Bank of Canada’s Governor, Stephen Poloz, speaking at the Canadian-U.S. Securities Summit in New York this morning.
The year 2016 got off to a rough start, with plenty of financial market volatility. Of course, there is no shortage of fundamental issues to worry about: another downgrade to the outlook for global growth, uncertainty about the economic transition in China, the pace of normalization in the United States, worries about Europe, worries about Japan, just to cite a few.
Financial markets have a love-hate relationship with volatility, and central bankers usually try to see through it all. But one worry I hear a lot these days hits pretty close to home—the idea that monetary policy just isn’t working anymore. That’s one myth I’d like to dispel right off the top.
The fact is that policy actions—both monetary and fiscal—taken in the wake of the global financial crisis prevented what would have been a second Great Depression. But many of the negative forces that were acting then are still acting now. That’s why ultra-low interest rates are not causing rapid growth and inflation.
If you think monetary policy is not working, ask yourself what would happen if interest rates suddenly returned to 3 or 4 per cent. Most would agree that such a move would trigger a recession. This is just another way of saying that severe headwinds are still acting on our economies, years after the crisis, and low interest rates are keeping them at bay.
It’s a bit like riding a bicycle up a steep hill. Your progress may be slow, but that doesn’t mean your legs aren’t working hard or that your bicycle is broken. Monetary medicine hasn’t cured everything, but it is working, and it has surely saved us from the worst.
Still, as central bankers, we need to take market anxiety, and the volatility it creates, seriously, regardless of the source. Although volatility can go both ways, “market volatility” is usually code for “market declines,” which can erode consumer and business confidence and cause a weakening in economic fundamentals.
So, what I would like to do today is address another current source of anxiety in financial markets—the striking weakness of international trade. After all, international trade is the lifeblood of the global economy. Firms, consumers and investors alike all rely on it to keep the economy growing, create and sustain jobs and deliver investment returns.
The exchange of goods and services has been happening as long as people have been able to produce more than they needed to survive, leaving them free to follow other pursuits. Expanding exchange into the international arena is the next logical step, and that is exactly how global history has unfolded.
Trade is a grand facilitator that permits people and firms to specialize and innovate. The resulting improvement in living standards continues until trade reaches a balance point in the economy where all advantages have been exploited. That balance holds until circumstances change and people react to new opportunities.
Given the central importance of trade, it’s not surprising that investors are worried about what the data show. For roughly 20 years before the financial crisis, global trade had been expanding by more than 7 per cent a year—about twice as fast as the world economy. Trade collapsed in the wake of the crisis, but rebounded sharply in 2010. Since then, though, trade growth has again slowed dramatically, trailing even the tepid pace of global GDP growth.
What is behind this slump in trade? Has the link between trade and economic growth changed? Is the trade slowdown a warning of another global recession? And, if trade is central to the productivity and efficiency of companies, what does the slowdown in trade mean for productivity growth?
I hope to shed some light on these issues today, and help everyone better understand the forces that are at work.
Explaining Slow Trade Growth
Let’s dig into the data a little. The post-crisis slump in international trade was initially concentrated among advanced economies, particularly in Europe. More recently, the trade slowdown has been centred in the emerging markets of Asia, including China. This has led many investors to link weak trade to the slowdown in China, and therefore in the global economy.
Recent work at the Bank of Canada and elsewhere shows that about half of the slowdown in trade growth among advanced economies in the post-crisis period can be explained by weak economic activity, especially sluggish business investment. Throughout this period, companies have been dealing with high levels of uncertainty about the prospects for the global economy, in some cases because of aggressive deleveraging. This has held back investment and, in turn, contributed to soft trade. Investment spending involves capital equipment, with inputs from many countries, and therefore is very trade-intensive. So when economic growth slows because of weak investment, trade slows disproportionately.
While advanced economies were dealing with the worst of the crisis, China’s economy continued to expand. This supported demand for commodities, thereby keeping a portion of international trade flows moving. Higher prices for commodities also prompted commodity producers to make big investments and ramp up supply.
Ultimately, though, growth in China began to moderate to a more sustainable pace. More importantly, the Chinese economy has begun to shift away from investment-driven growth toward consumption, especially of services. Quite simply, this has meant less international trade. Even so, China’s imports of many commodities continue to grow at double-digit rates.
So, we have reason to expect global trade to grow more slowly than in the past: first, because global investment spending is in a lull, and second, because China’s economy is restructuring toward more domestic consumption and less trade. We can certainly expect global trade to pick up when the world economy gets back onto a self-sustaining growth track, with stronger business investment. Still, as I just noted, cyclical factors can explain only about half of the trade slowdown, so we have more explaining to do.
Indeed, I think we need to step back and consider the possibility that the rapid pace of trade growth that prevailed for the two decades before the crisis was the exception, and not the rule. Why would I say that? What we saw during the 1990s and 2000s was the result of the natural incentive to use trade to increase specialization, in reaction to reduced trade barriers and major advances in communication and transportation technology.
During those years, countries formed regional trading blocs through arrangements such as the North American Free Trade Agreement and the European Union. Previously closed economies, such as China, became more engaged by joining the World Trade Organization (WTO).
This combination of elements gave the natural incentive to trade a great deal more room to grow. It paved the way for companies to build global supply chains—the “integrative trade model.” A factory that made a product no longer needed to be next door to the product’s designers. Firms could now exploit their comparative advantage by specializing, not just in one particular good or service, but in one part of a good or service. The result was an explosion of specialization as markets became global and companies became more efficient.
As the Peterson Institute for International Economics put it in its recent persuasive report Reality Check for the Global Economy, “trade boomed during the 1990s and early 2000s in part because intermediate goods began globetrotting.”
However, any trend that goes on for 15 or 20 years becomes ingrained in our expectations. We should have realized all along that this process of integration simply could not continue at the same pace forever. At some point, trade would reach a new balance point in the global economy where firms had built optimal supply chains that crossed international borders, slowing the integration process, at least for the present.
Yes, there are other structural reasons you can point to for the deceleration in global trade. A troubling number of protectionist measures have been put in place since the crisis, for example. But I believe that the most important structural factor behind the slowdown in trade growth is that the big opportunities for increased international integration have been largely exploited. China can join the WTO only once. That’s not to say that further integration waves won’t happen—I certainly hope they will. But if global trade has reached a new balance point, we should not fret that global export growth hasn’t recovered to pre-crisis levels. Read more