What is a bear market rally?

As the global financial crisis plays out, Report on Business writer Richard Blackwell examines and explains the economic outlook and the turmoil in credit and stock markets. Here, we answer your questions daily, with the most recent at the top.

What is a “bear market rally”?

A bear market rally is a significant upward movement in stock prices, but within a long-term overall downtrend.

It’s essentially the reverse of a “market correction,” which is a short-term decline in stocks within an overall bull market.

Usually, bear market rallies and market corrections don’t last very long, but they can shift markets by as much as 30 per cent or more, before the overall trend continues.

After the 1929 market crash, for instance, there were several substantial rallies, but after each one stock prices continued on a long downward trajectory. Several of those rallies saw indexes jump more than 10 per cent in one day.

The big question at the moment is whether the recent upturn in stocks, which has pushed prices up by about 20 per cent since the trough in November, is the beginning of a long-term trend, or just a bear market rally.

The disruption in European natural gas markets makes me wonder if the same thing could happen in Canada. Do we depend on foreign suppliers?

In Canada, almost all of our natural gas comes from domestic production, so it is very unlikely that any other country could disrupt our supply.

Most Canadian gas is produced in Alberta, Saskatchewan and British Columbia, with a small amount generated from offshore gas fields in Atlantic Canada. It is sent through hundreds of thousands of kilometres of pipelines to customers, including homeowners, industrial users and electrical power plants.

However, some of the gas consumed in Ontario is imported from the United States.

So we are essentially self-sufficient in gas?

Yes. It helps that Canada is the third-largest producer of natural gas in the world, after Russia and the United States. About half of what we produce is sold to customers in the United States.

What exactly is “quantitative easing”?

Quantitative easing involves a central bank pumping money into the financial system by buying up a variety of securities, including government debt, mortgages, commercial loans and stocks. By flooding the financial markets with cash, interest rates charged to a wide range of borrowers should be reduced.

With official interest rates in the United States close to zero already, quantitative easing is one of the few remaining tools that the Federal Reserve Board can use to try to get retail lending rates down and more money flowing to individual borrowers and small businesses.

Why is it called that?

The word “quantitative” refers to the money being pumped into the system, while “easing” means lowering rates. Essentially, cash is being used to reduce borrowing costs and expand lending, which differs from the Fed’s usual route of lowering its benchmark interest rate.

Normally, pumping cash into an economy would boost inflation. But deflation, rather than inflation, is the key concern at the moment.

The term quantitative easing was first used in the 1990s to describe Japan’s monetary policy at the time.

What is the difference between monetary policy and fiscal policy?

Monetary policy involves actions taken by agencies, such as central banks, to control the supply of money and shift interest rates.

At its most basic, lowering interest rates or adding to the money supply can help expand an economy in a period of weakness.

Tightening money supply and raising rates can slow economic activity and keep inflation in check during expansionist times.

Fiscal policy, on the other hand, involves government actions to alter taxation and spending levels. These moves can also have a substantial impact on the overall economy, as higher government spending or lower tax levels tend to give a boost to economic activity.

Royal LePage says house prices will drop 3 per cent this year in Canada. How much did prices fall during the last recession?

The problem with housing price statistics is that there are so many different ways to compile them.

But there is no question that at the start of the last recession in the early 1990s, house prices took a hit. According to the Canadian Real Estate Association, there was roughly a 3.5-per-cent fall in the average Canadian house price in 1990, compared with the previous year.

CREA numbers suggest there was a similar drop in prices in 2008 compared with 2007.

Some monthly comparisons show much bigger drops, however. Between November, 2007, and November, 2008, for instance, the average house price across the country dropped almost 10 per cent, according to CREA.

Individual markets showed even bigger swings.

Royal LePage’s numbers suggest that house prices fell only 1.1 per cent in 2008. The company projects a 3-per-cent fall in prices in 2009.

Royal LePage president Phil Soper said the housing market is currently in better shape than in the early 1990s, as price increases have not overshot income gains to the same degree, and there has been less speculation in the market.

AUTO INDUSTRY

We’ve heard so much about the U.S. and Canadian governments’ plans to bail out the North American auto industry. What has the Mexican government done?

The U.S. bailout package, amounting to $17.4-billion (U.S.) in loans to General Motors Corp. and Chrysler LLC, was announced in December.

Canada and Ontario responded with a commitment of $4-billion (Canadian) in emergency loans to the two companies’ Canadian subsidiaries.

Mexican auto producers have asked their government for $3-billion (U.S.) in loans to spur vehicle sales. This money would provide financing for car dealers and buyers. The Mexican government has yet to respond.

Still, Mexico is likely to benefit from the U.S. bailout package because General Motors and Chrysler – along with Ford Motor Co. – build small, fuel-efficient cars there, and wage rates are very attractive to the auto makers.

CENTRAL BANKS

What is the difference between the U.S. Federal Reserve Board and the Department of the Treasury?

The Federal Reserve Board, often called the Fed, is the central bank of the United States. It has a similar role to the Bank of Canada, in that it sets interest rates and lends money to member banks.

It also regulates banks, a job that in Canada is performed mainly by the Office of the Superintendent of Financial Institutions. The Fed also manages the United States’ cheque clearing system.

The Department of the Treasury is the arm of government that manages finances, much like Canada’s Finance Department.

It collects taxes (a role performed in Canada by the Canada Revenue Agency), pays government bills, and manages federal government debt. The Treasury also prints paper currency and mints coins.

What is the purpose of countries having foreign currency reserves?

Foreign reserves usually include cash held in foreign currency, along with gold, and reserves set aside for the International Monetary Fund.

Holding foreign reserves gives a country flexibility in influencing the exchange rate of its own currency. If Japan wants to prop up the value of the yen, for example, it can sell some of its vast foreign reserve holdings to buy yen, a move that effectively increases demand for the currency, which will tend to increase its value.

(In recent years, the Japanese have been doing exactly the opposite. They have purchased billions of U.S. dollars and sold yen to try to slow the appreciation of the yen, which was hurting Japan’s exports.)

What is “currency intervention?”

When a country doesn’t think its currency has the right value compared with that of another nation, its government or central bank can make large purchases or sales of currency to try to right the imbalance.

For example, if country A wants to see its currency lower relative to country B, it will sell its own currency and buy large amounts of country B’s currency. That would increase supply of the domestic currency and drive down demand, likely depressing its value.

If a number of countries work together, they can have an even bigger impact on currency value?

There has been speculation that the largest industrial nations might attempt to intervene in currency markets in the near future, to try to trim the value of the Japanese yen, which is near a 13-year high compared with the U.S. dollar. The finance ministers of the G7 countries said Monday that they will monitor markets closely and “co-operate as appropriate” because they are concerned about the volatility in the yen.

In the past, the Japanese have been among the most active countries in using currency intervention to shift the value of the yen. Several times since the mid-1970s the Japanese government purchased billions of U.S. dollars and sold yen to try to slow the appreciation of the yen, which was hurting Japan’s exports.

The last major multinational intervention was in September, 2000, when central banks in Europe, the United States and Japan sold massive amounts of U.S. dollars and bought euros in order to prop up the European currency, which had fallen about 30 per cent since its launch in January, 1999.

What is a liquidity injection?

Central banks can use their financial clout to try to get money flowing to the banks and their customers. In a liquidity injection, they make money available for banks to borrow, although the financial institutions have to post securities as collateral to get it. Last week the Bank of Canada said it would make $20-billion available to Canadian banks, and on Monday it said it would let banks pledge their troubled asset-backed commercial paper assets as collateral. This will give some banks more flexibility. One problem, said TD Bank chief economist Don Drummond, is that the central bank’s injection is just for the short term – Bank of Canada loans usually have to be repaid within 90 days. But the demand from customers is trending towards longer-term loans – especially from corporations who can’t get money any other way – so the central bank money won’t help much on that score.

Where do central banks get the money for a liquidity injection?

The Bank of Canada has billions of dollars in assets – about $56-billion at last count – mostly held in very safe securities such as bonds and treasury bills. In essence, when it makes money available to commercial banks, it is temporarily swapping its safe securities for the riskier ones the banks are putting up as collateral.
Do interest rate cuts actually help boost the stock market?

In theory, they should. If an investor is trying to make a decision between putting money into a bond or a stock, he or she will look at the difference between the yield on the bond and the possible return on the stock. Bond yields should fall when interest rates go down, making stocks more attractive. Essentially, for a stock to compete for an investor’s money, it doesn’t need to offer as high a rate of return. However, bond yields do not always follow central bank interest rate cuts, and they haven’t this time. Some very high-quality corporate bonds, for example, are offering huge yields compared with the stock market. While lower interest rates should also make corporate borrowing easier and thus lower costs and finance growth, that hasn’t been happening either in the current credit crunch. On top of all this, worries over a recession or panic over falling stocks can trump any minor tweaking of interest rates.

What will the co-ordinated rate cuts achieve?

Central banks around the world moved Wednesday morning to cut their benchmark interest rates by half a percentage point, marking the first co-ordinated action since the terrorist attacks of September, 2001. It was an extraordinary move to bolster markets and help ease clogged credit markets. Among the central banks were the Federal Reserve, the Bank of Canada, the European Central Bank and the central banks of Britain, Switzerland and Sweden. The Bank of Canada’s key overnight rate falls to 2.5 per cent, while the Federal funds rate moves to 1.5 per cent.Economists cited the action as a positive and necessary step, but said there’s still more to do. London-based Capital Economics, for example, said the move would provide “at least a temporary boost to confidence.” Derek Holt, vice-president of economics at Scotia Capital Inc., cited the risk of 50 basis points not being enough and possibly not passing through to consumers and businesses. So far in Canada, major banks have cut their prime rates by just one-quarter of a percentage point. The Bank of Canada itself said the move does not preclude another rate cut at its next scheduled policy meeting on Oct. 21. Indeed, Toronto-Dominion Bank deputy chief economist Craig Alexander said the bank expects both the Federal Reserve and the Bank of Canada to cut another half-point at their next meetings, and the ECB and Bank of England to cut even deeper in the months ahead.

Don’t interest rate cuts tend to fuel inflation?

In normal circumstances this is true, and that is one of the reasons the Fed has held rates steady for several months. But with oil prices dropping sharply, and commodity prices falling as well, the threat of inflation is taking a back seat to worries about credit and the functioning of the economy.

What was behind the Federal Reserve’s Oct. 7 plan to buy up commercial paper?

The central bank is stepping in as a buyer of last resort in the $100-billion market for commercial paper. This is a form of short-term debt that thousands of companies use to finance their daily operations, including paying employees and buying supplies. The Fed hopes to kickstart this market and free up funds for corporations. The central bank said it was taking the action because money market mutual funds and other investors were loathe to buy commercial paper. Ian Stannard, a currency strategist at BNP Paribas in London, described the move as “probably the first piece of news we’ve had that starts to address the underlying problem in the financial system. This is a very proactive step and will be a huge help to getting things moving again.

What are the specifics of the plan?

Using Depression-era powers, the Fed will create a new temporary lending vehicle that eligible companies can tap for short-term cash (IOUs of less than three months). In return, the Fed will collect fees and interest, assuming the role of private investors, such as pension and money market funds, that have become too nervous to buy the paper.

How effective will the Fed’s new measure be?

The historic move should unclog the market for these business IOUs, helping to insulate the real economy from the credit crunch. The hope is that, over time, private investors will feel confident enough to return to the market, allowing the Fed to withdraw. The catch is that the commercial paper market is just one piece of a massive and interconnected credit system that is no longer functioning, and the Fed can’t possibly nationalize it all. Credit markets saw some slight easing Tuesday after the announcement, described by some observers as the most effective measure to date. Douglas Porter, deputy chief economist at BMO Nesbitt Burns, said the central bank is putting itself even more into the “credit creation process” and taking on more risk as a result. Will it work? “This welcome step should alleviate some of the pressure on companies which were finding even day-to-day operations difficult to manage … Still the problems besetting the credit markets are so multi-dimensional that no move will be a single fix,” Mr. Porter said, noting the Fed wants to use every measure possible before cutting its benchmark Federal funds rate.

COMMODITIES

Is the recent jump in oil prices directly related to the conflict in the Middle East?

It is impossible to pinpoint exactly what causes changes in oil prices, although the explosion of hostilities is certainly a factor in the jump in prices in recent days. Any conflict in the Middle East raises concerns about oil supplies from the region.

Over the weekend a military commander in Iran called for Islamic countries to cut oil supplies to countries that support Israel. While this was not taken seriously – and was dismissed outright by some sources at the Organization of Petroleum Exporting Countries – it does make some traders nervous.

Are there other things that are making prices swing so radically?

There are so many factors that go into energy prices that it is hard to figure which is most important. In addition to the conflict in Gaza, a dispute erupted on New Year’s Day between Russia and the Ukraine over natural gas payments, and this has disrupted supplies to Europe, pushing up prices.

At the same time OPEC is in the process of instituting oil production cuts, and some analysts say a mildly optimistic mood in financial markets may presage higher oil demand. Those could also be reasons for higher prices.

Reports of a damaged oil pipeline in Nigeria have also raised some concerns about supplies from that country – yet another possible explanation for upward pressure on prices.

What does it cost to produce a single barrel of oil from the Alberta tar sands? At what price is it no longer profitable?

It varies, of course, depending on the project and a wide variety of factors.

But the Canadian Association of Petroleum Producers says the “all-in” cost of producing a barrel of oil sands oil is between $75 (U.S.) and $90 a barrel. That includes the cost of capital, operating expenses, royalties, taxes and a return on investment.

A recent report from Calgary-based investment dealer Peters & Co. estimated the prices needed to generate a 10-per-cent after-tax rate of return on new developments starting up in 2012. Peters said the threshold would be $60 per barrel for a SAGD (steam-assisted gravity drainage) project, $100 for an integrated oil sands mining project with an upgrader and $55 for a conventional mining project without upgrading.

Peters said long-term price trends should still support oil sand development, particularly if production costs can be reduced.

Have oil prices, which have fallen more than 50 per cent since mid-July, ever dropped this fast before?

In early 1986, oil fell sharply over about three months from about $26 (U.S.) a barrel at the start of the year to just over $10 by the end of March, a price that had not been seen since the mid-1970s. The blame for the price drop was placed on increased production by Saudi Arabia and other OPEC countries, a move that caused a glut on world markets.

Again in the late 1990s there was a plunge, from over $22 in the fall of 1997 to below $11 about a year later. That was the lowest price oil had traded at in more than a decade.

Again, the Organization of Petroleum Exporting Countries got the blame, because it could not agree on production cuts.

A decline in demand – particularly in Asia, where the economy had weakened – also exacerbated the downward price pressure.

Why are Saudi Arabia and other OPEC countries allowing the price of crude oil to fall so dramatically? Can they not control the price of oil by adjusting production?

OPEC (the Organization of Petroleum Exporting Countries) does have significant control over production, but it is not an instantaneous process and changes don’t always have an immediate effect. In early September the cartel said it would cut production by about 520,000 barrels a day, and OPEC is set to meet Oct. 24 to talk about possible further action. (On Thursday it shifted the meeting forward from Nov. 18.)

Still, as University of Alberta business professor Joseph Doucet points out, OPEC has no direct control over prices, but can merely control the quantity of its production, which has an indirect influence on prices. Other factors – such as the level of crude and gasoline supplies in the United States – can have a greater impact. In addition, Prof. Doucet says, oil prices have been shifting quickly in the past few weeks and production changes take some time to put into place.

The internal politics of OPEC account for yet another complicating factor. “Saudi Arabia has the largest reserves of any OPEC country and is the ‘patient’ one – the country with the longest view,” Prof. Doucet said. “They have an interest in a moderate oil price [because] they want to be able to sell oil for a long time. Countries with shorter views, say Nigeria, have more pressing needs for cash flow … and thus worry less about long term oil substitution.”

And even when OPEC sets quotas, not every country in the organization always respects them.

Is the recent jump in oil prices directly related to the conflict in the Middle East?

It is impossible to pinpoint exactly what causes changes in oil prices, although the explosion of hostilities between Israel and the Palestinians is certainly a factor in the jump in prices in recent days. Any conflict in the Middle East raises concerns about oil supplies from the region.

Over the weekend, a military commander in Iran called for Islamic countries to cut oil supplies to countries that support Israel. While this was not taken seriously – and was dismissed outright by some sources at the Organization of Petroleum Exporting Countries – it does make some traders nervous.

Are there other things that make prices swing so radically?

There are so many factors that go into energy prices that it is hard to figure out which is most important.

In addition to the conflict in Gaza, a dispute erupted on New Year’s Day between Russia and Ukraine over natural gas payments, and this has disrupted supplies to Europe, pushing up prices.

At the same time OPEC is in the process of instituting oil production cuts, and some analysts say a mildly optimistic mood in financial markets may presage higher oil demand. Those events could also prompt higher prices.

Reports of a damaged oil pipeline in Nigeria have also raised some concerns about supplies from that country – yet another possible explanation for the upward pressure on prices.

CREDIT MARKETS AND CRISIS

What is the “money market,” and why does it matter if it freezes?

The money market is made up short-term loans (generally of less than one year), such as certificates of deposit, commercial paper, banker’s acceptances, and 30-day treasury bills. If the money market freezes up – in other words, no one wants to make short-term loans because they are worried about borrowers defaulting – companies cannot get the cash they need to pay staff, buy supplies or pay rent. Often companies need to borrow this money because they are waiting for revenue that may not arrive for a few days or weeks. But if they can’t get short-term cash from the money markets, it can make day-to-day operations very difficult.

What is a credit default swap?

These were originally set up as a kind of insurance against bad debts. A holder would pay a series of “premiums,” and in return would get a payout if a specified organization failed. It’s the same idea as paying a life insurance premium, where the beneficiary gets a payout only if the specified person dies. Like life insurance, everything is in balance unless there is an epidemic and people start dying left and right. With more companies going under, or threatening to do so, firms that issued swaps are themselves in trouble. That’s what happened to insurer AIG, which sold credit default swaps that protected investors against bond defaults. When bonds started defaulting, AIG itself was left vulnerable.

What is counterparty risk?

When you lend $20 to a friend, the counterparty risk is the chance that he or she won’t pay you back. And it works the same way with corporations or financial institutions, although their measurement of risk is a little more sophisticated. If the counterparty risk is high, traders and banks won’t lend money unless they get some solid collateral or loan guarantees, or they might just say “forget it.”

Commercial paper is normally issued only by the most credit-worthy companies, providing them with short-term cash to run their day-to-day operations. Issuers almost always need to have a credit rating on their commercial paper, because the buyers want assurance that their money is very safe, and will be paid back quickly. But getting a credit rating is an expensive and time-consuming process that is conducted by bond-rating agencies. As a result, most commercial paper is issued only by large, stable companies, or entities such as utilities.

What other measures could the U.S. take if the bailout package and interest rate cuts don’t stabilize markets and the economy?

The U.S. government and Federal Reserve have used two of the key tools in its toolkit to try to stem panic and stabilize the financial system: The $700-billion bailout of the problem assets at the big banks, and an interest rate cut. But there are other tools as well that have not come into play yet. They could try to stimulate the weak economy by cutting taxes to individuals, they could beef up spending on federal infrastructure to create jobs, or they could give specific tax incentives, for home purchases for example. And while the U.S. government has already boosted insurance on bank deposits to $250,000 from $100,000, it could follow the lead of some European countries and move to unlimited insurance. And if things get even worse at any of the major financial institutions, the government could take direct equity stakes. That seems an unlikely move, but the current situation is unprecedented.

Where will the $700-billion (U.S.) in the Wall Street bailout package go and how will prices be determined?

The money will be paid to Wall Street firms, banks, pension funds and other companies that hold bad mortgages and other toxic assets. The values aren’t known at this point, and the amount paid will be decided in a reverse auction, in which the sellers of the assets compete with each other and decide how cheaply they will sell the toxic debts. The government, through the newly appointed Office of Financial Stability, then pays the lowest price offered.

Will the money ever be recovered?

The U.S. Treasury Department has said there is a good chance it will recover some if not all of the money, although observers are not so certain. Previous rescue efforts have actually turned a profit, although others have cost billions.

Who wins and who loses?

While it’s theoretical at this point, financial institutions could win out by having their toxic assets bought by the government at what is effectively a premium. While banks can dispose of some of these assets now, they would be doing so at firesale prices if buyers are found. In an ideal world, the U.S. government would hold on to the troubled assets until maturity, when hopefully the real estate market will have recovered, and then dispose of them at at least breakeven. But it is a long-term process, and thus it is too early to tell how the taxpayer makes out.

ECONOMY

Ford’s CEO says he will work for $1 a year if emergency government funding for the car industry is provided. Who were the original “dollar-a-year men”?

Dollar-a-year-men were wealthy business executives – usually in the manufacturing sector – who were recruited by governments to help run crucial war-time production. They were paid nominal salaries to do crucial government work.

The term was first used in reference to men who went to Washington to help President Woodrow Wilson during the first World War. It was used again in World War II in both the United States and Canada.

In Ottawa, C.D. Howe, the “minister of everything” (who was actually minister of Munitions and Supply during the war) recruited dozens of these “buck-a-year men.” They included John Wilson McConnell, the owner and publisher of the Montreal Star, H.R. MacMillan, founder of forestry company MacMillan Bloedel, and Henry Morgan, President of Morgan’s department store in Montreal.

What does the term mean now?

It has been used recently to describe corporate executives who have taken hefty pay cuts because their companies are doing poorly. A few years ago John Chambers, CEO of U.S. telecommunications equipment firm Cisco Systems Inc., cut his pay to $1 for three years after the firm’s stock price plunged. But he was given millions of stock options over that period.

Last week troubled international insurance company AIG said its new chairman and CEO, Edward Liddy, will get only $1 in cash salary this year and next. But he’ll collect his compensation in other forms.

Ford’s CEO Alan Mulally said Tuesday he’ll work for $1 per year if the car company has to take any government loan money.

How did the National Bureau of Economic Research figure out that the U.S. has been in a recession for a year?

The NBER doesn’t use the usual definitions of a recession – two quarters of decline in gross domestic product. It instead looks for the peak of economic activity, by considering GDP and several other factors such as production, employment, consumption and real income.

When the peak is reached and the economy begins to decline significantly, that’s when the recession has started, according to the group.

This often means that an official recession – or at least its duration – is not declared until it is well under way, or is even over. And it means that there can sometimes be a recession when there aren’t two consecutive quarters of GDP decline. So far that’s the case this time.

The recession will not be considered finished until the economy reaches its trough.

What is the NBER?

The NBER was founded in 1920 by a group of economists who wanted to study business cycles. It is a non-profit research organization with more than 1,000 university professors and researchers functioning as “associates,” who study how the U.S. economy works. Since the 1960s it has been considered the official arbiter of when the U.S. is in recession.

The NBER’s business cycle dating committee actually makes the decision to declare a recession. That key committee is currently composed of economists from Harvard, Stanford, MIT, Northwestern University, the University of California at Berkeley, and the Conference Board.

The Americans “stimulated” their economy by issuing cheques to millions of citizens this past spring. Has Canada ever done anything like that?

Canada has never sent cheques directly to its citizens to try to stimulate the economy. The closest thing to that took place early in 2006 when the Alberta government sent $400 “resource rebate cheques” to every resident of the province – the so-called Ralphbucks. In that case, the idea was to share an unbudgeted surplus, not an attempt to stimulate the economy.

Occasionally in the past, Ottawa has cut income tax rates retroactively at the end of a year, so that many people got tax refund cheques in the spring, but that’s not quite the same thing.

Wouldn’t this kind of direct payment be a good idea?

The problem with direct rebates, and even tax cuts, is that a lot of the money doesn’t actually help the domestic economy. Many people save the money, pay down debt, or buy consumer goods that are made in other countries.

Why is the U.S. Fed’s key interest rate (at 1 per cent) different from the Bank of Canada’s key rate (2.25 per cent), yet the prime rate in both countries is the same (at 4 per cent)?

Last weekend’s G20 meeting in Washington has been called Bretton Woods II. Wasn’t there already a Bretton Woods II?

The term “Bretton Woods II” has been used for decades, but usually in a theoretical sense. Some countries or institutions have called for a Bretton Woods II when they wanted to revisit the way exchange rates were set, or to put in place a new global financial architecture. Sometimes this call has been accompanied by a proposal for a global meeting of economic and political leaders.

The original Bretton Woods conference in 1944 decided that the best route to a stable world economy was to set fixed exchange rates for currencies pegged to gold. (It also created the World Bank and the International Monetary Fund). By 1971, when the United States went off the gold standard, that system essentially collapsed.

In the late 1990s and early 2000s, however, China and other countries fixed their exchange rate to the U.S. dollar, while funding the United States’ current account deficit. That era is sometimes referred to as Bretton Woods II.

But the term has gained its greatest currency in reference to last weekend’s meeting of the G20 leaders, which was called – like the original postwar session – to try to fix a crumbling international financial marketplace.

What exactly is a ‘have-not’ province?

The calculation of equalization payments – thus determining provinces’ “have” or “have not” status – is complex.

There are about 33 economic criteria that go into the formula, and these are averaged over several years.

But the calculation is heavily weighted toward the provinces’ abilities to raise tax revenues, including resource royalties.

So when prices of resources such as oil and gas go up, provinces rich in these commodities are more likely to be “have” provinces – those with economic well-being that is above the average for all the provinces.

Because the numbers are averaged over an extended period, the drop in oil prices in the past few months won’t likely change the relative status of the provinces in 2009, keeping Newfoundland, Saskatchewan, Alberta and British Columbia as “have” provinces.

Is there a better way to measure the economic health of the provinces?

According to Dale Orr, chief economist at Global Insight Canada, most economists determine the relative health of provinces or countries by looking at per capita measures of real gross domestic product. On that score, Ontario is not a “have not” province, and would not likely be next year or for some time to come.

In 2007, Ontario’s real GDP per capita was about 4 per cent more than the national average (according to data just released in the past few days). It is expected to stay about 3 per cent above average next year, even though it is set to begin collecting equalization payments.

And even with tougher times ahead for Ontario’s manufacturing base, the GDP per capita measure in the province is expected to stay above the Canadian average at least until 2013.

Why have European interest rates been so much higher than those in North America in recent months?

In Europe, as in every other developed economy, the central banks generally set interest rates to spur economic growth (by moving rates down) and to control inflation (by moving them up).

Until recently, inflation has been a much bigger concern in Europe than in North America, so rates there were set higher to try to keep upward price pressures in check. In the United States, growth has been sub-par for several years, so the Fed has already moved rates down to try to stimulate the economy.

In addition, Europeans tend to be even more concerned about inflation than North Americans, said Toronto-Dominion Bank senior economist Richard Kelly, because in Europe many wages are indexed to inflation. As a result, a jump in inflation in a country can almost immediately accelerate wage costs and damage the economy.

Now, the focus in Europe has shifted to economic growth, as the consequences of the implosion of U.S. financial markets spread around the world. Inflation is much less of a worry, so we’re seeing big interest rate cuts to try to curb shrinking European economies.

I read that Saudi Arabia is already one of the largest contributors to the International Monetary Fund. How much does it give?

Saudi Arabia is indeed one of the largest contributors to the IMF, and as such it has a large number of votes at the organization. Saudi Arabia’s “quota” — or the amount of credit it provides to the IMF — is just over $10-billion (U.S.), slightly more than Canada’s quota of about $9.5-billion.

Since votes at the IMF are proportional to quota, that means Saudi Arabia has about 3.2 per cent of the votes, compared with Canada’s 2.9 per cent.

That makes Saudi Arabia the sixth most powerful country within the 185 members of the IMF, beaten out only by the United States, Britain, Japan, Italy and France. The United States has the biggest quota (about $55-billion) and the largest number of votes (about 17 per cent of the total).

Member countries keep the bulk of their IMF commitments in their own reserves at home, but they may be called on to provide cash when troubled members seek help.

With the economic downturn, is Canada’s unemployment rate anywhere near a record high?

The unemployment rate may rise in the coming months, but at the moment it is very low in historical terms. The current rate, at 6.1 per cent, is not far above the 33-year low of 5.8 per cent that was hit in the early months of this year. Economists are expecting the rate to rise to 6.2 per cent when the new labour force numbers for October are released later in November.

We have had much higher unemployment rates at several times in the past. During the depth of the Depression, in 1933, the rate peaked at about 25 per cent. By the end of the Second World War there was virtually no unemployment, and for the next three decades the rate stayed below 7 per cent. Then in the early 1980s and again in the early 1990s there were spikes when unemployment rose above the 11-per-cent mark, but it has been trending downward since then.

When the Canadian dollar took its recent dip, did it come close to its lowest point ever relative to the U.S. dollar?

The Canadian dollar bottomed out at 61.75 cents (U.S.) in January, 2002, so the fall to 77.59 cents on Oct. 27 was quite a way from that point. What was more unusual about the recent drop was the speed with which it occurred. The dollar tumbled more than 19 cents in the space of a month.

The recovery has also been quick, however. The dollar was up more than 7 cents in the five trading days since it hit the trough a week ago.

The Canadian dollar’s highest point compared with the U.S. dollar, at least in modern times, came just last November, when it briefly nudged above $1.10. Way back, during the U.S. Civil War in the 1860s, the Canadian dollar reached $2.78.

Why do economists always say that the consumer is 70% of the economy? Isn’t the consumer really 100% of the economy, since all business is just an intermediary activity that ultimately sells to the consumer?

In a broad sense, you are right that individual consumers ultimately make up the entire economy, said Doug Porter, deputy chief economist at BMO Nesbitt Burns. But the way economic activity is measured, there are different categories that make up the overall picture, he said. This includes government spending, residential construction, domestic business purchases and exports, along with consumer spending.

But Mr. Porter notes that the 70-per-cent number you are referring to actually applies only to the United States, “which is the real outlier compared to most of the rest of the world.” Elsewhere, consumer spending makes up a much smaller proportion of the economy.

In Canada, consumer spending is about 55 per cent of the economy. The big difference between us and the Americans is that health care purchases are mainly made by government here, while in the United States most of that spending comes under the consumer category, because individuals write the cheques.

Government consumption makes up almost 20 per cent of the economy in Canada.

What provinces have run deficits in recent years?

Most provinces have had balanced budgets or surpluses for several years. The only exception is Prince Edward Island, which had a small deficit of $37-million in its 2007-08 fiscal year, and projected a $35-million shortfall for 2008-09.

The days of almost-universal provincial surpluses may be gone, however, because of the gloomy economic outlook. Ontario said Wednesday that it will now have a $500-million deficit in the current fiscal year because it does not want to cut health or education spending, even though its revenue is declining. That’s a change in direction after three years of surpluses.

Alberta has been running surpluses for the longest period – it hasn’t had a budget deficit in 15 years, thanks to its blossoming oil revenue. And Alberta is also the only province that has managed to completely eliminate its accumulated debt. That happened in 2004.

The international financial summit set for November has been called Bretton Woods II. What was the first Bretton Woods conference?

Bretton Woods is the informal name for the United Nations Monetary and Financial Conference held in Bretton Woods, N.H., in July, 1944. Officials from 44 countries attended. The central agreement hammered out there said each country would maintain a fixed exchange rate – a policy that has long since collapsed – in order to help encourage the flow of capital across borders. The International Monetary Fund and the World Bank and the World Trade Organization trace their origins to the meeting. The coming summit is likely to be held in New York after the Nov. 4 U.S. election.

Several countries are now lining up for assistance from the International Monetary fund. What is the IMF?

The IMF, established at the 1944 Bretton Woods conference, provides financial help to countries in serious economic trouble. It uses money gleaned from its 185 member countries.

Those funds, called quotas, vary depending on each country’s size and strength. The U.S. has the biggest quota, at $58-billion. Canada’s quota is about $10-billion. Countries keep the bulk of their IMF commitments in their own reserves at home, but they may be called on to provide cash when troubled members seek help.

Voting rights in the fund are proportional to quota. Rich nations also contribute to a separate emergency fund. The total quotas now amount to more than $350-billion, and the fund has about $20-billion in outstanding loans to more than 60 countries.

The IMF makes money on the spread between what it earns on its loans and what it pays in interest to countries that provide the funds. It uses that cash to pay administration costs.

Why would a recession push the Canadian government into a deficit position?

A recession would likely cut into Ottawa’s revenue at a time when it is not expecting a very big surplus. If there is no economic growth, the government will take in less personal income tax, corporate tax and GST.

At the same time, employment insurance benefits could rise if more people are out of work, and there will be pressure to stimulate the economy with government spending.

Unless the government actually cuts spending, it could be forced into a deficit position. The same would apply for any individual province.

Isn’t there a “buffer” to take up some of this slack?

When Paul Martin was finance minister, he usually included a “reserve for economic prudence” to protect against the economy being weaker than forecast, and a “contingency fund” to protect against other unforeseen problems, says Dale Orr, chief economist at Global Insight Canada.

However, in its 2008 budget the Conservative government did not set aside either of those reserves, and that might force it to take extraordinary actions to avoid a deficit.

Iceland may become the first western nation in 32 years to get a loan from the International Monetary Fund. Which was the last one?

In 1976 Britain received a loan of more than $4-billion (U.S.) from the IMF after inflation leapt to record levels and the pound fell sharply. In return, the IMF demanded that Chancellor of the Exchequer Denis Healey cut spending and implement other austere economic measures. Reports Monday said Iceland is expected to get about $1-billion from the IMF, as part of a $6-billion rescue package that includes funds from central banks in Scandinavia and Japan. Iceland’s government was recently forced to take over the country’s major banks after their liquidity plunged and the country’s currency lost more than half its value.

What is deficit financing?

It is the concept, first promoted by British economist John Maynard Keynes in the 1930s, that governments should be prepared to run deficits during tough times in order to stimulate the economy by increasing spending. It was not enough to let market forces deal with high unemployment, he said.

The idea was that budgets would be balanced over the course of an entire business cycle, as revenues would increase – and surpluses would replenish government coffers – when the good times returned.

The concept fell out of favour in the 1970s and 1980s, when many governments began to run large deficits on a regular basis and cumulative debt spiralled out of control. There was no Keynesian solution to “stagflation” – prolonged periods of inflation, low economic growth and high unemployment.

Why could a recession push the federal government into a deficit position?

A recession would likely cut into Ottawa’s revenue at a time when it is not expecting a very big surplus. If there is no economic growth, the government will take in less personal income tax, corporate tax and GST. At the same time, employment insurance benefits could rise if more people are out of work, and there will be pressure to stimulate the economy with government spending. Unless the government actually cuts spending, it could be forced into a deficit position.

Isn’t there a “buffer” to take up some of this slack?

When Paul Martin was finance minister, he usually included a “reserve for economic prudence” to protect against the economy being weaker than forecast, and a “contingency fund” to protect against other unforeseen problems, says Dale Orr, chief economist at Global Insight Canada.

However, in its 2008 budget the Conservative government did not set aside either of those reserves, and that might force it to take extraordinary actions to avoid a deficit. Mr. Orr thinks there will be likely be a budget deficit in the 2009-2010 fiscal year because the surplus forecast was so small – about $1.8-billion.

Everybody keeps talking about a recession, but when will we know if we’re really in one?

The classic definition of a recession is a period when the economy shrinks for two consecutive quarters. But that is considered very rough and imprecise by most economists.

By that measure we won’t know whether Canada or the United States is in recession now until well into next year. The third-quarter gross domestic product (GDP) numbers are due at the end of November, and the fourth-quarter stats will be out at the end of February. In the second quarter, both economies grew.

One of the problems with the simple definition of recession is that it doesn’t take into account swings in the economy. If GDP shrinks in one quarter by 2 per cent, rises in the next by 0.5 per cent, then shrinks in the third by another 2 per cent, then the country is not in recession under the definition, although it very likely is, in reality.

On the other hand, two consecutive 0.2-per-cent drops would mean we’re in recession, even if there was strong growth in earlier quarters. That’s not very realistic either.

GDP numbers can also be skewed by population growth, which can disguise a possible recession. And they are often revised months after the fact, so that what initially looked like a recession might not actually have been one.

“We’ve had situations in history where a recession has been revised away, two years later,” says Dale Orr, chief economist at Global Insight Canada.

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Source: The Globe and Mail – Canada

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