A condensed version of this article was published in the Globe and Mail.

The Canadian economy can be analyzed from the demand or supply side. On the demand side, economists sometimes lament that “if not for this or that temporary influence” – e.g. oil prices, uncertainty or global events – Canada’s economy would be humming. The Governor of the Bank of Canada often talks about using interest rates to finesse demand into a “sweet spot,” where the economy is operating at full capacity and inflation is stable at around 2%. This is important. When demand is insufficient, capital equipment and workers are less than fully utilized. This “output gap” detracts from productivity and living standards.

Arguably, however, these days the output gap is a second-order problem. The more fundamental problem is the lack of growth from the economy’s supply side, mainly because of anemic labour productivity growth.

The demand side of Canada’s economy – striving for a “sweet spot” that ain’t so sweet

Let’s consider the Bank of Canada’s latest projections for actual versus potential real GDP growth (Table 1).[1]If all temporary factors abated, and all idle capacity was absorbed, the Canadian economy can at best sustain growth of only 1.2-1.5% to 2.1-2.4% per annum without generating above-target inflation. By historical standards, that is utterly meagre. But right now, it’s the best the country can hope for.

Table 1
Actual versus potential GDP Growth

The supply side of Canada’s economy – firing on one cylinder

From a supply side perspective, the situation is more worrisome. Canadian GDP growth appears to be firing on one-cylinder: population growth. Canada’s population grew by an incredible 530,000 in 2018 – the largest annual increase in more than four decades (Figure 1). Births minus deaths (“natural increase”) contributed just 103,000 persons to the increase. The rest came from net immigration inflows, including permanent and temporary residents, that are among the highest in more than a century.[2]

Looking ahead, the federal government plans to super-charge population growth by adding 1.33 million new permanent residents between 2018 and 2021. Only 15% of these will be in the refugee or humanitarian categories and about 27% will be reunions of immediate and extended families. For the most part, therefore, this is an economic strategy.

Figure 1
Canada saw extraordinarily high population growth in 2018 due to immigration

* Net immigration is calculated as population change less natural increase.
Source: Statistics Canada

Population growth raises GDP, but not GDP per person

Population growth raises GDP by boosting demand for consumer goods, housing, infrastructure, public services and so on. It also increases the workforce. But it does not raise GDP per person. That matters. Real GDP per person, not total GDP, is the key measure of the country’s living standards.

Yes, the Canadian economy is getting bigger because of a rising population. However, this is not translating into higher living standards. In fact, recent growth in real GDP per person is close to zero (Figure 2)! The arithmetic helps to explain why people nowadays seem increasingly skeptical about whether economic growth delivers improved individual prosperity.

Figure 2
Growth in GDP per person has stalled due to anemic productivity growth

Source: Statistics Canada.

Labour productivity determines long-run living standards

The vital, missing ingredient in Canada’s macroeconomic growth strategy is labour productivity: that is, output produced per hour worked. It is made up of capital intensity, skill intensity and the extent to which labour and capital are put to their most productive use. Growth in labour productivity has been tepid over the past decade and shuddered almost to a halt in 2018 (Figure 3).

Figure 3
Labour productivity growth has shuddered to a halt

Source: Statistics Canada.

What can be done to spur productivity growth?

A comprehensive review of Canada’s inefficient and uncompetitive tax system would be a good place to start. The last such review was in the 1960s. Sound tax policy should promote capital formation and attract talent. It should encourage firms to innovate and to pursue scale, not incentivize them to stay small.

Competition policy should ensure markets are characterized by vigorous competition and daring new entrants. “Survival” is a powerful motivator of business innovation and the shifting of labour, capital and entrepreneurial talent to better uses.

Canada’s byzantine regulatory approvals processes should be streamlined and modernized to welcome rather than repel capital formation. A stepped-up program of infrastructure investment should focus on improving transport and communications infrastructure.

Read more about these policy priorities here: Canadian Living Standards Are Slipping Relative to Peer Nations: Time for Action on Productivity.

Conclusion

Even if temporary demand-side factors abate, allowing Canada's economy to grow in line with its potential, this would still amount to a historically paltry rate of growth.

There is little prospect of achieving meaningfully higher growth in real GDP per person or real wages, or being able to afford better universal public services, without a sustained, material improvement in Canada’s labour productivity growth rate. If policy-makers are truly interested in fostering better living standards for all Canadians, that is where they should be directing their attention.

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[1] Potential GDP is the product of labour productivity (output per hour worked) and total hours worked. Growth in potential GDP acts as a natural “speed limit” on the economy. Actual GDP cangrow faster than potential GDP – but only temporarily. Higher inflation will arise as labour and capital reach full employment. To stabilize inflation around its 2% target, the Bank of Canada adjusts interest rates to try to minimize the output gap between actual and potential GDP. Actual GDP growth therefore tends to converge to potential GDP growth over time.

[2] Net immigration is calculated here as population growth less natural increase (births minus deaths). It therefore includes arrivals of permanent residents (equivalently called immigrants or landed immigrants) and temporary residents (arrivals on visitor/tourist visas and work, study or ministerial permits, and refugee claimants), less departures of permanent and temporary residents.