Macleans.ca Interview: Don Drummond

TD Bank’s chief economist talks about deficits, the dollar and countries going broke


Don Drummond

Q: The Canadian dollar has swung wildly in a period of just a few months. Is it currently undervalued?

A: My perspective is that two things drive the Canadian dollar. One is the default value: on average, Canadian business is about 85 per cent as productive as U.S. business, so if nothing else happened, we should see a dollar averaging about 85 cents. The second big influence is where commodity prices are relative to their longer-term trend. We saw the dollar dip down to 62 cents when commodity prices crashed, and we saw it go to $1.10 when they soared. Commodity prices right now, despite the big pull back, are around their long-run trend value, so it’s not a shock to me to see the dollar hovering fairly close to that default value of 85. Now there’s a third phenomenon, and it seems a little perverse: the U.S. has been the catalyst of much of the worldwide economic problems, yet there has been a flight to safety in U.S. Treasuries, and that has bid up the U.S. dollar and bid down the Canadian dollar. I think that will wear away, and we will see the loonie trading in that 80- to 85-cent range for quite some time, though it could dip back down to the 70s if commodity prices pull back again.

Q: You recently predicted federal deficits, though the Prime Minister hasn’t owned up to that yet. What are you projecting?

A: I now anticipate a modest deficit for this current fiscal year, likely less than $2 billion. What’s troubling is that we think the deficit for the next fiscal year, which starts in April 2009, will be between $10 and $12 billion. We’re projecting the deficit will stay around $10 billion in 2010, and decline only narrowly in 2011 and 2012.

Q: Harper inherited a surplus when he took office. If the government does in fact start running deficits, how much of the blame will lie with its own policies over the past few years?

A: Certainly, they took $12 billion of revenues out of the GST [by cutting it by one per cent last year]. If they hadn’t done that, we wouldn’t have gone back into deficit. But I tend to look not at the revenue side but the spending side: we’ve had spending growth at the federal level of five to six per cent a year for the past several years, and they’re going to have to trim that to at most three to four per cent, and likely lower. Not necessarily right away or even for 2009, when the economy is at its weakest—I don’t think that’s advisable, it would just compound the weakness—but you basically have to take $10 billion out of spending. It’s very hard if you don’t take an axe to the major transfers, including old age security, employment insurance, transfers to the provinces, and I think there’ll be a great reluctance to do that.

Q: How do you rate Jim Flaherty as minister of finance?

A: I don’t want to be uncharitable, but you have to keep in mind that in his first two years, he was basically tasked with introducing the 30-odd fiscal and economic items that were in the 2006 election platform, which he wasn’t directly involved in creating. I still can’t really say what he stands for and what he wants to achieve, though there are some interesting glimpses. I am amazed by the tenacity with which he promotes the economic union, pushing for the single securities regulator, pushing for the elimination of interprovincial trade barriers and free mobility of labour. It’s tough, there’s a lot of resistance.

Q: You were at the federal Ministry of Finance for 23 years, before moving to TD Bank in 2000. Do you miss being in the middle of the action?

A: I don’t miss it in the sense that I wish I was there, but that doesn’t mean I didn’t love every single minute of it. There’s definitely a buzz from being there when the economy is turbulent, and I would be surprised if there weren’t people in the government who didn’t take some perverse . . . pleasure’s the wrong word, but interest in what’s going on. You don’t wish for anybody to lose their jobs or investments, but it is fascinating and there is an adrenalin rush; it taxes your analytical skills and your knowledge of history, looking back to see if there are parallels. It’s great when everything’s going smoothly, but more exciting when it’s not.

Q: On the U.S. side, how would you rate the performance of Ben Bernanke at the Federal Reserve and Treasury Secretary Henry Paulson during this crisis?

A: I think they’ve performed admirably given the deck of cards they were handed. There’s limited value in looking in the rear-view mirror, but you really have to look back to how this was allowed to occur. It’s not as though [the global credit crunch] is coming as a shock. We certainly missed the extent of it, but we had the story absolutely bang on. David Dodge said it was being talked about at international meetings as early as 2003, and yet, seemingly, nothing was done.

Q: How much responsibility do you think Alan Greenspan, chairman of the Federal Reserve for almost 20 years, has for this mess?

A: Ultimately, stabilization of an economy rests with the monetary authority, so I think you have to assign a fair bit of the blame to the Federal Reserve Board, which is the main regulator in the U.S. You sort of wonder, what were they doing with subprime?

Q: From an economic point of view, do you think it matters who wins the U.S. presidential election?

A: A pox on both their houses. I haven’t heard much that indicates either one has any inkling of the problems facing the United States. Particularly when you hear McCain talking about some tax cut, you go, “What’s that all about?” They used to have a structural deficit that was about six per cent of their gross domestic product, and I would argue that’s increased greatly [under the current administration]. So at some point, they have to take six per cent of GDP out of their spending, or raise taxes, or some combination of the two. I haven’t heard Obama or McCain indicate any plan to do that. I think either one of them is going to have to do the fairly common political trick of coming into office, rejecting virtually everything he said to get elected, and doing an about-face.

Q: Given the past few decades, how is it that Conservatives and Republicans still have a reputation for fiscal responsibility?

A: It’s a little surprising, be­­cause left-leaning governments have a better track record of cleaning up fiscal messes. Reagan came in with an almost-balanced budget and left with a huge deficit. Bill Clinton left a significant surplus, and look what we’ve got at the end of the Bush administration: pretty much a straight line down, though to be fair, economic circumstances played a role. If you think about Canadian economic history, the first province to get out of the deficit problem in the early 1990s was NDP-led Saskatchewan. And despite years of talking a great game, the Conservatives under Wilson and Mulroney and Mazankowski didn’t really accomplish much on the deficit. Yet the Liberals won in 1993 having a very modest objective for trimming the deficit and, four years later, produced a gigantic surplus.

Q: Let’s talk for a minute about the economic situation internationally. How does an entire country like Iceland find itself on the brink of economic collapse?

A: They became overextended. Their financial institutions had an enormous amount of questionable loans on their books, and questionable investments, and they cratered. I suspect Iceland will get a substantial amount of international assistance, and while they will be impoverished, they will survive. We have, unfortunately, this notion that the only problem in the world is the U.S subprime problem. First of all, even in the U.S., it’s not just subprime—there are all kinds of debt problems in other markets as well. Second, in some other countries, there’s been an even more severe housing cycle than in the U.S. Spain was at a point last year where one-third of all the workers in the country were in the construction sector, which is absolutely ridiculous, and it’s all collapsed. Third, countries like Germany—yes, they’re suffering because of the U.S. subprime problem they imported, but they also have every bit as much of this extreme leverage in their financial institutions as the U.S. So the U.S. is a common denominator in a lot of other countries’ problems, but a lot of them also have problems of their own making.

Q: Credit default markets are pricing the likelihood of a national default by Italy or Greece at nine per cent, and Ireland at just a little less. What does that mean, in plain English, and is a European default a real possibility?

A: If you look at the bonds a sovereign country would issue, and people around the world tend to buy them, there’s always some probability that they will not repay their principal. It’s a fairly low probability, but there have been cases: New Zealand, about 20 years ago, Argentina, a couple of different times, and in the early 1980s, a host of Latin American countries defaulted on their loans. So there’s always some probability, but one of the reasons it tends to be fairly low is that governments do have the ability to tax their citizens if they end up with these huge borrowing requirements they can’t sustain. While I think the whole economic union in Europe has been weakened, we do have to remember they have a larger entity, and I don’t think the European Union will allow any significant member to go under. Especially not Ireland. With the U.K. not joining the EU, you have to think they’d be very appreciative of the Irish, and very reluctant to see them go under. And in fact, I think the European economy in total will be more stable over this period than the U.S. economy.

Q: What should we watch for in the next six months?

A: There is going to be an instinctive reaction for everyone to make their regulations on the financial sector more severe. But what body and person will lead? It almost seems farcical that the first meeting, which is on Nov. 15, will be hosted by George Bush. It’s not a promising first step.

Q: Are there any instructive historical precedents for tightening regulations?

A: The one I’ve got my eye on was the response to Enron and the difficulties related to the lack of disclosure by publicly traded companies: Sarbanes-Oxley [the U.S. federal law enacted in 2002 in response to major corporate and accounting scandals], which I would argue has been a disaster. It obviously didn’t help avoid this crisis in the U.S. financial sector, and we’re finding out all kinds of things now that the disclosure rules didn’t produce. So what [the legislation] was really designed to address, it didn’t, yet it put an enormous cost on small- and medium-sized businesses, which had to double and triple their budgets for auditors and external evaluators simply to comply. And it has coerced a whole bunch of companies to go from publicly traded to private, so I would argue that the net result has been less rather than more disclosure. So there’s the history lesson. I’m not that confident that we’ll avoid repeating it.

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Macleans.ca Interview: Don Drummond

  1. [O]n average, Canadian business is about 85 per cent as productive as U.S. business, so if nothing else happened, we should see a dollar averaging about 85 cents.

    Thanks to the new format at Maclean’s I can now tell their readers (well, at least the ones who are reading the web version) directly that this is wrong. Yes, there is a case for thinking that a long-run equilibrium for the CAD-USD exchange rate is in the region of 0.85, but the ratio of productivity levels is most emphatically not why that should be the case. Happily, Drummond does not go on to explain why he thinks that the yen is undervalued by a factor of 100, so I’m prepared to believe that he doesn’t really think that.

    But no-one else should, either.

  2. I agree — it’s just a weird comment. I can’t imagine that he meant it the way it sounds.

  3. Couple of comments

    1) I wish budgetting at the federal level were as simple as portrayed…if they had the extra 12 billion then we wouldnt be going into deficit. True to an extent, but do you believe the federal government could hang on to the 12 billion without enormous pressure from any one of a number of pressure groups, including the provinces? Fiscal imbalance anyone?

    So while true on the surface I think the truth lay somewhere else, and it shows why you need majority governments to cust the spending side of the equation. Even in a majority, like Mulroney’s Drummond gives no credit, I assume he lived through the same years I did, and remembers the HOWLS I do from the opposition if Wilson came anywhere near a cut, which he did. Only when threatened with Argentina like status and a tax that peed money, the GST, and a compliant and divided opposition was the government able to politically cut spending. But Don is a little invested in the “Come Hell or High Water Years.” Getting the government books out of operational deficit was an acheivement, but I do ultimately agree they should have gone further, the question will always be could they. I do fear we are on our way into deficit again, but perhaps that is required for us to devlop the collective fortitude to limit spending again.

    2) His comments on the credit crisis are fascinating. Yes it was like watching an intersection during a bout of freezing rain. You can see there is a problem, you can even see a likely outcome as the vehicles slowly slide toward one another, adjusting direction and you hope they will either stop or avoid, you are never fully prepared for the cacophony when the vehicles actually hit. 2003, wow, cant say I heard of it that far back. but I definitely heard rumblings in 2006 and early 2007. Once again you just couldnt decide if it was isolated. The worldwide nature of it is the piece that is the surprise.

    3) Yes! someone else who detests Sarbannes and sees that there were numerous unintended consequences to this. Mark to market accounting in particular. It always struck me as unecessary. Disclosure was always a requirement, there was fraud that went on, perhaps disclosure on some of the off balance sheet items should have been there, but there is a school of thought that said they should have been there anyway due to them being material….as proven when the whole house of cards came down all these loans come out of the woods, which tautologically said they should have been deemed material in the first place….anyway, the spririt of the accounting rules was broken and clearly the letter often was as well. The dramatic tightening probably wasnt as required as the jail sentences, defrocked accountants and lost capital to the senior partners was.

    4) You ask him about the Fed, which he properly lambasts over the subprime side of things, but he doesnt address Europe, which supplied the majority of the funds for the subprime loans, or at least brokered them. The savings or funding for them may well have come from developing countries like China and others. The unanswered question from him is where were the European regulators? and what are the implications of allowing your economy to be financed with contract rates that are not under the control of the domestic government. Example, you have mythicala homebuyer in cleaveland buying a home with a Sub Prime mortgage and the contract listed uses a base rate of LIBOR. The US government has no effect whatsoever, as they are finding out, on LIBOR. Is there something to be said that non commercial loans for cars and homes should always be based on domestic interest rates even if the funding comes from abroad…..it forces others to the hedging, not the domestic government and not the simple borrower. I would be curious about Drummonds or others thoughts on that one.

    Good interview though.

  4. Sorry Mr. Drummond, but the UK did in fact join the EU, and long ago, it just did not adopt the Euro currency.

  5. I believe it was Einstein who first noted something to the effect that no problem can be solved from the same level of consciousness that created it. And so it is here – the problems we are facing today were created by banks and bankers, and here we have another banker completely oblivious, apparently, to the actual root of the problem. And you cannot solve any problem by avoiding acknowledging the root, as everyone is currently trying to do with this global financial mess. It all stems from one single massive evil root – we allow the great bulk of our money supply (~98% in Canada) to be created out of thin air by private banks, who expect, of course, to be paid interest on that money. And, of course, banks by their nature, and the investors who invest in them, want to max their ROI, leading to all other related problems, as those whose primary goal is wealth maximisation are not the most morally sound people in the morality drawer. All else follows. More detail here – BANKETEERING http://www.rudemacedon.ca/lgi/banketeering.html .

  6. Mr.. Drummond has the nerve to give credit to the Liberals for cleaning up the deficit without giving the real credit to the provinces upon whose backs the deficit was slain. The Liberals did not do it by reduced spending they accomplished it by trashing medicare and by making other massive reductions in payments to the provinces. Mr. Drummond is being very partial and dishonest, shame on him. It seems that he is still a shill for the Liberals, albeit a sophisticated one.

  7. Mr. Patterson comments that the great evil of the system is that “we allow the great bulk of our money supply (~98% in Canada) to be created out of thin air by private banks”.

    The structural problem with banks is that they use short term payables (our deposits) to finance long term receivables, with reserves being the only insurance that they’ll be able to meet those unpredictable short term obligations. Perhaps reserves should be higher?

    Canadian banks have been praised for being so conservative that they didn’t invest in a lot of speculative derivatives. But they are also so conservative that they don’t invest in real businesses. Many a start-up has had to go abroad to find financing.

  8. “I wish budgetting at the federal level were as simple as portrayed…if they had the extra 12 billion then we wouldnt be going into deficit. True to an extent, but do you believe the federal government could hang on to the 12 billion without enormous pressure from any one of a number of pressure groups, including the provinces? Fiscal imbalance anyone?”

    Easy. Plow the surplus over $3 billion into an infrastructure fund. People can’t scream about it being ‘wasted’ on debt repayment, and it deals with a huge infrastructure deficit in this country. I seem to recall a certain guy with a thick French accent proposing this during our past election.

    “I assume he lived through the same years I did, and remembers the HOWLS I do from the opposition if Wilson came anywhere near a cut, which he did.”

    This is why the Liberals have been the party of fiscal responsibility. When the Libs cut programs, the CPC can only be lukewarm in its opposition (unless it is military funding). The Conservatives here, and in many jurisdictions tend to be quite spendthrift.

    “I do fear we are on our way into deficit again, but perhaps that is required for us to devlop the collective fortitude to limit spending again.”

    So we need to run massive deficits once more in order to avoid deficits in the future? This is insane spin-doctoring. There is no indication whatsoever that the Liberals would have budgeted their way into deficit. The CPC has that on their hands, and theirs alone.

  9. A week earlier, Mr. Drummond was featured on TVO’s The Agenda, with a far more pessimistic attitude, declaring huge deficits and a massive downturn in the economy, especially Ontario. Did his opinion change that much in a few days?

    Earlier in the year, he remarked that the spike in crude prices was based on real world supply and demand, and not from the huge, half-trillion inflow of investment capital into the oil market, even though all evidence at the time, pointed to market speculation.

    Alan Greenspan is ultimately responsible? Does he even know what the federal reserve does?

    This does not bode well for TD Bank

  10. “Did his opinion change that much in a few days?”

    No, he is still very pessimistic. He is forecasting a deficit THIS year, and large deficits at least through 2012.

  11. On The Agenda, he was a little more pessimistic, forcasting a far larger federal deficit and provincial deficits ballooning. I agree with his more pessimistic forecast, but perhaps we are the ones mistaken when every other well-respected economist disagreed with his previous forecasts.

    Maybe oil was really driven by supply and demand.

    Maybe Greenspan, and not Congress and the SEC deregulatory rules, foreign influx of borrowing money, were the cause of the subprime crisis.

    Maybe Toronto residents and UofT PhD economists are incorrect and the federal budgets were not balanced because of offloading first onto provinces and than municipalities.

    And maybe the Chinese Yuan should be worth 2-3X more than the Canadian dollar because Chinese businesses are 200-300% more productive than Canadian businesses.

    Not saying he’s wrong on everything and agreement among economists is not always easy.

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