Montreal, November 8, 2003  /  No 132  
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Harry Valentine is a free-marketeer living in Eastern Ontario. He can be reached at
by Harry Valentine
          Optimism is back in response to suggestions that the American economy is gaining renewed strength. Earlier this year, the US Federal Reserve had lowered interest rates to a record all-time low of near 1%, pushing the year-on-year growth of the money supply to an average of 8% over the following months. The recent 7.2% increase in GDP, that is, the value of all sales in the economy, reflects this increase. There is simply no alternative other than these two figures eventually matching each other. Rapidly increasing the money supply can distort critical market information that sellers need for efficient business planning. Accurate market demand information has historically been obtained through price fluctuation. 
          Sellers record increases sales when prices are lowered and reduced sales when prices are raised. Tabulating this data gives reliable market information. One of two events could lead to an increase in sales when prices are raised. One is genuine economic strength resulting from new wealth creation, while the other is a distorted market signal resulting from an artificial increase in the amount of paper money in circulation. Sellers have no means by which to distinguish the authenticity of the market signal, except to either respond or lose business. Producers receive a signal of increased market demand from sellers. They increase production unaware that a new round of malinvestment may be underway. America's renewed economic strength may likely be malinvestment driven.  
          The distorted market signal would inevitably infiltrate into Canada, especially into the Ontario economy, which accounts for the bulk of Canadian exports to the American market. Most of these exports are either big ticket items or components of big ticket items. The new market signals from the US may be welcomed by Ontario suppliers of Sport Utility Vehicles parts, who will likely see an increased demand for their products. An American tax law allows small businesses to write-off such expenses as a new truck (weighing over 6,000 lb), which includes large SUVs. Hence, there is a high probability of small business owners buying new SUVs, spending money that could otherwise be spent on improving business efficiency or on creating new wealth. The visible hand of government transfers funds from one economic sector to another sector, increasing the inefficient use of resources and promoting malinvestment. Over the short term, this combination will contribute to the illusion of economic recovery occurring in the USA. 
          When US interest rates were lowered earlier this year, Canada's economy was showing signs of renewed strength, courtesy of 85% of Canadian exports going into the USA. While many Canadian companies viably exported into the US market despite a lower US dollar, other Canadian exporting companies either lost competitiveness or lost business in the USA, due to the increased value of the Canadian dollar. There have been no shortage of calls to lower Canadian interest rates as a way of lowering the prices of Canadian goods on the US market. However, despite the American economy showing signs of recovery and the US dollar showing renewed strength against other currencies, the US dollar could suddenly drop in value as a result of America's record debt. The total American public and private debt is now estimated at US $27,000 for every American citizen (more than double the US $13,000 per capita Canadian debt).  
     « The visible hand of government transfers funds from one economic sector to another sector, increasing the inefficient use of resources and promoting malinvestment. Over the short term, this combination will contribute to the illusion of economic recovery occurring in the USA. »
          The US Federal Reserve has stated its intention to maintain the record low interest rates well into 2004. The latest surge in American economic growth would likely correct itself in 2004, before the Federal Reserve begins raising interest rates. They may have little leeway left to re-stimulate the economy by lowering interest rates. A period of deflation (market self-correction of malinvestment combined with dropping market prices) may be followed by a long period of economic stagnation in the US economy. The likely scenario may parallel Japan's recently ended 10-year hiatus with near-zero interest rates and massive government (public works) expenditures. The American government has indicated that it will engage massive deficit spending over the next few years, much of it allocated to the Iraq debacle. A few politically well-connected industries will benefit from this initiative. Their sales would have contributed to the recent spectacular rise in the American GDP, which was not accompanied by new job creation. Political opportunists may now be tempted to create or save American jobs through trade tariffs. 
          American authorities have already shown such favour to politically-favoured domestic producers in the lumber and steel industries. Canada's lumber industry was a victim of such a tariff. More such tariffs may be expected during a prolonged American economic slowdown, which could begin within the next year. Very few US policy makers care to consider the destructive side of such trade tariffs. As an example, higher tariffs on imported steel and on Canadian lumber have raised the prices of products made from steel (automobiles) and wood (homes). These price increases also contributed to the 7.2% increase in the US GDP. Protectionism is likely to increase if the American economy does not create new jobs soon and reducing opportunities for many Canadian industries exporting into the American market.  
The dilemma for Canada 
          Canada would face new economic challenges following the onset American's next economic slowdown. Canada's tax base could be eroded, forcing various levels of government to either operate more frugally, or run high deficits. Radical policy changes may be needed to assist Canadians in dealing with challenging economic times. During such times, populations look to governments to provide relief. Yet political behaviour in the economy is what has often precipitated the economic hardship in the first place.  
          At the present time in Canada, an increasing number of people are seeking help from food banks, dining at soup kitchens and sleeping at shelters for the homeless. In previous articles I have shown how over time, political behaviour reduced the availability of low-cost rental housing. Minimum wage laws combined with tax laws discourage the hiring of short-term casual labour. I have also shown how market entry restriction and economic regulation not only violates Canada's Constitution, it also promotes inefficiency while reducing employment opportunities.  
          Continued enforcement of economic regulations, minimum wage laws, zoning bylaws, property taxes, business tax practices, various labour tax laws and a host of other related regulations, ultimately serve to discourage entrepreneurs from creating greater numbers of new jobs in Canada. Excess economic regulation in the USA and Canada is one of the factors encouraging domestic companies to open production facilities in countries like India, Indonesia, Malaysia and China. The chances of any level of Canadian government abandoning such destructive regulatory practices and controls during a severe economic slowdown is virtually non-existent. This is despite at least four Nobel laureates in economics (Friedman, Hayek, Stigler and Coase) all having conclusively shown through extensive research that economic regulation ultimately fails in the long term.  
          Within the next year, the American economy could be on the brink of deflation, with a Federal Reserve essentially powerless to stop it. The American government will likely respond with massive government spending on public works projects and a new round of protectionism. Canada's economy would likely undergo a major upheaval, especially if the American dollar loses value against other currencies. Government run social assistance programs could be stretched to the limit, while no level of government would even consider cancelling obsolete and harmful economic regulations. Such action would leave citizens with little choice other than to begin trading in the underground barter economy, as happened in Argentina (see Argentina's RGT - The World's Largest "Usury-Free" Barter and Trading Network) during their mid-2002 economic crisis. When a population finds itself engulfed by extreme economic challenge and government refuses to repeal harmful economic regulations and related action, people have little choice but to resort to underground economic activity. 
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