By Charles St-Arnaud The Canadian economy has been facing significant economic challenges: housing unaffordability, stagnant purchasing power, stalled

gross domestic product (GDP) per capita and underperforming productivity. As a result, Canada is falling behind economically relative to many of its peers.

All these challenges point to an economy in need of a new compass. However, to put the right remedies in place, redirect the economy and avoid repeating past mistakes, it is crucial to understand what brought us here.

Canada’s current economic malaise can be traced back to having followed the wrong economic growth model.

Consumer spending has become a major, if not the main, source of economic growth in Canada over the past three decades, with household consumption being responsible for more than 75 per cent of growth between 2000 and the pandemic. As a result, the share of household consumption in GDP has risen to about 57 per cent of GDP, the highest on record, from about 50 per cent on average between the early 1960s and the late 1990s.

However, this surge in consumer spending was in large part supported by a sharp rise in household debt, with the average indebtedness level now at 177 per cent of disposable income, compared to about 110 per cent in 2001. As a result, Canadian households are the third-highest indebted amongst countries tracked by the Bank for International Settlements.

But there is clear evidence that increased household borrowing over the past 25 years has crowded out productive business investment, as massive government borrowing similarly did in the 1980s. As such, while Canadian spending on machinery, equipment and

intellectual property declined as a share of GDP over that period, spending on renovation and homeownership transfer costs increased by a similar magnitude to the point where Canadians were spending almost as much on buying-selling-renovating homes as on productive capital.

The result has been weak productive investment and a household sector that is basically too big to fail — a too-important source of growth and a source of vulnerability to shocks due to its high debt levels.

The situation arises because most policymakers have an economic model based on Keynesian views, which emphasizes short-term demand fluctuations as the main drivers of the economy. Moreover, Canadian policymakers have also been influenced by the widely held view amongst United States policymakers that, since consumption expenditures represent two-thirds of real GDP, modest changes in consumer spending can have a noticeable effect on economic activity, leading to policies that are often tilted in favour of household spending.

Weak productivity growth, stagnant purchasing power, unaffordability and stalled GDP per capita are all linked to each other. They are all evidence of cracks forming in this economic model and that households can no longer be the growth engine of the Canadian economy.

To consume more, households either need higher income or to borrow. However, growth in household disposable income per person has significantly slowed, with growth since 2015 well below the average growth between the mid-1990s and mid-2015.

Similarly, with households unable or unwilling to push their record indebtedness levels higher, slower income growth leads to weaker consumer spending growth. The stagnating purchasing power also leads to frustration and the sentiment of falling behind economically.

What the current demand-driven model has missed is that households need to receive higher incomes in order to consume more. However, higher incomes are the result of wage gains, which in turn are a direct result of improved productivity. Hence, the weak productivity growth in recent decades is holding back the demand side of the economy.

In other words, we are reaching a point where the supply side of the economy is what generates demand and growth, not the other way around.

This means the only way out from the current economic funk is by putting emphasis on policies to improve the supply side of the economy and income growth. This is why the Bank of Canada has sounded the alarm regarding productivity.

The latest federal budget proposed some positive developments, signalling a reorientation of the government’s focus toward improving the supply side of the economy, rather than mostly focusing on supporting the demand side.

Nevertheless, more will need to be done. Canada’s economic system needs to be reformed to put greater incentive on investment, whether it is physical capital, innovation or research and development, and more emphasis on improving competitiveness.

The financial system will also need to be reformed to ensure businesses have access to the capital needed for these investments. Financial regulations will need to be tweaked to encourage greater lending to the business sector to ensure it can access the financial resources required and avoid the sector being crowded out once again.

The tax system will also need reforms to encourage business investment. The budget announced steps in that direction with the so-called productivity super-deduction. However, more will need to be done to ensure the tax system supports investment.

Reforming the tax system does not necessarily mean simply cutting business taxes to the lowest level possible. It means taxing more efficiently and in ways that do not discourage investment or distort the economy. After all, Belgium, Denmark and Sweden are amongst the most productive countries in the

Organization of Economic Co-operation and Development ; all are small, open economies with relatively high taxes. Canada could learn a lot by studying their success.

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This new economic model will come with its challenges. Households will no longer be at the centre of the economy and will be required to make sacrifices to ensure Canada’s long-term prosperity in the form of subdued spending growth, deleveraging and increased saving. Their long-term reward will be faster income growth, increased purchasing power and improved affordability.

The crucial question is: are households ready for these sacrifices? And will they be patient enough to allow the economic reorientation to bear fruit?

Charles St-Arnaud is chief economist at Servus Credit Union.