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This financial hurricane will hit Canadian shores

From Monday's Globe and Mail

In two incredible weeks, the United States has been turned upside-down, both economically and politically. Washington is suddenly nationalizing big swaths of the financial industry, at massive cost to taxpayers. Regulations are being rewritten so quickly that the financial rulebook now resembles a gigantic dry-erase board. From one trading day to the next, the markets alternate between partying and panicking. And in the political realm, John McCain is “wearing” the mess (quite rightly, given his personal role in deregulating the financial system) while Barack Obama has surged ahead in the polls.

From our perch not so far away, we Canadians watch this stunning drama with growing unease. How is it all going to affect us? Here, too, that question has both economic and political dimensions.

Economists have been wondering for months if we can avoid following the U.S. economy into recession. But it turns out that we had the question backward: In fact, we may be leading the United States into recession, not the other way around. Despite the more dire financial news south of the border, the U.S. economy still managed to grow (at a 2 per cent annual rate) in the first half of this year - while Canada's GDP shrank. Our national productivity (output per hour of work) has declined dismally, and is now lower than at the beginning of 2006. Fewer Canadians were working in August than six months earlier. Among the G7 industrial economies, only Italy is forecast to grow more slowly than Canada this year.

Shrugging off the negative indicators, Prime Minister Stephen Harper and Finance Minister Jim Flaherty insist we're safe in their hands. Mr. Flaherty keeps reaffirming his faith in Canada's economic fundamentals: “as solid as the Rock of Gibraltar,” he once put it.

Well, the Rock of Gibraltar doesn't need emergency injections of liquidity to stay above the waves, but our banking system apparently does. Since Sept. 18, the Bank of Canada has announced $12-billion in new low-interest loans to Canadian banks and other financial institutions. It has arranged for $10-billion worth of U.S.-dollar reserves to be thrown into the brew as well, if necessary. And it has even started accepting asset-backed commercial paper (ABCP) from financiers as collateral for these loans. (Too bad mom-and-pop investors can't convert their frozen ABCP assets into cash so easily.)

True, most Canadian financial institutions didn't jump into subprime lending and other dangerous waters nearly as deeply as their U.S. counterparts. That was thanks more to their inherent conservatism, rather than stronger regulations or clearer foresight. Nevertheless, there is growing evidence of financial vulnerability in Canada.

As of the end of June, the debt of Canadian households equalled 107 per cent of their income - an 11-point increase from the beginning of 2006. Canadian house prices are heading firmly south: down 5 per cent in the past year, with the decline accelerating. Americans have already learned the hard way that falling house prices can unleash an unpredictable collapse in the debt chain, as assets that were borrowed against suddenly lose much of their value. Merrill Lynch Canada reported last week that Canadian debt levels were reaching a “tipping point,” and expressed concern over the potential for financial chaos on this side of the border.

This inconvenient warning elicited a very defensive reaction from the campaigning Prime Minister. After all, the Conservative campaign has worked hard to ensure that nothing untoward intrudes on their ruthlessly disciplined drive for a majority.

It's certain that at least some of the waves battering the U.S. financial system are now hitting Canadian shores. What's unknown is whether their arrival will have the same political impact on our incumbent Conservatives, as they're having on the incumbent Republicans.

Mr. Harper's claim that we're fundamentally stronger than the Americans is iffy at best. And lots of Canadians realize that, at a gut level. Many have lost their jobs; many more fear for them. Many lost money on ABCP. And many are now watching the wealth in their homes evaporate, too.

There are two weeks left in this campaign. I predict that concerns over the economy, and the success or failure of the opposition's efforts to pin those concerns on the Conservatives, will determine whether Mr. Harper gets his longed-for majority.

Jim Stanford is an economist with the Canadian Auto Workers union and the author of Economics for Everyone.

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