Interview with Don Drummond: Vice President and Chief Economist of TD Bank Financial Group

Q: There has been a lot of debate about the root causes of this economic crisis and there’s still no consensus. What is your take?

A: Individuals, companies and particularly financial institutions were aided and abetted by extremely low interest rates and engaged in very risky behaviour. This was especially prevalent in the U.S. housing market where mortgages were extended to people who were not credit-worthy. When it became apparent the housing boom was based on paper, prices started to decline and the whole financial house of cards started to collapse. Individuals went into default on their mortgages and financial institutions went under. While the focus of Canadians in on the U.S., similar things were happening in many countries in Europe and elsewhere, such as Australia. The trade and financial ties around the world quickly spread the problem around the globe.

Q: Some on the right claim that overregulation lead to this problem, while others say it was lack of enforcement of current regulations, while others still say there isn’t enough regulation at all. Who do you side with?

A: It is overly simplistic to put all the blame on regulation in one direction or another. Individuals and financial institutions in these countries should not have engaged in such risky behaviour. Near the end of the U.S. housing boom some mortgage brokers were not even bothering to check whether applicants’ claims of income and net worth were valid. In many cases they weren’t. Regulation did play a role, however. Particularly in the United States, regulation of financial institutions is spread across many government agencies and none were paying particular attention to the explosion of products such as subprime mortgages. Also in the U.S. and Europe, the regulatory authorities did not force financial institutionsto hold adequate capital and allowed them to operate at far too high a leverage ratio (meaning the overall size of the balance sheet relative to their capital base). Canada did not suffer from these regulatory inadequacies and consequently did not witness such reckless financial behaviour. Mind you, I believe Canadians and their financial institutions would have chosen to not engage in this behaviour with such risk even if the regulations had permitted it.

Q) Did the Conservatives overreact with the size of their stimulus spending? The economic recovery is already taking place and most of that money is just getting out the door now.

A) In the international context it would have been difficult for any country not to have applied a large amount of fiscal stimulus. Indeed, all members of the G20 were being urged to introduce stimulus amounting to at least two per cent of their Gross Domestic Product. And Canada did this. My belief at the time, and it continues to be my view, is that much of this stimulus will hit the economy when it is already in recovery and will lead to a gigantic fiscal headache for many years and Canada, and the other countries who ramped up spending, try to claw their way back to budget balance. I believe monetary policy was the key to ending the recession through the cut to almost zero interest rates and the range of liquidity programs introduced by central banks around the world. This monetary action bit more quickly than fiscal and will be easier to unwind as the economy recovers.

Q) Much criticism was made of government decisions to engage in corporate bailouts. In particular, bailouts of certain automobile companies came under attack in the media. What are your views of these kinds of bailouts? Are they ever necessary?

A) In theory, subsidies should not be given to distressed companies. They rarely ultimately change the fate, they create moral hazard and the financing of the subsidies is effectively a tax on successful companies. But I am sympathetic to the view that there was little choice. It was not just the jobs involved in Canada’s auto assembly. The Canadian auto parts industry is intertwined with the assembly of the Big Three North American car producers. If one or more of them went down it would have been devastating to the parts industry as well. One way of viewing the assistance to the assemblers is also as a lifeline to the parts companies, giving them time to diversify their customer base and perhaps broaden their own range of activities. And again, there was an international dimension of pressure. As the U.S. Government quickly decided to provide subsidies, had Canada not responded the industry would have just shifted south of the border. It’s a classic example of where policy can’t always be conducted according to the textbook.

Q) It is often said that when the US catches a cold, Canada gets pneumonia. Yet, this recession is clearly affecting the US more than us, and we are projected to recover sooner. This sort of flies in the face of conventional wisdom that Canada always follows US trends. Why is it different this time?

A) Even though the U.S. was the catalyst for much of the world’s economic woes during this cycle, Canada was hit almost as hard. Indeed, while the cycle will cost the U.S. a 3.9 per cent loss in its real Gross Domestic Product, the cost won’t be much less in Canada at 3.3 per cent. And we are recovering at the same time. Both countries will record their first positive growth rate in the third quarter of 2009. It is true that the so-called “fundamentals” were much better in Canada. Stronger banks, better household balance sheets, better fiscal position, et cetera. But the U.S. recession hit us where it most hurts. The collapse of housing wiped out demand for our forestry products. 90 per cent of our car production is for export to the U.S. and that demand almost disappeared. And almost one-third of corporate funding in Canada is provided by the U.S. market and that got cut way back. So the only good thing that can be said is that unlike some previous recessions Canada did not suffer more than the U.S. But there’s a sharp contrast to the 2001 recession in the U.S. where output did not fall at all in Canada. That’s because the weakness in the U.S. in 2001 was concentrated in information, communications and technology manufacturing, a sector that does not loom large in Canada. In contrast, this time, in the United States declined in certain sectors that are very important in Canada.

Q) Prime Minister Harper has tried to make the most of Canada’s relatively strong performance during the downturn, even making the case in the US to invest in Canada and in Canadian banks. What did you make of this strategy?

A) It is always a good idea to try to exploit your strengths relative to competitors, even if, as in this case, that strength is most evident because of the weakness of others. Initiatives like Minister Flaherty’s trip to China with Canadian financial executives is a good example of a positive initiative. The Ontario-based financial institutions are working with the Ontario Government at this time to see how the situation can be exploited to bring more jobs and income into Canada.

Q) Is the size of the deficit being run this year – now estimated at more than $55-billion – going to have lasting damage? Will taxes have to be raised?

A) The deficit is the highest in Canada’s history but needs to be put in a bit of context. Relative to the size of the economy it is about half what it was in the early 1990s. The more important indicator, the debt-to-GDP ratio, will hit a peak of about half what was recorded in the mid-1990s. So the situation is troubling, but not a crisis. It can and should be addressed without raising taxes. It will require an extended period of slower growth in government spending. Program spending (total spending excluding interest on public debt) will have to be constrained to much lower growth rates than the six per cent average over the past decade.

Q) What is the greatest lesson for Canada coming out of this recession?

A) For Canada, the lesson is a harsh one and one that we already knew. We are a small, open economy that is heavily influenced by international developments. So even if we have our own house in order, we will be buffeted by international economic cycles, especially those originating in the United States. There isn’t much we can do about that. The only thing we can hope for is to mitigate the damage by keeping our house as orderly as possible. We did that by having well-run financial institutions and solid regulation. We had fiscal balance and had maintained low, stable inflation for a long time. We’re still in good shape, but will now have to concentrate on returning to fiscal balance.

Don Drummond is Vice President and Chief Economist of TD Bank Financial Group.

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