BUSINESS

THERE WILL BE PAIN

Inflation is crippling nations around the globe. Can we really keep it out of Canada?

DUNCAN HOOD August 25 2008
BUSINESS

THERE WILL BE PAIN

Inflation is crippling nations around the globe. Can we really keep it out of Canada?

DUNCAN HOOD August 25 2008

THERE WILL BE PAIN

BUSINESS

Inflation is crippling nations around the globe. Can we really keep it out of Canada?

DUNCAN HOOD

A 10-million-dollar bill sounds like a lot of money, but in Zimbabwe, beggars in the street won’t bother stooping to pick one up. In the struggling African nation, million-dollar notes are used as toilet paper, and 100-billion-dollar notes won’t even buy a loaf of bread. Last month, the Zimbabwean dollar became so worthless that the reserve bank was forced to chop 10 zeros off it, turning 10 billion dollars into one.

Zimbabwe is a nation where inflation is completely out of control. The official rate is 2.2 million per cent—yes, million—but economists say it’s actually closer to 12 million per cent. That means the price of groceries, clothes, gas and other household goods is doubling every week. The economic catastrophe is partly due to the instability resulting from the contested election of President Robert Mugabe, but there’s more than that going on, because Zimbabwe is not alone.

Slowly, almost imperceptibly, inflation has infiltrated the developing world, and now it’s tightening its sweaty grip. In Vietnam, where inflation recently topped 25 per cent, builders are walking out on unfinished jobs because they can no longer afford construction materials. In Venezuela, where the inflation rate is now higher than 30 per cent, a hapless government is encouraging consumers to haggle over prices in a desperate bid to keep them from rising. Meanwhile, in Argentina, which has had an on-again, off-again hyperinflation problem for decades, the unofficial rate has hit 25 per cent. In Russia it’s at 15 per cent. China, Saudi Arabia and India are all heading north of 10 per cent. In fact, when measured properly, according to The Economist, two-thirds of

the world’s population will soon suffer from double-digit inflation.

All over the world, prices are soaring and currencies are crumbling—in some cases to the point where it no longer makes sense to lend people money. “On average, we estimate that global inflation will have gone up by more in 2008 than global interest rates,” says David Wolf, vice-president and head of Canadian economics at Merrill Lynch Canada. That means the global interest rate is now negative. When you borrow money at a negative interest rate from a bank, then after inflation they effectively owe you interest.

So far, Canada has been spared the brunt of rising inflation. But it doesn’t look like we’ll escape much longer. In late July, CIBC World Markets economist Avery Shenfeld declared that “we’ve lost our inflation immunity,” and warned that Canada’s inflation rate will surge above four per cent by the end of the year. That’s nothing compared to the crisis in poorer countries, but it does indicate that our central bank may be losing its grip. The Bank of Canada has publicly committed to keeping inflation between one and three per cent, but despite its best efforts, it admits we’ll hit 4-3 per cent by early next year.

Does this herald a return to the 1970s, when inflation ran wild, and you were lucky to get a mortgage at 10 per cent? Most economists won’t admit that’s a possibility—but it’s a scary thought. Back then, Led Zeppelin’s Stairway to Heaven blared on eight-tracks, Bob Barker began hosting The Price is Right, new cars cost $4,000, and Canada entered its worst economic decade since the Depression. Years of rampant

government spending followed by the expensive Vietnam War had weakened the American economy, and Canada’s soon followed suit. As then-prime minister Pierre Trudeau twirled for the nation, our economy sank into one of the longest slumps in Canadian history, marked by soaring unemployment and, in 1974, the largest stock market crash of the last 50 years.

Now, as Canada gets ready to sail past the four per cent inflation mark, it’s hard not to notice that our situation is eerily similar to the situation back then. As Donald Coxe, global portfolio strategist at BMO Financial Group, notes, the inflation crisis then was first kicked off by a sudden rise in food prices (partly due to Nixon’s “Great Grain Robbery” of 1972, and partly due to the loss of the anchovy crop off Peru, which created a shortage in protein supplements for animal feed). That was followed by a hike in oil prices, which helped create an inflation crisis in developing countries. By 1972, inflation in Canada pushed past four per cent, just as it will by the end of this year. One year later, the inflation rate hit 14 per cent.

Chris Ragan, one of Canada’s foremost experts on inflation, says there is no way things are going to get that bad this time around. Ragan’s opinion is that we’ve learned too much since then about how inflation heats up and how to stop it. Unfortunately, however, he says that stopping it still isn’t easy—in fact, it could be excruciatingly painful.

Ragan knows what he’s talking about. Not

IN 1972, OUR INFLATION RATE HIT FOUR PER CENT, AS IT WILL THIS YEAR. BY *73 IT HIT 14 PER CENT.

only is he an economics professor at McGill University and a member of the C.D. Howe Institute’s monetary policy council, he is also a former special adviser to the governor of the Bank of Canada. He says that back in the ’70s we thought all inflation was the same, but now we know that it comes in two distinct flavours.

The first is “supply-shock” inflation. That happens when oil prices go up, because a company selling you, say, plastic storage containers must pay more for the oil it needs to make the plastic, heat its factory, run its machines and fill up its trucks. The company must then pass along those higher costs to consumers through higher prices. (Incidentally, Rubbermaid has just sharply raised the prices of its storage containers, citing a 60 per cent increase in resin costs.) This often leads to “stagflation,” where you have a stagnating economy as prices soar.

Then there’s “demand-pull” inflation, which

you get when your economy overheats and workers are in short supply. This more dangerous and entrenched form of inflation pushes up wages and other business costs, which pushes up prices. “It’s like if you want to get a deck built at your house right when everyone else is getting a deck built,” Ragan says. “You have to wait longer, and you have to pay more.”

Right now, because of the high price of oil, the U.S. is suffering from the first kind of inflation, supply-shock inflation. “It’s going to produce stagflation in the States,” Ragan says. “It’s going to reduce America’s growth rate, and it will push up its inflation rate.” Canada is in a much better position—because, unlike the U.S., we’re a net exporter of oil. That means when the price goes up, we still lose at the pump, but we gain from our international oil sales. Because of that, as the price of oil has gone up over the last few years, so has the value of the Canadian dollar, which has helped to shield us from rising prices.

But this may be the calm before the storm. All the extra cash that has been rolling in from oil sales has been heating up the economy in the West, and Ragan says that if we’re not careful, that could spill over and ignite the much more dangerous second type of inflation—the demand-pull inflation that results from overheated economies. “The high price of oil is going to have a bigger inflationary impact in Canada than in the U.S.,” he says.

“Because it’s also promoting our growth. That makes it harder to keep inflation under control.”

Luckily, we have a knight in shining armour: Mark Carney, the governor of the Bank of Canada. If inflation rises, the bank, learning from painful lessons of the past, will raise interest rates until the inflation beast is slain. “Central bankers learned from what happened in the ’70s,” says David Wolf of Merrill Lynch. “They know that you can’t let inflation take hold because it tends to feed on itself and it becomes a lot more difficult to stuff back in the bag. We now pay Carney to make sure that doesn’t happen.” Ragan and several other economists agree: the Bank of Canada will do whatever it takes to make sure it doesn’t get out of hand. The problem is this: the cure for inflation ain’t pretty. Especially if you happen to live in Ontario or Quebec.

You don’t have to tell Karen Ashbee that we have an inflation problem. Thanks to the rivers of oil money that have been flowing into Alberta, she sees it all around her. Ten

years ago, Ashbee moved from Toronto to Calgary, where she now lives a comfortable life with her husband, who works as a doctor. Since arriving, she has seen housing prices more than double, and those aren’t the only prices going up. “Everybody told us when we moved here that it would be cheaper to live here, but it’s not,” she says. “The groceries are more, for instance. Our property taxes have gone up exponentially. And our gas costs more too.”

Ashbee says she’s seen lots of signs that Calgary’s economy is on the boil. “It’s very difficult to find somebody to work on your house,” she says. “We needed a tiler and a plumber for a small job, and all we could get was a really young guy who was hungry for after-hours work. He started in August and didn’t finish the job until November.” Restaurants are packed, and Ashbee says she’s become used to terrible service from inexperienced, overworked staff. BMWs and Mercedes are on back order at the car lots, and “people are generally out there spending money.”

Betty Thompson, managing partner at Calgary accounting firm Lo Porter Hetu, agrees, but for her the overheated economy has caused a few more headaches. Her small firm lost several good employees to the big oil companies, which pay better and offer stock options, so she’s had to raise wages to stay competitive. “We’ve had to increase fees, and that puts pressure on our clients as well,” she says. Wages have increased significantly in many sectors, and the economy in general has been “crazy”—although she’s sensed a bit of cooling in the last few months. “I think there is a lot of pressure on people in Calgary,” she says. “It’s the pressure from feeling that they have to do so much more productivitywise just to keep up.”

Meanwhile, in Ontario and Quebec, the situation couldn’t be more different. There’s no sign of the oil money here. Indeed, the manufacturing economy in the country’s heartland has been hit by a nasty slump. Many of its products are exported to the U.S., and the one-two punch from the higher Canadian dollar and the suffering American economy has been devastating—to the automotive sector in particular.

Just a few weeks ago, Dave Elliott, president of Canadian Auto Workers Local 1001 in St. Thomas, Ont., listened in dismay as the management at Sterling Trucks announced that 720 assembly-line jobs will be cut in November. “Two months before Christmas, those people are going to be out of a job,” he says. “We feel for them. They had to go home and announce to their families at the dinner table that they’re going to be laid off in four months.”

The layoffs at Sterling are just the beginning.

“There’s a problem in St. Thomas in general,” Elliott says. “For instance, there’s a big plant here called Formet Industries that produces truck frames for GM. With the slowdown in large pickup trucks, they just announced a layoff of about 400 people effective in September. Then we have the Ford Talbotville plant, which builds the Crown Victoria and Grand Marquis—they’ve throttled back to one shift now. In a small city of32,000 people, that has a huge impact.”

Elliott is bewildered by the downturn, especially at a time when the government and many economists are saying that we have nothing to fear. “I don’t know where they’re getting their figures from,” he says. “If they were to look at the job loss numbers alone, they’d see that there’s a problem here—and it’s not a problem with our plants, it’s an economic problem.”

It is indeed an economic problem, but what Elliott may not realize is that it’s a problem that only affects half the country. As the

price of oil has risen, Canada has split into two distinct and very different regional economies. In Alberta, thanks to the oil money, the economy is red hot. Factories are working overtime, workers are scarce, wages are rising, and yes, prices are rising too. Alberta isn’t nervously wondering whether it will have an inflation problem—it already has one. The average inflation rate in Calgary last year was a whopping 5.1 per cent, the highest in the country.

Meanwhile in Ontario, unemployment is rising and growth is down. It will rank second last in economic growth among the provinces this year, and record numbers of workers are leaving the province altogether. Last December, its unemployment rate was higher than the national average for the first time in 30 years, and Ontario is in serious danger of becoming a “have-not” province that receives—rather than provides—federal equalization payments. There’s no hint of an inflation problem here: Toronto’s infla-

tion rate last year was only 1.9 per cent, and cities such as Thunder Bay have rates hovering around one per cent.

If Alberta and Ontario were separate countries with separate currencies, the solution would be simple. In Alberta, the government could raise interest rates, which would put the brakes on the overheated economy and cool down inflation. In Ontario, the government could lower interest rates, which would stimulate the economy and help to lower the value of the dollar, making its products more affordable to foreign buyers. But, alas, Alberta and Ontario share the same dollar, the same central bank and the same interest rates. It’s a huge problem, and there’s no simple solution. “As long as we have a single currency in this country,” says Ragan, “the central bank can do exactly zero about it.”

So what will Mark Carney do? For now he’s holding rates steady. The bank’s recent statements have stressed that it takes the threat of inflation seriously, but when you strip out the more volatile components, such as fuel and food, the core rate is still quite stable. The bank also says that it expects inflation will return to the safe two per cent tar-

IF CARNEY RAISES RATES, IT WILL HURT ONTARIO. BUT IF HE LOWERS THEM, IT WILL HURT ALBERTA.

get by late 2009. But the C.D. Howe monetary policy council—which Ragan sits on— recently urged Carney to raise rates, arguing that inflation expectations are getting out of hand and wage increases are already well above the inflation rate. Yes, it would be like kicking the auto workers in the head. Yes, it would likely cause further layoffs in manufacturing. And yes, it would make life harder for homeowners who are already struggling with their bloated mortgages. “But it would be the right thing to do,” says Ragan.

Carney can’t win. If he raises rates, he could push the strained relations between East and West to the breaking point. If he caves in to political pressure and keeps rates low, then we could have an inflation crisis all over again. Neither scenario will be pleasant, but let’s hope he opts for the former. It will be painful, but not as bad as a decade of rampant inflation. And anyone who can remember the 19 per cent mortgages of 1982 would agree. M