechanisms. We could change the mechanisms directly, attacking the problems. But one indirect way and politically positive way is to have a hard fix of the exchange rate.

The Chair: Mr. Brison, I knew there was going to be an Italian response to this.

Professor Wilson would like to....

Mr. Scott Brison: Mr. Chairman, maybe Professor Wilson and Dr. Courchene can incorporate into their response....

Without the floating currency—the Canadian dollar is an operative mechanism—what would have been the operative mechanism, which would have compensated for the commodity price decline? I guess what I'm saying is with the Canadian dollar having dropped so significantly in recent months and years, wouldn't the operative mechanism have been unemployment rates or something to that effect? Would that have not been potentially more deleterious?

Prof. Herbert Grubel: Just quickly, the emerging consensus from people who have studied this is that willingness and the ability of the labour market to adjust to economic shocks and especially respond to declining trends like the commodity prices is endogenous to the exchange rate system. If you are sure as a worker that if you get into trouble the exchange rate is going to bail you out, you're not going to be as willing to make the necessary adjustments—lower wages, moving, and so on—that are necessary but which we summarize as labour market flexibility. Labour market flexibility is endogenous to the exchange rate regime. This is my theory. The theory of some others says there is no evidence that it is in fact working. Whether or not it is sufficiently strong a force to justify ex post that we should have done that is an empirical question, and there you have to take the risk.

The Chair: Professor Wilson, do you want to comment?

Prof. Thomas Wilson: Yes, I just want to make two points—more short term, looking over the last two years.

I was just looking at a graph in the Bank of Canada's recent monetary policy report, which has exchange rates from the beginning of 1997 to today. They have three rates in this graph. I commend it to you. One is the U.S. dollar rate, and we know what's happened to it. It starts off at 75¢. At the end of the graph it's below 65¢. The other is the index versus C-6. That's our six major trading groups now, including the euro, the yen, the Swedish krona, Swiss franc, and the English pound of course. So it's a representative group. But with the U.S. dollar having the lion's share of the weight, then that's an index that went from 90 down to 80. So again, we don't look so hot.

But when we look at the C-5, in other words all of our trading partners excluding the United States, we're virtually bang on now, as we were in 1997. So in a sense the question is what explains the great strength of the U.S. dollar, not so much why our dollar is weak. The U.S. dollar has been extraordinarily strong, and you can't explain it by current account fundamentals—it's the capital account that's been the massive flow of capital into the U.S. They've got the strong dollar, and the current account deficit is probably largely a consequence of the great strength of their dollar.

• 1050

We haven't benefited to the same extent. You could say that we're in North America and adjacent, so maybe if we had different policies we might have shared in that. You could do some “what-ifs.”

But the other point to make—more in relation to our decline with the U.S.—is that when we embarked on bringing inflation under control, we did it with a restrictive monetary policy. At that time, in the early 1990s, our dollar was very strong; it was over-valued.

When I went to Vermont to ski, I remember seeing shopping centres being developed right across from the Canadian border. I think those are all bankrupt now, because they were counting on that strong Canadian dollar. Cross-border shopping was the thing.

Later on in the 1990s, we got into a restrictive fiscal policy, and we credited the government for bringing the deficit under control with it. But at the same time, when there are restrictive fiscal policies to keep the economy on an even keel, monetary policy has to be more relaxed. The consequence of that particular combination of policies will be dollar weakness.

One of the reasons I'm relatively bullish in looking ahead on our dollar is that we're now looking at a much more balanced approach. Inflation is now entrenched in the target zone. We can now have more neutral monetary and fiscal policies and not really think of them as expansionary, because we're talking about policies that prevent a growing surplus. So again, they're relatively neutral.

I think this will allow the fundamentals to come through: the fact that we have a lower inflation rate than the Americans, and the fact that we have a positive current account balance and they have a large negative one. I don't want to place bets here, but my guess is we'll see dollar strength.

On the other hand—I keep a cartoon on my door that shows two hoboes sitting begging with cups and hats. One says to the other “The single thing that sustains me is that the fundamentals are correct.”

Some hon. members: Oh, oh!

The Chair: Mr. Robinson.

Mr. David Robinson: I just want to respond quickly to some of the things Tom said. I think it's important to understand why the Canadian dollar has been experiencing some weakness recently—I think Herbert and Tom have already talked about the longer-term issues.

What's happening now is that the fear of a global recession was pulling a lot of investment into the U.S., and that was propping up the U.S. dollar. Actually, if you look at how our dollar has performed recently compared to the euro, the yen, or the Australian dollar, we've actually been winners. The euro and the yen were the worst-hit currencies. We've even appreciated somewhat against the British sterling.

Once fears of a full-blown recession finally subside, I think lower interest rates in the U.S. will push the American dollar down slightly. Our dollar should rebound towards the end of the month. But we'll have to see.

The Chair: Mr. Courchene, a final comment, and then Mr. Cullen.

Dr. Thomas Courchene: I want to make a comment or two, since I brought this issue up in my paper. I'd like to support and amplify on what Herb Grubel said, because he tells part of the story: that using the exchange rate to buffer commodity prices traps labour and capital in the old economy and prevents it from going into the more productive new economy. In that process, our productivity tends to fall relative to the Americans.

But the other part of the story, which is consistent with what Herb says, is that we've been hit by another shock: the general-purpose technology such as computers and information systems. That's two shocks, the falling commodity prices and the new wave of technology, and initially Canada and the U.S. were hit to the same degree.

But the computers are priced in U.S. dollars, so when we drop our exchange rate, we're going to buy less of this new economy because the price in Canadian dollars rises.

• 1055

So that combination—of both the shortfall on investment in the new technology and the trapping of labour that Professor Grubel talked about because we're buffering the commodity prices—means that in the longer term, our productivity will fall.

This model, by Rick Harris, is available now, and I think it will really be quite important, because it introduces endogenous growth into an open-economy macro situation. He's done some empirical work, which shows that every time the exchange rate falls, you do get some productivity bump-up in the short run—our utilization goes up, because we can export more easily to the U.S. But over the long term, we tend to get a decline in productivity relative to the U.S.—both of which would support that existing theory.

So I think we have to look at this firmly entrenched notion the bank and the government have: that productivity is independent of the exchange rate. At least let's leave it open and take a closer look at it. That's an important area, and I think this committee could bring some productivity experts to look at it.

The second part of Mr. Brison's comments was, isn't there another way to accommodate these shocks? The answer is, of course. Washington State accommodates these shocks without having an exchange rate change. So does California.

Again, I'll support some of what Herb says. Part of the reason why flexible exchange rates became so important, when Canada was experimenting in the fifties and then in the seventies, was that wages were viewed as rigid. So the thinking was, why force a very difficult internal change on relative wages and prices when you could just do it through the exchange rate? But now prices have become far more flexible, so we can take on some of that stuff internally.

Another point—and this is one I've made in my writing—is that it's wrong to look at.... Typically, the people who use the buffer-stock argument for exchange rate rulings look at Canada as a single point. Canada has space associated with it. The nature of economic productivity in the Maritimes is different from that in Ontario, which is different again from that in Alberta, which is different from that in Saskatchewan.

So if I assume that Ontario is on track economically with Michigan, and Alberta is on track with the Texas Gulf in terms of energy, and an equal to B.C. is set up south of the border, and the Atlantic region's costs are associated with the eastern seaboard—then we get this commodity price shock and it affects all these cross-border areas identically. It affects Michigan the same way as Ontario. It affects Boston the same way as Halifax.

As Herb pointed out, if we take it out through the exchange rate, we put all Canadians and the entire Canadian economy offside. Wouldn't it be better to keep the north-south thing fixed and the east-west thing fixed—which means having a hard peg—and then rely on things like...?

What I'm saying is that the principal shocks are not north-south, they're east-west. Alberta gets hit differently than Ontario. That's the big impact of a trade shock.

So we can use equalization, use unemployment insurance, use the personal income tax, to sort out what's happening east-west. That's how I think you'd take the shock out. That's the new adjustment mechanism that replaces the flexible rate.

The Chair: Mr. Cullen.

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

I have an 11 o'clock commitment, so I'm going to be very brief. I'll put some questions, then read the answers in the transcript tomorrow.

Welcome back, Herb. Thank you very much, all of you, for being here today.

First, I'll be kind to Mr. Loubier, since he's left. I would just like to say I congratulate him on his laptop. It sounds as if it's more powerful than all the macroeconomic modelling systems, not only in Canada but around the world. I take my hat off to him.

I'm sorry I missed your presentation, Mr. Robinson, but I understand you talked about R and D.

To step back for a moment, Michael Porter has just done a ten-year retrospective on the report Canada at the Crossroads. He says we've made tremendous strides on the macroeconomic front, though there's still more to do. He talks about the challenge at the micro level, of provincial and business strategies. He argues that we've been adapters and adopters, but we should be more innovative, more entrepreneurial.

I'm going to move to another question, then, if you don't mind. Then I'll have to leave you and read the transcript.

In terms of economic and fiscal policy, what should we be doing in Canada to encourage more risk-taking, more risk capital, more entrepreneurial activity, and richer capital markets, to foster the growth of this emerging and changing economy?

• 1100

Mr. Courchene, I'm reading your book A State of Minds with interest. Thank you for your continuing contributions to economic and fiscal thinking in Canada. I must say, I skipped ahead to the chapter on tax policies and I'm going to come back to the rest.

I'd just like to cite a particular example of your thesis that Canada should be more aggressive in terms of competitive tax rates on mobile factors, as you call them. We've set in train some corporate tax rates in, let's say, Alberta and Ontario, where on a combined basis we're going to have very competitive tax rates compared to many of the bordering U.S. states.

I think you're arguing that the federal tax regime in Canada should be more aggressive on the higher marginal rates, notwithstanding the huge tax cuts. I understand what you're saying.

In terms of the federal government's role vis-à-vis the provinces—I know it's a very complicated subject. A lot of people come to visit us here in Ottawa, and of course they look at these so-called surpluses and perhaps forget about the debt and the other things we need to do.

Canadians tend to look to the federal government to move into areas with gaps, such as health care, post-secondary education, roads and highways, the homeless, public transit, affordable housing, and so on.

Part of this, of course, is that we're here to make our case, and part of it is a political issue. But I wonder if you could comment on the expectation there seems to be among Canadians—they're prepared to relieve the federal government of the tax relief you're looking for, leaving some of it to the provinces, but they still look to the federal government to fill in these gaps in areas they think are important.

Unfortunately I have to go now, so I'll just leave that with you. Thank you for your presentations. I'll read the transcripts tomorrow.

The Chair: Who's going to comment? Mr. Robinson.

Mr. David Robinson: On the question of research and development, and the innovation that firms and universities engage in, at the risk of oversimplifying, I think there are really only two kinds: process innovation and product innovation. Historically, Canada has been fairly good at process innovation, which is essentially doing the same thing but doing it better, with minor modifications. But we haven't been very good at product innovation, and that's where I think a lot of our big productivity gains can come from in future.

In terms of what kinds of policies the federal government might want to look at, I'm here representing university teachers, so I'll make a plug for university research, particularly basic research, which is critically important to the development of product innovation. Basic research is often a hard sell because it involves a long-term commitment and its results often only happen many years down the road. But historically, it's the basic research coming out of universities and government science that has largely driven product innovation down the road. Unfortunately, because of the fiscal situation the government has found itself in, in the last decade, we've seen a decline in the funds available for basic research.

Recently, the government has been putting money into the Canada Foundation for Innovation. I would argue that this initiative and others tend to focus on minor variations on existing products; they don't get to the problem of how we undertake basic research. If you look at the U.S. example, there's a much stronger commitment there in terms of federal research grants to the universities for basic research. But I'll leave that for now.

The Chair: Any further comments?

Dr. Thomas Courchene: Yes, two comments on the two questions raised.

In terms of taxes on mobile factors, I'd just like to note that I had to revise part of my book because the October budget did actually move much more strongly in the direction of lowering taxes on mobile factors—particularly on the corporate side—than the 2000 budget. Therefore I added a little annex to the book saying they really did quite well here. They're moving, at least on the corporate side.

• 1105

The provinces as well have acted very forcefully, so we now have the situation—setting aside Bush's tax cut—where the corporate tax rates in several Canadian provinces are considerably below those across the border.

But I think there still is a problem on the individual tax side. I was surprised that Ontario didn't move strongly to narrow the gap between Ontario and Alberta on the personal income tax side. It must be because Ontario felt it no longer had a booming economy. But that's an aside.

In terms of the role of the federal government, globalization, as we know, is sort of polarizing incomes. Every society is tending to look like the U.S. because incomes were always polarized there. Canada is a bit better, because we have a more intelligent and caring social safety net.

But the longer-term solution has to be to get the skills and the human capital of the lower parts of our labour force and to provide equality of opportunity. That's what it will mean to be a productive member in the 21st century, and also that's what it will mean to be a full citizen in the 21st century.

With regard to the role of Ottawa, at the very least—and it probably has to do much more—there are the huge infrastructure areas that have to be looked after. There's the infrastructure of the information system, where ribbons of steel are now being replaced by filaments of fibre. Ottawa has done a pretty good job with that. That's part of the information access and human capital access.

I think the whole notion that this new economy will do for human capital what the industrial revolution did for physical capital has to pervade the entire operations of our system. I made a suggestion about having as an implicit or explicit goal for what we are in the 21st century the development of a human capital bill of rights for our kids. Those kinds of things are the gaps Ottawa has to fill.

A lot of the implementing of human capital, it would appear, falls under provincial jurisdiction. I think one should give the provinces a chance to work this out among themselves. If they can't generate the pan-Canadian norms that are needed through SUFA or the annual premiers conference, then I think, as a Canadian and as a believer in our future, which means a human capital future, that Ottawa has to step in. I think it's that important.

The 21st century is about people. Electorally it's certainly about people. It's about people socially and economically. That's the mission statement we have to head toward. Ideally, let's do it cooperatively. We can't let our people down.

In the resource area you could. I don't know how many kids in my high school, which was small, left to work on the pipelines in grade 10 or 11. It has been 20 years, and I may still not be up to their salary. But times have changed now. We still have some of those people trying to do the same thing. In fact, the worst-off cohorts are those young males who still think in the resource-based economy mode.

In the 21st century human capital is where we're at. Ottawa has to take a leadership role and probably do more than that.

The Chair: Next is Professor Grubel. Then we'll go to Mr. McCallum, followed by Mr. Epp.

Prof. Herbert Grubel: If Roy were here, I would say it's really a fundamental and difficult problem.

It used to be said that in England before Mrs. Thatcher, if somebody living on the street arrived with an expensive car, the neighbours would all get together and say, “He must have stolen it. Let's all get together and take it away from him.” In the United States the attitude I encountered when I lived there for 10 years was that if somebody who lived on that street came along in a Cadillac, everybody would say, “Isn't it fantastic that he was able to get a Cadillac? Maybe I or my son can, too.” In Canada we are somewhere in the middle of those two extremes, but closer to that of the English sentiment.

• 1110

Somebody described to me the other day the way this phenomenon is noted in Canada. That is, if a poppy grows above the rest, we go and knock it off. I have a son. I think he's a poppy. I'm probably biased. He got an offer to go to Los Angeles, and he found out that after taxes he alone would earn more than he and his wife, who has an engineering degree and an MBA, earned together in Canada after taxes.

Why are we doing this to ourselves? Because we have a mentality here, which is difficult to explain. It's historic, but very similar to what it used to be in England. It is that we can't have these flowers grow higher than the others. Let's knock them off. We have to get out of this mode. We have to say, guys, when you do well, when you are taking risks, when you are involved in education for a long time and you're making it, you should be allowed to keep it. We need more of that than is being done now.

The other side, of course, is that there are all kinds of people going off to work on the pipelines even though they know the job will be over in five or six years, because they know that if they fall into misery, the government is going to bail them out. I'm not saying we shouldn't have a safety net, but we should look at the longer-term implications of all of that.

Finally, I've been in universities long enough on both sides of the border. In Chicago there's a wall of portraits of people who have won Nobel prizes. It's a private university without a faculty association. I was told by Milton Friedman, when we give someone tenure, it doesn't matter. Why? Because if it turns out he's not living up to our standards, we keep his pay down and give him so much work that he leaves.

In a Canadian university that's how you get a wall full of Nobel Prize winners. In Canadian universities—and John knows this very well—we have mandatory retirement at 65 because you can't get rid of deadwood. That's why the amount of money we're spending on education is one of the highest in the OECD. The foundation of human capital is very well financed.

But this entire ideology that drives Canada and makes it for many of you such a wonderful place to live has this as a consequence: we're less efficient. We're not going to get the wall of Nobel Prize winners with the kind of policy that says, the professors of English, whether or not they produce something society wants, have to have the same pay as the engineers. That is what John was fighting all the time. He didn't get very far. Maybe he got a little bit. But it is a very serious problem. We need to have a change in attitude on those things and changes in institutions corresponding to it.

The Chair: Thank you, Professor Grubel.

Mr. McCallum.

Mr. John McCallum (Markham, Lib.): Thank you, Mr. Chairman.

It wasn't so long ago that Herb Grubel was sitting over there as the then Reform Party critic and I was sitting over there as a witness. So there has been something of a reversal.

I thought Herb Grubel and Tom Courchene in particular, being strident advocates of dollarization and particularly in light of David Dodge's comments, would be talking more about this. Perhaps I was wrong.

Just by coincidence, I'm giving a lunch talk tomorrow in Michigan, and I have copies of it, if anyone is interested, dans les deux langues officielles. You're welcome to it. Just to give you a flavour of where I'm coming from, the title is “Canada Should Avoid Dollarization Like the Plague”, ou en français, “le Canada devrait éviter la dollarisation comme la peste”.

I'd like to raise three issues and ask three questions regarding those issues.

It's a pleasure to see Herb. I disagree with just about everything he says, but I don't have time to get into that.

• 1115

I'll just raise these three issues.

First of all, as a question of philosophy, if you like, I think that certainly Bernard Landry and Yvan Loubier, and some elements in the Canadian Alliance Party, want to apply the European model to North America. That implies one thing, dollarization, and secondly, harmonization. But in a North American context, harmonization means that we copy the U.S., because who do you think is going to harmonize to whom? Obviously us to them.

So this is the sort of sameness, or you could call it Americanization over time, that our taxes, our social programs, will evolve to the American model. That poses clear problems from a sovereignty or philosophical-political point of view. But even economically speaking, I think we're better off not to copy them, but to capitalize on our differences.

For example, we have lower corporate tax rates than the U.S. For example, we can have deeper trade relations with third countries than the U.S. has. For example, we can have a better immigration policy than the U.S. has. For example, our health system is better than that of the U.S., even though it has some problems. So I believe our economic future lies in capitalizing on differences rather than going for sameness, which is what the European model implies. I'd like any reaction you might have to that.

Second, on this question of dollarization, which two of you support, Argentina is sitting out there for all to see. Argentina is crippled by this dollarized fixed parity with the U.S. Argentina is in a deep recession. Argentina is possibly facing a financial crisis because it has this albatross around its neck, which is a fixed parity with the dollar. Why on earth would we want that?

Another example is Ireland, which needs higher interest rates because it has a property bubble. It can't, because it's tied to German European interest rates. A third example: I argued that if we had had a fixed parity or a currency board during the Asia crisis, we would have lost that extra degree of freedom and probably had a recession or a severe economic downturn. So why in the world would you want to do such a thing?

My third point is a more technical one. I think there's a confusion between those arguing for fixed currency and those arguing for stronger currency. I don't think there's much evidence that productivity has been affected by a low currency, but even if you believe that, the prescription is a stronger currency to make manufacturers less lazy, to make them work hard rather than play golf every afternoon hiding behind a weak dollar. So the prescription would be a strong currency, like 75¢ to 80¢, or whatever you say. The prescription is not a fixed currency, to lock it in today at 65¢ forever. But you guys never tell us how you're going to get from here to there. How are you going to get the strong currency? You don't tell us that. Do you want it fixed, locked in forever at 65¢?

Prof. Herbert Grubel: That's right.

Mr. John McCallum: All right, so that's my question.

Prof. Thomas Wilson: I haven't said anything about a fixed dollar. I'm a floater from a way back. For one thing, I think if you were to fix with the U.S. dollar, you probably should do it at an appropriate time, when the purchasing power parity has been achieved. If we did it right now at 65¢ I think we would guarantee a fair amount of inflation as the whole system adjusts. We would very much be like Ireland. On the other hand, if we had done it when we were fighting inflation with very high interest rates in 1990, then we would have locked in a serious recession as we adjusted. So the only time you should peg, or dollarize, would be when the exchange rates have got to that right kind of balance.

But I agree 100% with what you said, John. I don't see any gains at the present time for taking that step, giving up that additional degree of freedom.

Dr. Thomas Courchene: I think John is wrong on all three points, but our criticisms go way back.

On the first one, that we adopt all U.S.-type policies if we have a fixed exchange rate, when did Canada become this flower of creativity and compassion and caring? It was in the 1960s. It was with Pearson, in part, when we got medicare. We got the full equalization program, we did the Canada Pension Plan, the Quebec Pension Plan, and the Canada Assistance Plan. That's what gave us the identity as a caring, compassionate community.

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What was true of the 1960s and only the 1960s in the post-war period? We had fixed exchange rates with the Americans. We adopted their monetary policy. In effect, when looking at the evidence, one can say that this must have released us from focusing on this bloody exchange rate to become creative in the rest of the policy area. At least that's as plausible as what you're saying.

So you have to show me. Find another timeframe where fixed rates have made us adopt everything else on the U.S. monetary policy.

On the Argentinian issue, I agree there are two conclusions. One is, my goodness, does a currency board ever hold under such terrible circumstances? The second piece of evidence is, why on earth, if you're going to have a free trade agreement with Brazil, with your major trading partner, would you peg your currency to the U.S.? That's absurd.

We have 85% and Ontario has 90% of their exports through the United States. So it's different for us. We would be pegging our currency to the country that we export with and import from. So the problem with the Argentinians is they went into MERCOSUR and got a free trade agreement with Brazil, Uruguay, and Paraguay with a peg to the U.S. That was dumb. I agree with you, if that's the point you're making.

Finally, how do we get there? I agree with Tom, and in fact my earlier writing suggested that when it was about 80¢ was the right time to peg the dollar, when the free trade agreement came in. In terms of how we get there, the Europeans went through a decade-long process of the snake and the European monetary system to try to move towards a parity. If we think about a North American monetary union, we're going to have to go through that same process.

Let me just say one thing in John's favour. I think people on both sides of this issue believe strongly in what they're saying.

In answer to Scott Brison's earlier point, the finance department is not wrong. It just has a different perspective of what it wants to do. I think it's acting honourably. When Minister Martin says he's in favour of a flexible rate, I think he really means that. The bank means it currently.

So this is a debate that research and experience, probably more the latter, is going to resolve. Ultimately, if we don't get the currencies in order, dollarization will start creeping up and that process will erode the ability to bank. We will be driven into a North American currency union by dollarization or, another way to put it, by default.

[Translation]

Mr. Mario Fortin: Unlike the people asking questions or answering them today, I have not written on the issue of whether or not we should form a monetary union with the United States, but I have done some reading on the matter.

It comes down to just how we adjust to a shock that reduces the number of jobs in Canada. There are two things we can do and that have been mentioned before: we can either lower the value of our currency in order to make our products more competitive, or we can bring down salaries. There is a third way of adjusting: people can just leave the area affected by the downturn.

Between 1989 and 1993, New England lost more jobs than Quebec and Ontario, but the unemployment rate in New England went up less than in Quebec and Ontario because people left the area to go find work and settle elsewhere, most probably in the southwestern United States.

This mobility—as Mr. McCallum is in a good position to know—is much lower between Canada and the United States. This is a fact and that is why I believe Canada would be ill-advised to change over to the American dollar. Were Canada to do so, I feel that it would at the same time be compelled to promote policies improving worker mobility between the two countries. If population mobility between the two countries were to increase, would we be able to maintain, to the degree we do now, different social policies? It seems to be very much an open question.

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[English]

The Chair: Mr. Grubel.

Prof. Herbert Grubel: Quickly, on equalization, John, the fact that fixing exchange rates does not mean equalization of culture or expenditure on programs is evident from the fact that Massachusetts is as different from Texas as is Canada from the stereotype of the United States. There is no reason why we couldn't preserve the same distinctiveness as Tennessee, Florida, and California have in the United States, relative to the norm. There is every opportunity to do so.

Secondly, on Argentina, Tom already hit one of the main points. It is unfair to say that Argentina is doing badly. Do you know how badly it used to do before the minister brought in the currency board? They were desperate. In the 1930s, much like Canada, Argentina had a higher per capita income than the United States. Then they got into the clutches of the Peronistas and socialists, and the country went down the drain and had to be turned around. It had to be turned around, and the idea was that it would be done by a currency board. It was a very good model until it turned out they made that stupid mistake that Tom has just made. They should have fixed it to something else.

You are totally wrong on Ireland. In Ireland, there are no tariffs. There's perfect goods arbitrage. You can't have prices of traded goods in Dublin that are any different from that across the channel. Therefore, where does the so-called inflation come from? Inflation, as you used to teach—I think you taught; you should have—is a process of continuous price increases. This is a bubble, as you said. Here we have a country that lowers taxes, makes it a friendly country to be in, and—very importantly, not discussed widely in Canada—they made a compact between the unions, the employers, and the government that they would keep wages below productivity. Since productivity increased rapidly, their wages rose rapidly. They have an enormous amount of prosperity.

When prosperity comes...Mario just told me that the income elasticity of demand for housing is one. What they got as a result of this great prosperity was a demand for more and better housing. Well, we all know that you can't create housing or all the accompanying, non-traded services overnight. So they have a bubble—a once-and-for-all increase—which will be worked off as the houses get built. They don't have inflation. They have the side effects of economic success.

What we would do in Canada with your exchange rate system is we would kill the success so that we wouldn't have any bubble. Is that the right way to go? To me, the important thing is that we all do very well, and too bad that house prices go up, but we want to consume these houses.

I have one last thing, John. John is a Keynesian. I know that John McCallum has been one of the diehard Keynesians. I remember when we were colleagues. The way I was taught at Yale was that the fundamental problem of the capitalist western economy is the inflexibility of wages and prices. Therefore, what we needed to do was the first prescription. Let's have inflation so that we can get the real wages of workers below their real productivity, and therefore we will have prosperity forever and ever. We did it in the 1970s. It's now a historic record what a disaster it was. Nobody thinks that's a solution any more.

Then came John McCallum and his creed, and they said, in order to overcome the labour market rigidity, what we need is deficits. Well, we had our kick at that can. You know what happened. It nearly bankrupted the country. Everybody now agrees that maybe labour market inflexibility isn't as bad a problem as we made it out to be when we made those recommendations. But the same people who have been proven wrong on those issues are now running around the world and saying, labour markets are so inflexible that we need flexible exchange rates. I predict herewith that this idea will go the way of the dodo bird and the way of these other two ideas that came out of Keynesian economics, and it will be dead forever.

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Prof. Thomas Wilson: I want to react with a quick point.

First of all, one of the most ardent proponents of floating rates is Milton Friedman. I don't think—

Prof. Herbert Grubel: Freely floating rates.

Prof. Thomas Wilson: Freely floating rates.

I just want to say that one thing that hasn't been brought into this discussion is that Canada has had experience with pegged rates, in two episodes in the post-war period. If you look at when we floated, in both cases, it was under extraordinary demand conditions—one was the Korean War and the other was the Vietnam War. So there was strong demand for our exports. If we had maintained the peg, we would have had, granted, a transitory but significant inflation in both cases. So in the short run, you lose control over your inflation. Then, in the longer run, you give up any independent inflation targets.

Basically, you accept whatever policy the Federal Reserve puts in place over the long run. If they decide they are going to inflate by 4%, 5%, 6% a year—which was what it was not that long ago—well, we would get it willy-nilly. If they decided, well, we're going to go absolutely to price stability, and we didn't want to do it, we'd get that. So we give up that policy choice in the long run, and we also expose ourselves to fluctuations in the price level in the short run.

The Chair: Thank you, Professor Wilson.

Mr. McCallum, you're looking at 30 seconds. We'll have to go to Mr. Epp. We're running well over time because of the interest, of course, that the panel has generated. We'll have to be out of this room pretty soon, so Mr. McCallum, 30 seconds.

Mr. John McCallum: I just have 30 seconds to respond to all these attacks.

I'm a reconstructed Keynesian. A lot of us said stuff in the past that we wouldn't say now, but we learned, Herb. Unlike some people, we learn with the passage of time and new ideas and experience.

Second, on the European model and this homogenization with the U.S...obviously the fact of having fixed exchange rates in the 1960s doesn't make us the same as the U.S. But the European model is more than that. It's the idea that you have ever-increased integration and harmonization of taxes, competition policy, etc. That's what I'm saying would lead to sameness, not just a fixed currency.

A decade-long process to arrive at this new nirvana of a single currency—that sounds like a decade of a pegged rate, which is what they had in Europe. Nowadays, with capital flows huge, pegged rates are a standing target for speculators, so I don't think that would work.

Finally, Ireland has an inflation rate that is well above the European average, and that proves my point, Herb. I'm not trying to destroy prosperity.

Prof. Herbert Grubel: Traded goods are in the consumer price index, but it's not inflation because they print too much money, because they can't print too much money.

The Chair: Mr. Solberg.

Mr. Monte Solberg (Medicine Hat, Canadian Alliance): If I could say this just briefly, first of all I've enjoyed this immensely. I no longer sit on this committee, regrettably, but it's been just fascinating. I think this is the way committees should work.

And I just want to say, Herb, that we miss your passion. It's great to have you back here. It's been so much fun to watch you today, and you are just so articulate and lucid, and we really appreciate that.

I have no questions. I'm going to read what people have had to say today. It's been very interesting and even entertaining. Thank you.

The Chair: Thank you, Mr. Solberg. Mr. Epp.

Mr. Ken Epp: Okay. I have a couple of questions, and I'll really hurry along and skip the niceties about thanking you. I just won't take the time to say how much I enjoy this one session, every year when we get it in this committee.

One thing that several of you mentioned—Professor Wilson did, and I believe Dr. Courchene.... You talked about human capital, and particularly you're talking about education. Most of you come from an academic environment, where you bring in young people and you begin to teach them in your particular field of economics, but of course that's true for engineering; it's true for the medical fields, and all of these other fields. You talk about strengthening that part of our economy, which is indeed a huge part of the investment in the future of this country. But how do you propose to do that?

We already have free education up to the end of the secondary level. Then, when we get into post-secondary, there are costs involved. Right now we have students gaining huge debts with their degrees. Would you change that? What specific plans would you have to improve the development of our human capital in our country?

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Dr. Thomas Courchene: I mentioned one proposal, which was adapting some of the ideas of Dr. Maria Montessori, or, if you want, more recently, Fraser Mustard, and worry about, certainly, early childhood development, but normally have as a vision of what it means to be a Canadian, to have the equality of opportunity to develop your skills in human capital.

One other way of looking at this is that the family plays various roles in society, but one of them should be as the locus of production for human capital. So charge the family and provide incentives and transfers...or take the existing transfers, but tilt the incentives in ways that encourage them to embark on human capital for themselves and their offspring.

For example, quite often we focus on the issue of whether we should have child care by which one means looking after the child anywhere, in the home or elsewhere, or day care, which I interpret to mean looking after the child so that one of the spouses can go to work. We decide whether this should be the function of whether the people are at home or whether they're working, or their income level, but why don't we just say if we're going to help this child, the voucher should go to the child? It's the child we're worried about, so let's focus on the person who's going to get this human capital.

Thirdly, on the bureaucracy side, it seems to me that human capital has to drive much more of what we're doing in the next century. If you look at the federal government right now, it has Industry Canada, and under Industry Canada somewhere there's the information and human capital division. I think that's all wrong.

I think human capital should be on top of all that, and under human capital should be industry and competitiveness, and also social cohesion. This should be our framework. That's why I called my book A State of Minds, which I think is a nice title. After I got the title, I couldn't help but write the book.

But it's not just spending money that I'm talking about; it's having the right mind of state to put citizenship, human capital, information, and power into all Canadians uppermost. Part of it may be spending some money, but part of it is just to get a conception of who we are in the upper half of North America, how we can be different, and how we can maintain those things we hold near and dear to us. I think that's part of what I'm thinking about.

Prof. Herbert Grubel: Maurizio, I really appreciate your patience in going overtime like this, but I'm having so much fun. So let me quickly respond.

I believe we have an obligation to make both our medicare system and our health care system more efficient. It is one thing for the state to be compassionate and say everybody is entitled to certain rights, but this does not necessarily mean that the state also has to produce the services that are needed to provide people with these entitlements.

It is simply a mistake for us to have state-run, union-run high schools, elementary schools, and universities. What we need is competition. The state can provide the education—I'm following up on what Tom said—to the people who we want to get the opportunities, all the poor who you want to get the money. Give them the money, but then give them the choice to select the institution where they want to study. We know when this kind of thing happens you will get competition, and competition will produce superior outcomes to what we have.

Canada is one of the highest countries in the OECD in terms of spending on education per capita, and our results are not there. Why not? I just explained it, and in my mind, I think that's the solution.

The Chair: Are there any further comments?

Professor Wilson.

Prof. Thomas Wilson: I have just two points. One goes back to one of Herb's earlier comments about how much we spend on education.

That's not true on higher education. We underspend relative to the Americans. I've seen comparisons our university has prepared where the public support for private universities in the United States is higher per student or per faculty member than public support in Canada.

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How do we go about getting more resources? I think tuition increases are part of the story. But the way to cover that without it affecting accessibility is to put in place an effective income contingent repayment scheme for student loans so that when they first leave, students don't carry with them a big debt burden that the banks keep dunning them for, but it would be paid back through the tax system once their earnings reach a certain level.

I think that measure would go a long way, but we do need to look at the question of resources. I know when we compete in the market for faculty members, competing with American universities, it's very tough. The only reason the University of Toronto is effective in terms of economics is because we have a business school that is raising a lot of capital privately. But a lot of economics departments across the country are really hurting in this competition.

The Chair: Mr. Robinson, a final comment.

Mr. David Robinson: I'll be very quick.

To reiterate what Tom has said, we have seen a significant decline in public support for universities in Canada over the past ten years. That has resulted in higher tuition fees and also in a significant loss of full-time faculty. We are trailing the Americans on post-secondary education.

People raised the Irish example earlier. That might be another way of looking at how we can increase access, because Ireland, in combination with reducing taxes and entering into an accord, also significantly lowered, and in some cases eliminated, tuition fees for post-secondary education. Part of the high-skill boom that we see there is a lot of those graduates entering the marketplace now. So that's another solution.

The Chair: On behalf of the committee, I would like to express to you our sincerest gratitude for your input. This is always a very interesting panel.

It's quite timely, because next week we'll be hearing from the Minister of Finance. So of course we'll be raising with him some of the points you have raised.

Unfortunately, I had a number of questions I wanted to ask, but as chair of this, I always get the benefit of not asking them. I have exactly 27 questions. So I'll be sending them to you, and perhaps I can get a response.

Once again, thank you.

The meeting is adjourned.