Mo' money, mo' problems?

Ever since Hurricane Katrina hit, forecasters have busied themselves marking down their economic growth forecasts for the United States. That might seem intuitive, but in fact natural disasters often end up giving a lift to the economy, as homes and infrastructure are rebuilt and policy-makers provide offsetting stimulus to activity. Both factors are clearly relevant here. The big difference with this storm, however, is the hit to the energy sector. The forced idling of Gulf Coast rigs and refineries, however brief in some cases, has compounded a tight energy-supply situation, sending prices surging from their already lofty levels. Amid more recent volatility, crude oil and natural gas prices are up a crushing 60% and 120%, respectively, from the beginning of the year. The U.S. economy is a big consumer and importer of energy; these higher prices will at best chip away at growth, or at worst be the straw that breaks the eagle's back.

The impact on Canada's economy is rather more complicated. The simplest view pegs higher energy prices as a positive for the economy. Canada runs a huge surplus on energy trade with other countries ($44 billion last year). A higher price for that energy is what economists call a (positive) terms-of-trade shock: the country gets more for what it sells than it pays for what it buys, representing a transfer of real income to Canadians. But there are three good reasons to believe that positive terms-of-trade shock is not in fact going to translate into higher real economic growth in Canada anytime soon.

First, the terms-of-trade view abstracts from the balance of winners and losers within the economy. In Canada's case, it is very much an imbalance. The benefits are to the few, such as oil-and-gas companies and the Alberta government, and those gains look. likely to be largely saved rather than spent. Energy companies already seem to be expanding as much as they usefully can in the near term, and the province of Alberta seems content to let surpluses build. Meantime, the costs are to the many, and the hit to spending there is likely to be virtually immediate. Firms for whom energy is a big cost will be more cautious; consumers who have to pay up at the pump will tend to curb other purchases; have-not provinces that are trying to limit deficits will tighten policy. For the economy as a whole, then, real incomes might well go up, but real spending--what matters for growth--probably won't follow.

Second, while the implications of higher energy prices for Canadian domestic demand are uncertain, the implications for foreign demand are not. Weaker U.S. growth means weaker demand for Canadian products of all stripes, curbing real exports.

Third, higher energy prices are lending new-found support to the value of the Canadian dollar. The rising share of energy in Canadian trade, along with enthusiasm over the Alberta tar sands' future prospects and accompanying strong energy-driven gains in the Canadian stock market, all seem to have tightened the historically tenuous link between the exchange rate and energy prices. That is sending the loonie back up to the 13-year highs it hit last year.

For Canadian manufacturers, this is a triple whammy-higher energy prices are raising costs, cutting foreign demand and making the exchange rate even less competitive. The 108,000 jobs lost in Canada's manufacturing sector over the past year are equivalent to about one-half of the entire workforce of the mining and oil-and-gas sectors.

In this magazine's Outlook edition last December, I talked about the need for Canada to take care not to fall victim to the "paradox of plenty"--an unfortunately common phenomenon through history, whereby newfound resource wealth ultimately makes a country worse off, in squeezing out more productive industries and in spurring people to fight over distributing wealth rather than to focus on creating it. That risk appears to be growing.

Make no mistake, having the energy has to be a much better problem than not having it. But unless the opportunity is carefully managed, politically as well as economically, a problem it will nonetheless be.

PHOTO (COLOR)

PHOTO (COLOR)

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By David Wolf, head of Canadian economics and chief strategist at Merrill Lynch Canada

David Wolf is head of Canadian economics and chief strategist at Merrill Lynch Canada.