The Perils Of A Rising Loonie

News reports say that President Bush has accepted an invitation to visit Canada. This is good news -- a sign that the childish anti-Americanism of the Chretien years has been laid aside. It is news that comes just in time, for Canada now faces a stark new challenge from the United States: not war in Iraq, not security at the border, but a sudden decline in the value of the U.S. dollar.

After years of trading in the US60 cents range, the Canadian dollar has recovered to the low-80s. The Euro has surged from about US90 cents to almost US$1.30. The yen and British pound are gaining too -- and many shrewd analysts expect the dollar to decline still further.

The Bush administration has welcomed the dollar decline. Treasury Secretary John Snow makes perfunctory noises about supporting a strong dollar, but unlike his Democratic predecessor Robert Rubin, Snow is not daily devising clever little traps and snares to punish speculators who bet against the buck.

It's not hard to understand Snow's thinking. If the dollar drops, American-made goods become cheaper and foreign-made goods become more expensive. American exports rise and imports fall. At least at the beginning, a declining currency can be very bullish for industrial production and industrial employment.

Which brings us back to Canada and Canada's problems. In the mid-1990s, the Chretien government accepted a dramatic drop in the Canadian dollar -- from US89 cents at the beginning of the decade to as low as US60 cents. The cheap Canadian dollar turbo-charged Canadian exports into the U.S. market, accelerated Canadian economic growth and tossed off government revenues by the billion. Along with spending controls and high taxes, the cheap dollar policy helped transform the massive government deficits of 1991-92 into giant surpluses.

But what happens to Canada as the U.S. government mimics the Canadian cheap-dollar policy?

The Chretien devaluation was sometimes defended as an emergency measure: a temporary across-the-board cut in wealth and incomes that would grant Canada time to get its finances and its economic structure back in good order. But the years were not well used. Canadian taxes remain crushingly high - as will the cost of doing business in Canada once the Canadian dollar returns to its historic valuations.

Given Canada's uncompetitiveness, it may seem surprising that the Canadian dollar should be rising at all. There's a very short explanation: oil and gas prices. Rising prices for Canadian commodities mean rising demand for Canadian currency with which to buy those commodities. Alberta's boom portends bust in Ontario and Quebec.

Bush's re-election compounds these problems for Canada. As president, John Kerry would have tried to hike taxes in the United States, narrowing the cost gap between the U.S. and Canada. Stephen Harper has pressed Paul Martin to work harder to address U.S.-Canadian trade disputes. In fact, the combination of low Canadian competitiveness and a rising Canadian dollar will do more than diplomacy ever could to put an end to trade frictions: As Canadian goods and services get priced out of U.S. markets, there will be less and less for American competitors to complain about.

So the Martin government will have to act -- and fast. But what will it do?

Over the medium and long term, a government determined to improve its people's competitiveness will want to consider many policy reforms. It will want to toughen educational standards and upgrade its transportation and communications networks; simplify its bureaucracy and remove barriers to internal trade.

But in the very short run, which is the run Canada must be concerned with today, there is just one thing such a government can do: reduce taxes, especially taxes on investment.

From the point of view of the individual Canadian company, the most obvious effect of a rise in the Canadian dollar is to increase the real cost of labour -- without any offsetting improvements in productivity. There are two obvious responses to a cost increase like that: (1) shift operations overseas to someplace where the unit-cost of labour is lower or else (2) invest in new technologies to substitute for labour. But a company contemplating a big new investment in plant or equipment will ask itself some very hard questions about where that investment should be placed -- and the decision tends to go against high-tax environments like Paul Martin's Canada.

When the President comes, he and Prime Minister Martin will have a great deal to talk about: Iraq, homeland security, trade. But before he bids the President good-bye, Mr. Martin should reserve a minute to ask him: "So tell me -- this tax reform idea of yours -- you wouldn't happen to have an extra copy handy, would you?"