There is an old cliché that inflation results from ‘too much money chasing too few goods.’ If the supply of goods and services doesn’t match the purchasing power of people who want to buy them, then prices will be bid up, causing inflation.
People with a bit of economics training often smugly assert that this adage somehow explains the inflation currently bedevilling Canadians. Unfortunately, the adage is a truism: it doesn’t provide any insight into what actually sparked an inflationary imbalance, nor how to fix it.
Is the problem too much money? Pierre Poilievre’s army of monetary quacks and crypto bros fervently believe this. They blame Justin Trudeau for ‘printing’ all that money, helped by the Bank of Canada (supposedly acting as the Prime Minister’s personal ATM).
This fable is wrong on multiple grounds: most money in Canada is not printed, most is created by private banks (not the Bank of Canada), the supply of base money in Canada is now shrinking, and the federal deficit has almost disappeared. So according to this theory, prices should be falling. Clearly they aren’t.
The Bank of Canada has its own view about where the ‘too much money’ came from: too many Canadians have jobs, and are earning too much at them. So Governor Tiff Macklem says the unemployment rate must rise, and wage growth be suppressed, to wrestle inflation back to the ground. This theory doesn’t fit the facts, either: wages have lagged behind prices from the outset of post-COVID inflation, and real wages (adjusted for consumer prices) are falling rapidly.
Perhaps the problem is not too much money after all, but too few goods. In that case, the remedy is not to dampen economic activity (via chilling interest rate hikes), but rather to stimulate more of it. If an inflationary imbalance is caused by a shortage of supply, then suppressing demand to match it can lock the economy into long-term underachievement (through what economists call ‘hysteresis’).
Indeed, a large body of international research suggests that the post-COVID surge in global inflation mostly resulted from supply disruptions caused by the pandemic — that is, by too few goods, not too much money. This raises a fundamental question about the effectiveness of demand suppression policies: how will higher interest rates in Canada reduce prices for global energy, imported foodstuffs, scarce semiconductors, or anything else in short supply?
New data released last week by Statistics Canada adds weight to the conclusion that inadequate supply, not excess demand, is the main problem. The agency reported that Canada’s GDP began shrinking in December, for the first time since the Omicron variant hit a year ago. This means that the recession feared by many economists may have already begun.
This data can also indicate the difference between actual and potential output: that is, the gap between what Canadians are currently producing, and what we could produce if the economy was operating at full capacity.
Canada’s GDP shrank rapidly during the initial COVID lockdowns, and then bounced back — impressively, but not completely. Not until the end of 2021 did we regain pre-COVID output levels. But during that time, our labour force and productivity continued to grow, allowing us to produce much more.
In short, GDP never caught up to the level of output that should be possible, given the pre-COVID trend. Now, with GDP shrinking, that gap is widening.
In December, the economy produced 3.3% less than what would be expected given the pre-COVID trend. That represents a loss of more than $90 billion a year (in current dollar terms) of foregone output. In other words, the economy is producing $90 billion too few goods.
That additional production would help address the urgent needs facing the country: like shoring up health care, building affordable housing, or accelerating the rollout of renewable energy. Expanding output is a much better way of closing any gap between ‘too much money’ and ‘too few goods.’
Canada’s economy has not yet repaired the damage done by the pandemic. We are producing too little, not too much. Instead of chilling (and now shrinking) the economy, we should focus on fixing the ‘too few goods’ half of the old inflation adage.
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