After Trade Deal, Attention Turns to Trudeau’s Deeper Economic Woes

(Bloomberg) -- The tough economic work may only just be starting for Justin Trudeau after Canada struck a last-minute deal to be included in the new Nafta.

Wages are barely keeping up with the cost of living, business executives complain they can’t compete and households are carrying record levels of debt that will weigh down the expansion.

Trade peace with the U.S. means attention now turns to more deep-seated problems clouding the economic outlook. Pressure is growing on the Canadian prime minister to act starting with a budget update in coming weeks, with potential implications on a range of policies from how quickly he reduces deficits to the scope of planned corporate tax cuts heading into an election year.

The concern, however, is there may be few short-term fixes, leaving the economy mired in a cycle of low growth and stagnating incomes for years to come.

“We’re looking at long term challenges to the Canadian economy -- what we call competitive wedges -- and Nafta or no Nafta they are still there,” Dagmara Fijalkowski, head of global fixed income and currencies at RBC Global Asset Management, said at the Bloomberg Canadian Fixed Income Conference Tuesday in New York.

After Trade Deal, Attention Turns to Trudeau’s Deeper Economic Woes

So far, these issues have been masked by generous new benefits, financed by debt, that the Liberal government has handed out to households. Workers are also tapping into savings. A recent surge in immigration has helped, as have still extremely low borrowing costs. The end result has been decent gains in national income, despite underlying problems, that have been strong enough to prompt the Bank of Canada to begin raising interest rates. But none of these drivers are sustainable.

“The Canadian economy has done significantly better than was expected this year,” Fijalkowski said. “We believe some of that positive surprise was borrowed from the future.”

Nowhere are the economy’s deeper problems more palpable than with the sluggish wage gains, which have barely budged since the beginning of last year -- at just under 2.5 percent. Inflation, however, has shot up on the back of gasoline prices and is expected to average about the same pace of wage growth this year. That will mark the second time in three years that pay after accounting for inflation -- what economists call real wages -- has been flat, suggesting workers haven’t shared in whatever prosperity there has been.

Political Headache

For Trudeau, the stakes are also high politically. The wages trend threatens to erode his record on a key pillar of the government’s agenda -- curbing inequality and boosting incomes for the middle class. Over the three years he’s been in power, real wages have averaged annual gains of just 0.3 percent, versus 1 percent the previous decade.

The truth is economists aren’t exactly sure why wages are stagnating, particularly given the relatively low unemployment rate, and the phenomenon is hardly unique to Canada. Possible explanations include weak unions, persistent slack in the economy and aging demographics. But most analysts agree a slowdown in productivity is an important component.

Canada’s business lobby has pressed Trudeau for corporate tax cuts to remedy the problem. Executives argue weak competitiveness is curtailing investment and preventing them from paying higher wages, and warn the situation has only deteriorated since the U.S. lowered corporate taxes.

“What I hear from our members is they are squeezed for every penny of profitability,” Perrin Beatty, chief executive of the Canadian Chamber of Commerce, said in an interview. “It means their ability to maintain, expand or improve the conditions for their current work force is very much challenged by this.”

After Trade Deal, Attention Turns to Trudeau’s Deeper Economic Woes

But there are limits to what lower taxes can do to boost productivity, which is a function in large part of global technological and economic forces such as the growing reliance of developed nations on older workers. Younger work forces typically have more scope for faster productivity increases.

Putting more of the economy’s resources into corporate pockets also requires a leap of faith that companies will pass on those gains to workers -- a tough pivot for the left-leaning Trudeau government, especially heading into an election year.

What our economists say..

“There are both big knives, and a bunch of little daggers, slicing away at real wage growth. There isn’t much the Bank of Canada can do except run the economy hot to try and remove any remaining slack in the labor market. Yet labor shortages are already at an expansion high, and pushing the economy too hard for too long risks even more inflationary pressure.”
--Tim Mahedy, Bloomberg Economics

There may be other factors at play as well for why investment has lagged -- perhaps the lingering effects of the oil price slump or skepticism the economy can generate enough demand, given its aging population, to make investments profitable.

If that’s the case, the best response to the economy’s deeper problems may simply be more of the same from Canadian policy makers -- continued stimulus to keep the expansion humming, and hope companies spend and wages creep higher.

But that too has limitations. The Bank of Canada can’t ignore rising inflation for too long, and growing government debt has its own challenges.

©2018 Bloomberg L.P.