Canada’s Failing Productivity Is Feeding Inflation

Canada’s productivity trails behind that of almost all OECD countries, according to numbers assembled by the C.D. Howe Institute in a recent report.

In Canada, GDP per member of the labour force stands at $104,875 compared to $148,746 in the U.S. (41.8% lower), $142,749 in France ((36.1% lower), $140,690 in the UK (34.1% lower). Only Japan and New Zealand fare worse than Canada with $97,224 and $72,015 respectively.

Since its peak in 2014, when heavy investment in the oil sector greatly contributed to productivity gains, Canada’s productivity has been steadily declining, thanks mostly to falling capital investment. In machinery and equipment, investment has dropped by 7%, in engineering, by 2%, and in the crucial area of intellectual property, by 5%. It was expected that productivity in this last category would be spurred by Covid and work-from-home, recalls Bill Robson, CEO of the C.D. Howe Institute. It was even expected to “trigger a new period of prosperity, notably in the U.S. where investment progressed by 8%,” he says. But Canada did not follow.

Higher Wages vs. Lower Productivity

Meanwhile, wages are increasing, points out Derek Holt, Vice-President and Head of Capital Markets Economics at Scotia Bank. “From February to April, wage growth was negative, then there was a rebound, he recalls. Now it is sharply reaccelerating. Month over month, annualized growth is 10.6%.”

Combining declining productivity with rising wages isn’t great. “Wage gains in rising productivity, that would be great,” asserts Anil Passi, Director of global corporates at DBRS Morningstar, “But wage gains in declining productivity, that is certainly not good.”

“Wage gains while productivity is declining are not necessarily invigorating and may be reflective of a stagflationary environment,” Passi says, “Wage gains that are the result of rising productivity are more real and the ultimate path to greater prosperity.”

More With Less

Productivity is not output. It is a measure of the efficiency of output. If you produce more with less input or with a stable level of input, your productivity is rising. Prices can fall, or at least remain stable, or you can produce more, raising prosperity for everyone. Canada is heading the other way, and alarmingly so. “Earlier this year, the OECD put out long-term projections showing that [Canada’s] living standards would be growing at the slowest rate of OECD countries,” says Robson, “The 2022 Federal budget even highlighted these projections, observing that Canada would rank dead last among OECD countries over the next 40 years.”

Low productivity is not a direct driver of inflation, Robson explains, but it is eroding the economy’s capacity to fight back. “Suppose the economy’s ability to supply goods and services was rising at 4% per year,” he explains, “Bringing demand back into line with supply might mean reducing its growth from 5% to 3%. Disappointing, perhaps, but hardly a disaster. On the other hand, if supply is growing at only 1 percent a year, then bringing demand into line might mean reducing its annual growth from 2% to 0%.”

In other words, low productivity means that the central bank’s tightening monetary policy causes the economy to flirt more dangerously with a recession, or to wallow longer in it. “Faster growth of Canada’s productive capacity would make bringing demand back in line with supply easier, Robson continues. We could hold the line on demand while supply catches up, rather than push demand down. We could lower inflation with less risk of recession.”

Passi laments the sudden, and most likely transitory, preoccupation with productivity. “I understand that, because of inflationary pressures, there’s more focus than ever on productivity, but companies and businesses should focus on it at all times, 365 days a year. Like many companies say: ‘Things are getting rough, so we’ll improve a few things and cut some fat here and there’. But even when times are good, you should be cutting fat.”

Adding Weight

Canada is definitely putting on fat. The economy is becoming increasingly labour intensive and capital poor, while the contrary is happening elsewhere, notably in the U.S. “The only historical period where consistent data (if any existed) might show something similar is the depression of the 1930s,” Robson claims, “From the perspective of Canadian workers, our economy is decapitalizing.”

Robson doesn’t expect much from the government on the productivity front. He points to the 2022 budget: “the federal government’s current directions promise no help for productive capacity. It continues to increase spending. It is depressing investment with discriminatory tax hikes – singling out specific sectors, such as banks and insurers, and specific products, such as cars, airplanes and boats – and it now proposes tighter limits on the deductibility of interest when businesses borrow to invest. It is undercutting confidence with changes to competition law and greenhouse gas policies that seem longer on slogans than practicality.”

In its latest Monetary Policy Report, the Bank of Canada expects productivity to improve moving forward. Holt is “a bit skeptical,” he says. He recognizes that the performance of the oil sector, thanks to strong production and high prices, could contribute to improving productivity numbers, but it would only be temporary. “I don’t think we’re turning at the structural level and that we’re likely to perform better than the U.S. any time soon,” he says.

Looking ahead, if economies go south with a recession, Holt fears Canadian federal policy. “Will the government allow jobs to fall? Or will it smother the job market with strong worker support measures at the expense of productivity? I believe it will choose to support jobs.”