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Candid about Canada and the U.S. - for the future.

Anyone interested in investing in Canada, or in doing business there, probably has two concerns: the state of the Canadian economy and the referendum furor surrounding the rewriting of our country's constitution, particularly its effect on Quebec's relationship with the other provinces. I'd like to put you at ease on both counts.

First, you may have been reading about efforts in Canada to rewrite our constitution and the possible secession of Quebec. I don't think you have to be concerned, at least in the next seven to 10 years, that we're going to have a breakup of Canada. Instead, we're going through another chapter in the 125-year saga of Canada's trying to deal with its linguistic duality and its peculiar attitude towards the rights of individuals and the rights and powers of the state.

But what are the financial implications of all this referendum activity? As a financial manager, how should you regard Canada as a place in which to invest and do business?

Well, I think all of the exchange-rate and interest-rate repercussions have already happened. After all, financial markets can vote any time. They didn't have to wait to take into account the uncertainties associated with the referendum dispute. As a consequence, they've adjusted.

Interest rates immediately reflect any change of assessment of risk and, of course, Canadian interest rates had to spike upward--to make sure foreign investors would continue to lend us the very large amounts of money we need to finance our government debt and corporations. The short-term interest-rate differential shot up to 4 percent but has subsequently subsided. That upward spike and subsequent decline was the extent of the financial impact of the referendum.

From now on, with the referendum discussion behind us, the interest-rate structure will continue to subside, and the value of the Canadian currency should firm as we go forward.


Despite the difficulties we see in all of the Northeast of the United States and in Canada, I'm very optimistic about the prospects for the Canadian economy. Why? Above all, because the tax burden falling on Canadian families has stabilized. One of the major problems with our North American economies, and in fact with world economies, is the very large tax burdens that people are bearing. But in Canada for the last three or four years the tax burden has been stabilizing. People are more aware of and more politically sensitive to the undesirability of further increasing the tax burden. And the political process has responded favorably.

A second reason for my optimism is the fiscal position of our federal government. Its fiscal house is in order from several perspectives. The most important barometer is the deficit as a fraction of the GDP. In 1984, when the current government took office, the deficit as a fraction of GDP in Canada was nearly 9 percent. |Editor's Note: As this article goes to press, Canadians await the naming of a new prime minister in June, when Brian Mulroney will resign the post.~ At the same time, it was about 3 percent in the United States. Currently, however, Canada's deficit as a fraction of GDP is down to about 6 percent, whereas in the United States it has risen to 6 percent. In other words, our countries have been reversing their roles in terms of exercising control over the federal deficit. And I expect this trend to continue.

How have we taken control of our deficit ? We've done so primarily by changing our spending on and financing of entitlement programs--an accomplishment that 10 years ago most Canadians would have thought impossible. Fortunately, the government has tampered with some "sacred trusts."

For example, our noncontributory universal pension plan, called the old-age pension--our largest federal expenditure--is now indexed to means. If an individual's income rises above $53,215, his net old-age pension payment is reduced by a special income tax measure. At $83,170, all benefits are effectively taxed back. The same is true of our family allowance plan, once again a universal demogrant paid to Canadian families who have children irrespective of their income levels. The family allowance program has just been abandoned in favor of an income-level-geared refundable tax credit.

A third reason for my optimism is Canada's superlative inflation performance. The inflation rate in Canada is less than 2 percent. And it's likely to be in or around the 2 percent range for all of 1993. That's a full 1.5 percentage points less than the most optimistic forecast for the United States. That low inflation rate, together with the fiscal responsibility the federal government is exercising, makes Canada a very desirable asset pick.

Furthermore, the low rate of inflation in Canada augurs the kind of interest rates we all experienced back in the 1960s. And low inflation, through the low interest rates it will produce, has to be good for two things: capital acquisition and long-term thinking about Canada's future.

Long-term thinking is perhaps the element most responsible for Japan's outstripping North America. The Japanese have taken a long-term interest in their economy, their infrastructure and their investments in the future, while we in North America have let our investments in the future run down. One of the main reasons why the Japanese continued looking to the future during the 1970s and 1980s--and we in North America did not--was that we had to deal with interest rates and hence discount rates swollen by very high rates of inflation and by instability in the rate of inflation. As a result, many people were demanding high interest rates to protect themselves against the risk of inflation. High discount rates meant a shorter payout period and a corresponding lack of interest in the future.

With the inflation rate much lower than it has been in years, we in Canada can begin to look much more seriously at the long-term economic issues we've been ignoring.


As I go around North America, I'm absolutely appalled by the extent to which people are pessimistic. They seize upon each new fact and each new piece of news as further support for their pessimism.

But when I look at the North American economy, I see two major sources of optimism: low inflation, in the United States and in Canada (for the reasons I just noted), and the removal of what has been a major threat--the Soviet Union.

Yet many people in the United States aren't optimistic. They say that along with the removal of that threat went hundreds of thousands of jobs. But they don't see that the activity related to the war material production business was, for example, the main reason there isn't a decent North American automobile. Let me explain.

Aside from the substantial financial savings you get from "the peace," one of the great dividends lies in turning your best and brightest minds from military to civilian use. We were all tremendously impressed as we watched the U.S. "smart bombs" in the Gulf War, but I thought to myself: How many people realize that what they just saw was the North American automobile that might have been?

One of the reasons why the Japanese have beat us technologically in the automotive industry is that General MacArthur forbade Japan from investing any of its effort in military activity. That's the real peace dividend being able to devote not only your money but also your best brainpower to the private sector of the economy.

What about the loss of military contracts and jobs? 1 invite you to look at Seattle and the surrounding areas. Look how they were served by the loss of that major defense contract in the early 1960s. It was the best thing that could have happened to Boeing and Seattle. It laid the groundwork for developing software industries, and industries of all kinds, that are much more diverse in their customer base than the military contractors were, and Boeing itself developed a much broader economic base with many nonmilitary customers. After all, how stable can an economic environment be when it's dependent on one contractor or one payer?


Another source of pessimism, particularly in the northeastern part of the United States, as well as in Ontario, is the decline in goods production. Many people believe it's devastating that "We don't make anything anymore."l see it as probably the best thing that's happened to us this century.

If we look to history for guidance, I invite you to go back to 1900 and an economy that was 75 percent employed in goods production. Only 25 percent of the work force was employed in services, and these were mostly of the menial kind, such as domestic services. Of the 75 percent, 50 percent of the U.S. labor force was in agriculture, producing the food we ate. Today, however, we can see that the big task facing North America back then was to get those people off the farm and into something more useful, something that would help generate a huge increase in our standard of living. And that, in fact, is what happened.

Furthermore, at various points we had to do the same thing with many people in manufacturing. We had to get our labor force to do more intelligent and better things. What's going on right now in northeastern United States and in southwestern Ontario, the heartland of our old manufacturing sector, is that same kind of transition.

But if there were a minister of industry in 1910 with the power to stop all of that movement, he may have. He may have been saying: "Where are all of those people going to work if you fire them from agriculture, if you lay them off from our iron mongering business, from making horseshoes and saddles?"

And nobody would have been able to tell him. So they may have had an industrial strategy like Britain's today with the coal workers, designed simply to keep people employed. But now we can recognize that forsaking that transition would have been a gigantic mistake, one made in many countries, such as India.

Thus, we have to make this move from an economy with around 22 percent of employment in goods production to one with only about 10 percent in goods production by the end of the decade. The result will be a much higher standard of living than we have now and more opportunities for our children than we ever had. But the economy will look different.

Some people reject this way of thinking, assuming that we've got to manufacture something to produce value. One such person was the president of one of Canada's largest steel companies. "What's this nonsense," he said to me, "about services, about our not needing to manufacture things in order to create wealth?"

"Well," I said, "let's get your bill of costs out and see where your value is coming from." Together we saw that just 14 percent of his costs were devoted to purchases of iron ore and to the direct labor processing it. The rest--86 percent--went to the cost of services: sales, marketing, engineering, legal, financial. The labor jobs weren't really producing value for the company. Indeed, it would make little difference to the firm if it made nothing, but serviced its markets with steel made in South Korea. Because that's really where the company's value is produced--in servicing the markets, not in puddling the steel.

In fact, had the company switched from steel to plastic or ceramics, there'd be little difference. The service organizations would still function in the same way. And the wonderful thing about those service jobs is that they're not only producing all the value but they're also more stable jobs. The talents behind them can be used in a wide variety of industries. The puddling talents, on the other hand, don't produce the value, aren't stable and can be used only to make steel.

Dr. Walker is executive director of the Fraser Institute in Vancouver, British Columbia.
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Title Annotation:Viewpoint
Author:Walker, Michael A.
Publication:Financial Executive
Date:Mar 1, 1993
Previous Article:Deficit reduction and economic growth.
Next Article:A Canadian slant on the sensitive issues.

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