An Open Letter to Prime
Minister Brian Mulroney: On Canada's Monetary and Tax
Jude Wanniski and Alan Reynolds
December 27, 1989
Dear Mr. Prime Minister:
We were most pleased last year with your leadership in defending principles of free trade by realizing the historic U.S.-Canadian treaty that will serve both our countries well in the 1990s and beyond. Freer trade between us increases the efficiency and productivity of both our countries.
A free exchange of ideas between neighbors can do the same, and we hope you take this letter in this friendly spirit. For we have been observing the domestic economic policies your government has been pursuing this past year and believe them to be less than optimal. And we see no internal questioning of these policies from a classical, supply-side perspective.
Our most serious concern is that Canada, like the United Kingdom and Australia, will soon find that a policy of keeping interest rates far above those of other countries will indeed prove effective in stopping real economic growth, employment and productivity, but it will not result in lasting reduction of inflation. Indeed, inflation will end up higher than otherwise.
In the short run, the Bank of Canada has been able to bribe people to keep "hot money" in short-term securities and deposits, and thus shore-up the Canadian dollar. This may keep imported inflation down, for a while, but does not get to the roots of internal, domestic inflation. Such a policy is inherently unstable, not viable as a long-term strategy. Because everyone realizes that interest rates must come down after they have pushed the economy into stagnation or contraction, the currency becomes vulnerable to speculative attack on each new sign of economic weakness (such as the 1.3% drop in October retail sales).
This is the lesson of Britain and Australia, where a combination of budget surpluses and extremely high interest rates has not prevented deep devaluations, adding imported inflation to domestic inflation. Any policy that is not sustainable is also not credible, so that Canadians will continue to expect higher inflation and to act on that expectation by switching out of money into tangible assets.
A temporary, artificially high exchange rate obviously has a devastating impact on Canadian exports of raw materials, because their products are priced on world markets in U.S. dollars. Because most commodity prices have been falling throughout 1989 in terms of U.S. dollars, they must fall even further in appreciating Canadian dollars -- even though Canadian costs, including interest expenses, continue to rise. The higher Canadian dollar also shrinks profits and production of Canadian manufacturers of goods that could otherwise displace imports. Some of the most important industries in the country, such as furniture, newsprint and steel, are already in serious trouble.
This deliberate damage to producers of traded goods makes the longer-term inflation outlook worse, not better, for the following reasons:
1. The slowdown or reduction in output means reduced productivity and therefore higher unit labor costs. With fixed costs spread among fewer units produced, non-labor costs also rise.
2. A larger current account deficit (resulting from damage to export and import-competing industries) has to be financed with a larger net capital inflow. If the economy were allowed to expand at a decent pace, such a capital inflow could be forthcoming from worldwide demand for Canadian stocks, bonds and real property. But by depressing real output with high interest rates and an artificially high exchange rate, Canada is instead forced into the ultimately futile British-style strategy of trying to attract and retain more hot money with ever-increasing interest rates.
3. Keeping Canadian short-term interest rates three percentage points higher than in the U.S. raises the cost of capital so much that many otherwise viable investments in added or updated capacity are simply impossible. That erodes the long-term competitiveness of Canadian business, adding to future balance of payments problems. Cutbacks in fixed investment also imply future risks of bottlenecks and shortages at rates of economic growth that are not even adequate to maintain decent unemployment rates. Aside from Western Ontario, large parts of Canada are already experiencing painful unemployment rates of 10-25%.
4. The super-high Canadian interest rates clearly add billions to the government's interest expense, accounting for a very large share of the budget deficit. Attempting to offset this effect with higher tax rates simply drives more financial capital abroad, drives more investment projects abroad, and increases the number of unemployed, causing further drains on the budget.
High marginal tax rates on added income and sales reduce whatever profitable investment opportunities still remain at the high Canadian interest rates. West Germany, which is reducing marginal tax rates in 1990, is already experiencing a capital inflow driving its currency so high that interest rates will surely have to be reduced. Canada, by contrast, is the only major country that is increasing marginal tax rates, through steep surtaxes on higher incomes, an added wealth tax on business, and the General Sales Tax. These extra costs of government services, at the margin, drive both Canadian and foreign long-term capital elsewhere. Trying to offset this tax-induced loss of physical, financial and human capital with steep short-term interest rates is using the wrong policy tool to accomplish an impossible objective. All countries with genuinely strong currencies and favorable investment opportunities have relatively low interest rates. Canada's high interest rates, by contrast, reflect the risk that the currency may drop precipitously as production and productivity decline under the weight of uncompetitive taxes and interest costs. A reduction of supply, for any given increase in government and private spending, raises inflation, resulting in "stagflation."
High interest rates also reflect the high and rising marginal tax rates, which discourage domestic savings by reducing after-tax returns and discourage foreign capital inflows by reducing opportunities for profitable production. At a minimum, the plan to introduce a 7% General Sales Tax should not be accompanied by surtaxes on personal and business income.
With a quite different combination of lower tax rates and lower interest rates, the exchange rate would not decline as much as it eventually will with the current, opposite policy. That is because renewed hope of economic growth would bring in long-term capital inflows to replace the precarious flow of hot money. Added growth would also reduce the need for such inflows by allowing profitable expansion of export and import-competing industries, thus eliminating the recent trade gap.
Allowing Canadian tax and interest rates to decline toward those in the U.S. would reduce both government interest expense and subsidies to the unemployed sufficiently to achieve a much greater reduction in the budget deficit than is possible by trying to squeeze more revenues out of a shrinking economy. Even on static accounting, reduced interest expense would permit reduction of marginal tax rates back to the 1988 levels (which, in fact, brought very large increases in real receipts, because of added growth of taxable incomes and sales).
Even if the Canadian dollar dipped a bit with lower interest rates, this would be better than an ultimately futile effort to prop it up with high short-term rates. Most commodity prices have fallen sharply in terms of U.S. dollars throughout 1989, particularly in recent months. A slightly weaker Canadian dollar would simply attenuate that commodity deflation, rather than adding to inflation. It would result in a reduced squeeze on profit margins in Canadian raw materials industries.
A deliberate policy of using high interest rates to offset the capital flight arising from high tax rates is a recipe for national economic suicide that has already been well-tested in Latin America. What Canada needs, Mr. Prime Minister, is lower marginal tax rates to improve opportunities to work and invest. This would raise the demand for Canadian money, at home and abroad, allowing both interest rates and inflation to decline.
Sincere best wishes for the new year.
Alan Reynolds & Jude Wanniski