OECD sees signs of Dutch disease in Canada

The OECD is weighing in on the controversy surrounding whether Canada is suffering from an economic condition known as Dutch disease, and its qualified answer is yes.

The Organization for Economic Co-operation and Development warned in a report Wednesday that the run-up in commodity prices is leading to an uneven economy in Canada.

And it says the country needs to do more to develop non-resource aspects of the economy in order to maintain high levels of employment and an equitable distribution of wealth across regions.

Resource-rich provinces such as Alberta, Saskatchewan and Newfoundland and Labrador have prospered, while others have fallen behind, in part because a commodity boom has strengthened the Canadian dollar, hurting exchange-sensitive sectors such as manufacturing and tourism.

A similar problem occurred in the Netherlands after its North Sea oilfields created a new source of resource wealth and contributed to the hollowing out of the manufacturing sector there, hence the term Dutch disease.

"I don't think you can really deny it," Peter Jarrett, one of the report's authors, said in an interview.

"You can't explain the entire pattern of the history of manufacturing just by exchange rates. That goes too far. But anyone who argues it has no effect is clearly not looking at the data."

The issue has become politically charged in Canada ever since NDP Leader Tom Mulcair postulated this spring that Western Canada's booming resource-based economy was undercutting central Canada's manufacturing base. His comments were criticized as divisive by the federal government, as well as some prominent Liberals.

Mulcair recently visited the oilsands in a highly publicized fence-mending mission, but has not retracted his statements.

Flaherty sidesteps

Asked to respond to the OECD analysis, Finance Minister Jim Flaherty did not answer directly, instead saying that overall the report was "laudatory" of Canada's economic performance.

Alberta Premier Alison Redford said the OECD had expressed similar views in the past, but she disagreed.

"I think I've made it very clear with respect to Alberta's position … we are the economic engine of the country, leading growth in the country, attracting investment at a tremendous rate, seeing tremendous opportunity across this country with respect to manufacturing jobs," she said.

The 128-page report from the multinational organization does not use the term Dutch disease, but it traces the steep decline of manufacturing in Canada since the turn of the century and the equally sharp climb of the loonie. During the same period, demand and prices for Canadian commodities, particularly oil, also accelerated to record levels.

"The export-oriented manufacturing sector had by 2011 shrunk sharply to only 12.6 per cent of total value added, down from a peak of 18.6 per cent in 2000. Its share of employment has also fallen substantially over the past decade from 15.2 per cent to 10.2 per cent and somewhat more than in the United States," it notes.

"Both outcomes have been clearly correlated with exchange-rate developments."

Meanwhile, it adds: "Alberta remains the most affluent province, thanks to its energy wealth."

The fact that Canadian manufacturing has fallen further and faster than in the United States, where resources play a smaller role in the economy, can be partly explained due to exchange rate movements, Jarrett said.

Other recent Canadian papers on Dutch disease have tended to reach mixed conclusions.

Last month, the Pembina Institute said what it called "oilsands fever" has spread benefits unevenly across the country and could be hiding economic turmoil down the road.

A second report from the Macdonald-Laurier Institute argued that all provinces benefit from the commodity boom. And yet another, from the Institute for Research on Public Policy, split the difference — it found some evidence for the Dutch disease phenomenon, but said the impact was smaller than feared.

The OECD report does not recommend a slowing down of resource development, even in the case of the oilsands, although it continues to push for a carbon tax.

Instead, it advocates that Canada boost innovation and invest in churning out skilled workers to boost productivity, which should benefit the non-resource sectors.

Jarrett said another way of tackling the issue is to increase equalization payments from wealthier regions to less affluent ones.

"Basically it's a political choice as Canadians to say how much regional or provincial disparity in income per capita they think is the limit before they step in and do something about it," he said.

The OECD does not identify Dutch disease as a central problem in the economy, although it's advocacy for dealing with Canada's "sluggish" productivity growth would go some way to boost growth in non-resource sectors.

The report touches on a wide range of economic issues including interest rates, debt, government fiscal health and immigration.

It gives the most space, however, to why Canada is unable to capitalize on its highly educated population to commercialize ideas and innovate.

Canada's productivity falls

The country's productivity has actually fallen since 2002, the OECD notes with alarm, while in the U.S. it has increased by 30 per cent over the past two decades.

This is apparently not a unique Canadian problem. Other resource-rich countries like New Zealand and Norway also underperform when it comes to innovation, the report states.

Many of the solutions for the innovation deficiency advocated by the OECD have been advanced before, including that businesses spend more on research and development and that governments devote resources to post-secondary schools that turn out highly skilled workers.

But the report takes issue with some of changes to R&D funding proposed by Flaherty in his March 29 budget. The report says Flaherty should have followed more closely the Jenkins report recommendations he commissioned by reducing the small business advantage on R&D tax credits and by not being afraid to "pick winners" as long as firms also contribute to their own research.

On the current state of the economy, the OECD says Canada has weathered the global crisis comparatively well and should grow by about 2.2 per cent this year and 2.6 per cent in 2013.

As it has noted before, Canada faces a potential future risk over the high levels of household debt and real estate prices.

"Low interest rates are, for now, keeping mortgage and debt-servicing affordable for most, but the share of indebted households spending more than 40 per cent of their income on interest payments remains about the 2000-2010 average," it warns.

Jarrett said the house prices and debt levels are "not trivial but not enormous risks" to Canada's financial system at the moment, adding that "luckily" trends on both fronts seem to be going in the right direction.

He said failing a crisis in Europe, the Bank of Canada should start raising interest rates by the end of this year.