A Ludicrously Oversimplified Explanation of the Canadian Economy Under COVID, the Increase in Debt and Money Supply, and What Comes Next — PART I

  1. What’s going on with the Canadian economy, ignoring all international factors.
  2. Now let’s examine the international economy.
  3. What, exactly, is the Bank of Canada doing, and why?
  1. One person’s spending is another person’s income. For every thing sold, there must be a thing purchased. Or, put differently, one person’s expenditure is another person’s revenue. So if consumers are spending less, all else being equal, businesses have less revenue.
  2. (Most) economic activities are only captured in the data when there is a financial transaction. If I pay a company to mow my lawn, my expenditures have gone up, and the landscaping company’s revenues have gone up, and there is a flow of payments to workers, governments (through taxes, etc.). If instead, I mow my own lawn, there is no change in any economic statistics. Either way, the grass has been cut, but in the second case the value of the cut lawn, the effort exerted, etc. does not appear anywhere. That’s because our standard economic statistics ignore “home production”, which is problematic for all kinds of reasons, particularly because it undervalues the contribution of women to the economy, as they engage in far more home production (a.k.a. unpaid labour) than men.

Point 1: Fear of COVID, and need to look after children, keep people, particularly white-collar professionals at home. Retail closings only play a supporting role.

Source: Vox.

Point 2: White-collar professionals are spending less and performing more home production. This is driving the economic downturn.

Source. Vox. Yes, I really did gasp. Yes, I’m a nerd.
Source: TD Bank.
Source: CNBC. If anyone has good Canadian data, please send it my way.
Source: TD Bank.
Source: New York Times.
Expect many of these to be empty by the end of the year. That’s going to create some interesting challenges for commercial real estate.
  1. One person’s spending is another person’s income. For every thing sold, there must be a thing purchased. The reduction in spending of white-collar professionals has drastically reduced incomes in the losing sectors, with a less-than-offsetting increase in the income of winning sectors, causing an overall drop in economic activity.
  2. (Most) economic activities are only captured in the data when there is a financial transaction. This shift in economic activity is not a free-lunch for white-collar professionals (WCPs). Coffee and meals are still being made, kids are still being looked after, etc. However, instead of paying service workers to do these tasks, WCPs are doing these tasks themselves through home production. This home production does not show up in the economic statistics anywhere, due to a lack of financial transactions, but it absolutely is work. It just is work that does not raise someone else’s income, or does not generate tax revenues for governments. The workload of WCPs has increased tremendously, and although their market incomes have not risen, their savings have, as their work has displaced expenditures. This has equity ramifications, as this work is disproportionately carried out by women. (And too many men are gleefully unaware of this, even in their personal lives, as the New York Times headline Nearly Half of Men Say They Do Most of the Home Schooling. 3 Percent of Women Agree shows.

Outcomes in the absence of government assistance

Point 3: Government transfers to losing sectors is preventing an even bigger collapse. This is replacing the lost spending from WCPs, and will continue until spending by WCPs recover.

Source: Parliamentary Budget Office.
  1. Given the size and speed of government transfers, it was impossible to perfectly target them. As such, not all have made their way to losing sectors (and given the reduction of jobs and hours among some WCPs, it’s wholly appropriate that those individuals would receive some supports.)
  2. Although the intent of these policies was to keep losing sectors solvent, this did have a stimulus effect — market incomes are up (or less low than they otherwise would be) in both winning and losing sectors.
  3. This stimulus impact has reduced the overall economic hit. Our economy has now declined by 5 arrows, rather than 7.

Point 4: The Bank of Canada, rather than the private sector, is financing this debt.

Source: PBO.
Source: PBO.
Source: Bank of Canada.
  1. I’ve marked the Bank of Canada’s “selling” of money and the federal government’s selling of federal bonds in red, as these were not pre-existing assets, rather they have been created during this crisis.
  2. The overall supply of both money and federal bonds has increased, as shown on the far-right column.
  3. For every bond sold, or money “sold”, there has been a buyer. In the case of fed bonds, the Bank of Canada has purchased an amount that is roughly equivalent to the amount created by the federal government.
  4. In the case of money, the newly created money by the Bank of Canada, has largely flowed to WCPs and winning sectors, who have increased their savings, while losing sectors have seen a decrease in their monetary holdings.
  5. This increase in money has not caused an increase in inflation (in fact, inflation rates have fallen during this crisis, though COVID-related changes in purchasing patterns are distorting inflation data). The easiest way to think about inflation is “too much money chasing too few goods”, but WCPs aren’t using that money to chase goods (remember, their expenditures are down substantially). This has caused a decrease in the velocity of money (the speed at which money propagates through the economy). Below is data from the U.S.; monetary velocity has been dropping for the past 20 years. It fell substantially during the financial crisis, and looks to be again during this one.
Source: St. Louis Fed.

Point 5: The Bank of Canada may be able to monetize all of this debt forever, causing no rise in federal interest payments. That’s not necessarily a great outcome.

  1. When this crisis is over, there will be significant pent up demand by WCPs, who will go out and spend down their savings.
  2. This increase in spending will boost the economy (yay!), but will also create significant inflationary pressures. Too much money chasing too few goods, and all that.
  3. To tamp down this inflation, the Bank of Canada will be forced to sell their bond holdings and reduce the supply of money. In order to incent the general public (or whoever) to buy these bonds, interest rates will have to go up.
  4. This will be effective, and the rate of consumption growth will slow, as people are buying fewer cars and more bonds.
  5. The federal government will get dinged twice here. First, they’ll get dinged because rather than the Bank of Canada holding these bonds, non-governmental actors will be. So instead of paying interest to themselves (that is, paying interest to the Bank of Canada, which then flows back to the government), they’ll be paying interest to someone else in the economy, causing their net interest payments to rise.
  6. The federal government also gets dinged because interest rates have risen, so as all of those T-bills and bonds rollover (remember, 60% of them mature within 3 years), the government will have to finance this debt at higher interest rates, which also causes their net interest payments to rise.
  7. This increase in interest payments forces the federal government to cut spending (or slow their rate of spending growth) or raise taxes.
  1. When this crisis is over, WCPs go back to spending about what they did before, and there’s not a significant level of “pent up demand”.
  2. Economic growth remains tepid and inflation largely does not materialize.
  3. Interest rates stay low, this growth in the money supply is permanent, and the Bank of Canada continues to hang on to this debt. The debt is effectively monetized.
  4. Federal government interest payments stay around pre-crisis levels, and there is no pressing need to cut spending or raise taxes.
  5. WCPs use their increase in savings in a number of ways. They use it to pay down consumer and mortgage debt (which puts further downward pressure on interest rates). They sink it into the stock market; this is already happening, with a boom in day-trading during this crisis. They use it to purchase even more residential real estate.
  6. Although consumer inflation remains low, this increase in the money supply drives asset price inflation, particularly in the stock and real-estate markets. We’re already seeing this in the stock market, as the influx of day traders is pushing stock prices up. The S&P 500 is down only about 8% from its February 2020 peak, despite the world being in the midst of a massive economic crisis.
  7. WCPs may also gift the money to their kids, so their kids can buy real-estate. This further pushes up real estate prices in our cities, and effectively locks-out any young person that does not receive this wealth from their parents. This causes a reduction in social mobility, as kids from lower-income households are locked out from the most economically dynamic areas. This gifting of cash also allows the kids of WCPs to take unpaid internships, which gives them a leg up on their career. None of this would be new, but rather an acceleration of trends that we’ve seen over the past couple of decades.

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Senior Director, Smart Prosperity. Assistant Prof, Ivey Business School. Exhausted but happy Dad of 2 wonderful kids with autism. I used to do other stuff.

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Mike Moffatt

Mike Moffatt

Senior Director, Smart Prosperity. Assistant Prof, Ivey Business School. Exhausted but happy Dad of 2 wonderful kids with autism. I used to do other stuff.

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