The Political Bases of Inflation in Postwar Canada

The Political Bases of Inflation in Postwar CanadaAuthor(s): Michael R. SmithSource: The Canadian Journal of Sociology / Cahiers canadiens de sociologie, Vol. 12, No. 4(Winter, 1987), pp. 363-392Published by: Canadian Journal of SociologyStable URL: http://www.jstor.org/stable/3340943 .

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The political bases of inflation in postwar Canada*

MichaelR. Smith

Abstract. Barber and McCallum have attempted to explain the relative macroeconomic performance of rich nations in terms of the presence or absence of a set of institutions which produce "social consensus." In this essay I argue the following: 1) the evidence Barber and McCallum cite does not support their account; 2) the critical factor in the macroeconomic performance of a number of small nations (including Canada) is close economic ties with one or another larger trading partner. These ties provide political and economic incentives for the government of the smaller nation to attempt to maintain a fairly stable currency exchange rate with the larger trading partner. This, in tur, tends to produce similar rates of inflation in both nations.

Resume. Barber et McCallum ont cherchde expliquer la performance macrodconomique relative des pays riches en fonction de l'existence ou de l'absence d'un ensemble d'institutions qui suscitent "l'assentiment general social." Dans le prisent essai,je soutiens que: 1) les preuves avancees par Barber et McCallum n'etayent pas leur analyse; 2) l'eldment essentiel de la performance macrodconomique de quantite de petits pays (dont le Canada) reside dans l'dtroitesse des liens economiques qui les unissent i un partenaire commercial plus important avec lequel les gouverements des pays plus petits ont tout intdret a maintenir un taux de change des devises relativement stable.

* SSHRC grant number 410-81-0754 provided support for the research reported here. I am indebted to Axel van den Berg and the anonymous reviewers of this journal for their helpful comments on earlier versions of this paper. Please address all correspondence and offprint requests to Professor Michael Smith, Department of Sociology, McGill University, Montreal, Quebec, H3A 2T7.

Canadian Journal of Sociology 12(4) 1987

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What is the explanation for the postwar record of inflation in Canada? Why did Canada's inflation performance relative to other countries deteriorate so markedly from the 1950s and 60s to the 1970s? How do we explain the specific pattern of inflation rates in Canada including both year to year variations and the general tendency for the rate to rise from generally well below 3 percent in the 1950s to often over 10 percent in the 1970s?

There is, of course, a set of more or less contradictory economic accounts. The content of these accounts which is specifically economic1 deals with the mechanisms whereby demand and supply changes in product, money, and labour markets end up causing more or less inflation and unemployment. They are arguments about the slopes of curves; over, for

example, how much labour costs vary with the demand for labour (Cornwall, 1981) or to what extent changes in the money supply change conditions in the "real," goods producing sector of the economy (Laidler, 1981; Hotson, 1976; Barber and McCallum, 1980; Chick, 1977). Then, given the closer or looser relations between price and quantity changes embodied in the relative steepness or flatness of the curves over which they dispute, economists have

argued over which government policies will work best to produce full employment and price stability.2 But in the face of policies which in Canada, as in most other countries, have

manifestly produced neither full employment3 nor price stability, even the most orthodox economists include within their more general treatments of the topic the conclusion that the postwar inflation ultimately has its origins in "sociological and political factors" (Laidler and Parkin, 1975: 781). If inflation has its origins in a wage push, that wage push has to be

explained and if inflation has its origins in government policy, the choice of policy has to be

explained. Such explanations cannot be found in the smooth, market clearing, mechanisms of the neoclassical theory which dominates contemporary economic thinking, or even in the less smooth mechanisms of Keynesian and post-Keynesian theory.

If the economic treatments of postwar Canadian inflation are not in themselves sufficient, do we have the satisfactory political theory necessary to complement them? In this paper I will, first, critically examine a political analysis of the relative inflation performance of different capitalist nations and, second, attempt to sketch out the elements of an adequate political account of the Canadian record. The political account which I will critically examine is contained in an excursus into political science by the economists Barber and McCallum (1982; cf. also McCallum 1983). This account is very similar to some recent analyses which have attempted to explain macroeconomic performance in terms of the presence or absence

1. Writings on inflation by economists often combine an account in terms of the standard economic properties of markets with a supplementary account in terms of a mdlange of factors which fall outside of the orthodox categories of economic theorizing. For example, economists' accounts of the postwar inflation are often couched in terms of govemment irresponsibility or rising expecta- tions or a tendency for unions to be aggressive. Each of these sources is normally unexplained. For a scathing discussion of this use of "residual categories" in economic accounts see Goldthorpe (1978). For an honourable exception see Green (1976) in which there is an attempt by an economist to begin to deal with the non-economic origins of recent inflation in a systematic fashion.

2. The classic example of such a debate is that between Friedman and Meiselman (1963) and Ando and Modigliani (1965).

3. The precise meaning of full employment over the postwar period remains a matter of controversy. The issue and the literature is usefully summarized in Hum (1981). However, that some substantial amount of current unemployment is involuntary by any definition is, I think, indisputable.

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of neocorporatist institutions (e.g. Schmidt, 1982; Crouch, 1985; Bruno and Sachs, 1985; Tarantelli, 1986; cf. also a number of essays in Goldthorpe, 1984). Consequently, both my critique of Barber and McCallum and the explanation of the postwar pattern of inflation in Canada which I propose as an alterative have some more general implications for these most recent products of the necorporatism "growth industry" (as Panitch, 1980, called it). In what follows I will, where appropriate, make clear what these implications are. Nonetheless, my specific concerns are Barber and McCallum's account and the alterative that I outline here. My treatment of the problems in the work of Crouch et al. is by no means complete.

The argument that I develop in this paper has the following elements. First, macroeconomic outcomes are to an important extent determined by the desire of governments to get re- elected. This may seem so obvious that it is scarcely worth mentioning. But this is not, as we will see, part of either Barber and McCallum's explanation of inflation or, to any substantial extent, of the other neocorporatist explanations. Specifically, I will argue that because of their concern with re-election politicians will not normally choose macroeconomic policies which promise uncertain and long-term benefits at the cost of short term and certain costs.

Second, interational economic relations have profound implications for the range of macroeconomic options available to the governments of small countries. To put the matter more concretely, the room for manoeuvre of the governments of Canada or, say, Austria, is considerably narrower than it is for the governments of the United States and West Germany.4 This also might seem obvious. Certainly the "world systems" and "dependency theory" writings of the last decade or so both assume and demonstrate this. But, again, the international dependencies between small and large countries are not part of Barber and McCallum's explanation or of those of most of the neocorporatists.5 Indeed, their method for testing their theory of inflation precludes a consideration of the effects of international dependencies. It assumes, incorrectly, that countries can be treated as independent cases.

Third, in outlining my theory of inflation in Canada I will devote some attention to the details of the economic mechanisms likely to be associated with one or another macroeconomic policy. Certainly, I will devote more attention to economic mechanisms than is typical in articles published in jourals of sociology. I do this because I believe that one of the principal weaknesses of the various attempts by sociologists and political scientists to account for inflation (e.g., Hibbs, 1975; 1977; Goldthorpe, 1978; Skidelsky, 1979; Castells, 1980; and some of the essays in Medley, 1982 and Lindberg and Maier, 1985) is, precisely, that they studiously avoid confronting the plausibility of the strictly economic mechanisms that their theories assume. But those assumptions are often at best dubious and, more probably, simply false. Take Hibbs' account, for instance. He argued that, consistent with the preferences of their respective constituencies, parties of the left opt for policies leading to a combination of high inflation and low unemployment and parties of the right for policies

4. One might view this paper as a specific exercise in the analysis of Canadian-American "binational subsystems" advocated in Redekop (1976), or as an attempt to specify a specific form that Canada's economic dependency on the U.S. takes (cf. Marchak, 1985: 682). See also Fox, Hero, and Nye (1976).

5. The single exception to this is the work of Katzenstein. But Katzenstein pays almost no attention to macroeconomic outcomes. In his writing he is overwhelmingly concerned with industrial policy. Some of his writings, however, suggest (without developing the point) the importance of small countries' economic fragility in the international economy as a determinant of their domestic policies (e.g. Katzenstein, 1985: 235).

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leading to a combination of low inflation and high unemployment This account explicitly assumes the existence of a long run Phillips curve - that is, a long run trade off between

unemployment and inflation (1975: 4-10). But the notion of a long run Phillips curve is

theoretically controversial6 and the best evidence for Canada indicates a long run Phillips curve of such steepness that a reduction in unemployment would require an increase in inflation of such magnitude that it would be undesirable from just about any political perspective (Auld et al., 1979: 218-23, 226-7).

There is, obviously, not space to go into the assumptions of all the theories of inflation cited above. The general point is, however, that if you wish to say something about an outcome like inflation, which assumes some specific economic processes, it is better to be explicit about the economic processes being assumed. Thus, in what follows I will argue that if one of their central concerns is to try to win re-election governments are unlikely to choose macroeconomic policies which provide uncertain or distant advantages as opposed to

probable and immediate costs to the bulk of the electorate. Economic policies which policy makers have grounds for thinking will make almost everybody worse off (at least in the short and medium run) are likely to be systematically avoided. Clearly, macroeconomic policies that depend on the electoral calculations of governments are politically determined. But to the extent that those calculations depend upon estimates of the economic effects of alternative policies, they can only be understood if we pay some attention to what it is reasonable for them to think those effects are likely to be.

The rest of the paper will serve to flesh out these schematic introductory remarks.

Barber and McCallum's political account of inflation Barber and McCallum's theory is particularly concerned with inflation after the commodity price increases at the beginning of the 1970s. The surge in the price of oil and other primary materials that took place during that time slowed down the rate of growth in real incomes in industrial countries. Workers in these countries had to be persuaded to slow down their income claims commensurately. Where workers could not be persuaded to do this, the

commodity price shocks resulted in inflation or unemployment or both. It was possible to persuade workers to slow down their income claims where there was an institutional basis for "social consensus." The most important institutional path to "social consensus," according to Barber and McCallum, lies through the election of social democratic governments. Such govemments tend to act to reduce income inequality, to maintain full employment, and to intervene actively in the economy to shield people from the risks of the market. All of these, presumably, make workers less suspicious and resentful and more disposed to negotiate declining real income growth rates. Most importantly, social democratic governments tend to establish elaborate, centralized systems of wage negotiation which provide the institutional context within which economically feasible rates of income growth can be negotiated. They provide, in other words, either an incomes policy or institutional arrangements which have a similar outcome. Social democratic governments, however, are not the only path to "social consensus." Where through policies providing secure employment employers have

developed relations of trust with their workers, declining rates of growth in real income can be negotiated without government involvement The obvious case here, of course, is Japan.

6. Contrast, for example, Friedman (1975) with Tobin (1972).

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Note that this account does not deny that, prior to the commodity price shocks of the 1970s, social democratic governments might have been associated with somewhat higher rates of inflation. Barber and McCallum concede that under routine economic circumstances SDP's may tend to adopt policies (full employment and welfare state expenditures) that produce somewhat higher inflation (p. 7). But they argue that where an economy receives shocks (and on p. 90 they assert that such shocks are likely to become more frequent), social democratic governments are well equipped to produce lower levels of both unemployment and iflation.7

Theargumentcritically considered There are two tests of Barber and McCallum's theory. The first, in their 1982 publication, correlates the increase in the average rate of inflation from 1971-72 to 1973-79 with man days lost per thousand non-agricultural workers from 1950-69. The relationship is strongly positive. Rates of inflation in the high industrial conflict countries increased the most. In the second test (McCallum, 1983) the average rate of inflation from 1973-79 is regressed on a number of economic variables, the industrial conflict variable and an "institutional variable." This latter is an index constructed on the basis of a set of classification decisions found in an early draft of Crouch (1985).8

In that draft Crouch classified countries in terms of a set of "corporatism" indicators: according to whether or not they had a centralized union movement, low shop floor autonomy, coordination amongst employers, and works councils. The more of each of these traits is present, the more neocorporatist the country's industrial relations system in Crouch's treatment and the higher the score on McCallum's "institutional variable." In this test industrial conflict is, again, positively related to growth in inflation and in one equation the "institutional variable" is negatively related to it.

The logic of these tests is as follows. In Barber and McCallum's 1982 publication the industrial conflict measure is an indicator of "social consensus." It is assumed, in other words, that it is lowest in those countries with some combination of 1) low inequality, 2) low unemployment, 3) big government (itself an indicator of government regulation of market forces) and 4) centralized wage bargaining. In McCallum's 1983 publication it serves the same purpose except insofar as the "institutional variable" derived from Crouch directly tests the effect of centralized bargaining and works councils. The causal model that is assumed to underlie the association between industrial conflict and inflation in the 1982 paper, then, is one in which inequality, average unemployment levels, size of government, and degree of centralization of bargaining determine both the level of industrial conflict and change in the rate of inflation. In the 1983 analysis, the same model applies except that, as noted above, there is a direct measure of centralization of bargaining and/or works councils added.

7. Note that in this respect their account contradicts that of Hibbs. Govemments, for Hibbs, are forced to choose between unemployment and inflation. In Barber and McCallum's account, depending on the policies they choose they can have any combination of these macroeconomic outcomes. It is worth pointing out here that as well as resting on dubious economic assumptions, the correlations Hibbs presents in support of his theory depend upon a very "judicious" selection of cases and time periods included in the analysis (Payne, 1979).

8. The detailed classification has, in fact, been published in Bruno and Sachs (1985: 226).

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Now, whether or not their results support their interpretation depends, first, upon the extent to which scores on the industrial conflict measure are associated with the degree of inequality, the general level of unemployment, the size of government and, in the 1982 publication, the degree of centralization of bargaining - that is to say, whether or not it really does serve as an indicator for these variables. McCallum's 1983 version requires, in addition, that the index derived from Crouch's paper is valid. There is an immediate problem with the index derived from Crouch's paper. The published version of the early draft of Crouch's paper cited by McCallum drops the detailed classification according to each of the four criteria (union movement centralization, etc.) and substitutes a simple dichotomization of countries into neocorporatist and liberal categories. Crouch seems not to have been confident enough of the more detailed judgements to publish them. However, the dichotomization is clearly based on the (unpublished) detailed classification and allocates Austria, Denmark, Finland, the Netherlands, Norway, Switzerland and West Germany to the neocorporatist category and Australia, Belgium, Canada, France, Ireland, Italy, Japan, New Zealand, the U.K. and the U.S. to the liberal category.

Are these valid classification decisions? Is it reasonable to regard the scores on industrial conflict as an indicator of the degree of inequality, level of unemployment, and size of government? A careful consideration of some of the cases suggests that neither of these things is clearly true. I will not show this by going exhaustively through the eighteen cases in their study. I will simply take the extremes since, ultimately, the correlation that they report depends on the countries that combine high inflation with low "consensus" and low inflation with high "consensus."

Italy constitutes one such extreme. It has very high rates of industrial conflict and its rate of inflation increased dramatically during the 1970s. The same is to a lesser extent true of Ireland. We do not have reliable data on inequality for either of those countries (Sawyer, 1976: 3-36). Consistent with Barber and McCallum's argument, neither country has effectively centralized bargaining institutions but each has quite high unemployment Yet both countries have large goverments (and in the case of Italy a government which directly runs a large part of industry) and that fact is not consistent with Barber and McCallum's argument How well either country fits their analysis depends on how heavily you weight size of government versus presence or absence of centrli7ed bargaining institutions and relatively high unemployment and Barber and McCallum give us no clue to that9

Still, they do stress centrali7ed bargaining and so Italy and Ireland are, at worst, somewhat ambiguous with respect to their argument. But the case of the U.K. is flatly contradictory. Here is a country whose economic performance has been generally wretched throughout the postwar period. It is also a country in which there has been a series of examples of incomes policies, some of which have been bargained and some of which have been centrally imposed (Clegg, 1971; Tarling and Wilkinson, 1977; Davies, 1983). By any measure its degree of inequality is considerably lower than Germany's (and Germany is, of course, one of Barber and McCallum's high performers and one of Crouch's "neocorporatis't countries: cf. Sawyer, 1976: 17). It has an elaborate welfare state including a wide range of income support

9. On the organization of labour relations in Italy see Brandini (1975: 82-117) and Flanagan, Soskice, and Ulman (1983: 496-566). On the relative role of government enterprise in Italy see Veron and Aharoni (1981). On industrial relations in Ireland see Meenan (1970: 328) and Mulvey and Trevith- ick(1972: 204-32).

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measures (Beckerman, 1982). And, finally, up untl 1980, the legal position of organized labour had been considerably strengthened over the postwar period (Meade, 1982: 58-84; Lewis, 1983; Hepple, 1983). The U.K. has one of the worst postwar economic records notwithstanding the fact that successive govenments established a wide range of precisely the kinds of institutions which, according to Barber and McCallum, were supposed to insulate the economy from the effects of the price shocks of 1971-72. Indeed, in his classification of countries according to their degree of corporatism, Lehmbruch (1982) puts the U.K and West Germany in the same "medium" corporatist category.

Now consider some of the superior economic performers. Switzerland is the extreme at the other end of Barber and McCallum's least squares line with negligible industrial conflict and a superb inflation performan and is neocorporatist in Crouch's classification. There are no adequate income distribution data for Switzerland. But we do know that it has a small goverment (Barber and McCallum, 1982: 10). Only about 30 percent of its labour force is unionized (the exact percentage depending on the numbers of foreign workers in the country). In general, the labour movement is weak. The unions "join Switzerland's business commu- nity in actively opposing any form of incomes policy that would disrupt free collective bargaining" (Katzenstein, 1984: 146; cf. also pp. 134, 144ff. and Katzenstein, 1980: 67ff.). This is not to say that organized interest groups are incapable of influencing and bargaining over the policies of the Swiss federal govenment Katzenstein's work can be seen as an elaborate attempt to show how such influences operate. But the result is absolutely not a polity in which labour and capital bargain centrally to maintain shares in a growing national income-as the neocrporatist account tends to argue. Nor is it one in which, by international standards, the government is active in protecting individuals from the costs imposed upon them by changes in market conditions. When Switzerland's textile and watchmaking industries lost their inteational markets the government assistance provided was minimal; to all intents and purposes the industries were allowed to collapse (Katzenstein, 1984: 245). Switzerland may have some sort of "social consensus." But if it does it is certainly not founded upon the institutions that are outlined in Barber and McCallum.1 I will return to what those institutions might be shortly. But now consider the case of Germany.

The level of income inequality in Germany is high by any measure (Sawyer, 1976: 19).1 On the other hand, it has had a low rate of unemployment and a rather large government The net effect of these factors, then, is not clear. What about centralized bargaining which McCallum (using Crouch's neocorporatism classification) treats as a critical institutional characteristic (three of the four components of McCallum's "institutional variable" are indicators of centrli?mtion of bargaining)? Note, first, that other corporatism classifications

10. Barber and McCallum (1982) claim that Swiss employers, like some Japanese employers, give lifetime employment. But they provide no evidence whatsoever for this claim. Crouch classifies Switzerland as neocorporatist because "industrial relations are heavily dominated by a social peace agreement in the metal industry and similar arrangements in other major industries" (p. 116). But this classificatory decision neglects all the other relevant characteristics of the Swiss economy that I have outlined here (limits on central government spending powers, an autonomous central bank, "guest workers') which establish the context for "social peace" agreements in one or another industry.

11. Sawyer is also Barber and McCallum's source but I can find no table in Sawyer's paper that produces the same figures for income inequality as those presented in Barber and McCallum (1982: 10).

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have located West Germany quite differently. Among the fifteen countries for which Schmitter (1981) gives a corporatism rank, West Germany is in the lower half and in Lehmbruch's (1982) classification it is bracketed with the U.K. as "medium corporatist." There is, however, consensus that the West German employers act in a generally centralized and coordinated fashion (e.g., Tylecote, 1981: 32ff.) although the coordination is not absolute. In Germany, as everywhere else, whatever central power employer federations may have had has not prevented local owners from granting above settlement wage increases when they seemed necessary to preserve labour peace (Flanagan, Soskice, and Ullman, 1983: 259). Furthermore, although when the Social Democrats came to office in 1967 German union leaders did enter into long term agreements with the employers' federation (of which Barber and McCallum, 1982: 55-6 make a great deal), they failed to cary their members. As in other countries where comparable agreements were negotiated, the result was wildcat strikes and settlements outside of the negotiated agreements (Mueller-Jentsch and Sperling, 1978: 261-4; cf. also Sachs, 1979). Here, then, is a high performer which has neither effectively centralized bargaining over income shares nor a relatively equal distribution of income. My own view is that the conclusion of Flanagan, Soskice, and Ulman that "the

importance of concerted action as an institution can be exaggerated, although it has been a distinctive and highly visible characteristic of German incomes policy much admired by foreigners in search of importable solutions" (1983: 285) is both more considered and accurate than the rather casual classification decisions of Crouch and, derivatively, Barber and McCallum.

The ineffectiveness of centralized bargaining in the German case is not the only reason why the stress on "concerted action" is inappropriate. The more important reason is that in Germany - and also in Switzerland - there are other critical factors in the determination of macroeconomic performance which need stressing. One of these is the role of "guest workers" in maintaining full employment and wage stability (Thurrow, 1981: 43-4; Piore, 1979; Flanagan, Soskice, and Ullman, 1983: 217-9; Katzenstein, 1984: 103-7). Another is a set of labour laws which considerably weaken union bargaining power. In Germany, participating in an unofficial strike loses a worker a variety of state benefits including health insurance (Tylecote, 1981: 93; cf. also Flanagan, Soskice, and Ullman, 1983: 231ff.). Probably most important of all, however, is that both Germany and Switzerland have endowed themselves with central banks which seem to be substantially autonomous from political authorities (Banaian, Laney, and Willett, 1983). Thus, the German central bank refused to accede to expansionary policies which were urged upon it by the SDP in the early 1970s (Wooley, 1978: 434). Quite apart from its constitutional autonomy, the need for the Swiss central bank to finance government initiatives in an inflationary way is obviated by the strong constitutional limits placed on Swiss federal government spending initiatives (Aubert, 1979).

Now it should be clear that "guest workers," rather stringent labour laws, and autonomous central banks are not factors which are related to the mechanisms described by Barber and McCallum (or Crouch) but they are clearly conducive to low inflation and, perhaps, to good economic performance in general. The review of the evidence suggests that, at best, the

classificatory decisions of Barber and McCallum and of Crouch are debatable. And that is sufficient for my argument I think, however, that the point can be made more forcefully; some of their classification decisions border on the absurd.12

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Consider, finally, some of the other countries in Barber and McCallum's sample, which have particular relevance to the argument to be developed in this paper. A number of them are relatively small countries contiguous with larger countries into which their economies are closely integrated. This is clearly true of Canada with respect to the U.S. and of New Zealand with respect to Australia. In addition, Austria, Switzerland, Belgium, and the Netherlands are all contiguous with Germany and, as we will see, trade heavily with that country. Can these relatively small countries be treated as independent cases? Barber and McCallum's interpretation assumes that they can. So, for that matter, do the other neocorporatist analyses. All of the analyses within this genre assume that the governments of these small countries have the option of improving macroeconomic performance by redistributing income, making employment secure, providing welfare services and either constructing centralized bargaining institutions or a statutory incomes policy. Suppose, however, that the governments of these relatively small countries cannot run markedly divergent macroeconomic policies with any clearcut benefit. Suppose that all a government can be corfdent of doing is varying the rate of inflation, without any certainty of beneficial effects and with the possibility of pernicious effects on the level of unemployment. If this is true, and in the next section I will argue in some detail that governments have good grounds for believing that it is, it would mean that Canada's rate of inflation is largely determined by that of the U.S. and Austria's rate of inflation, for example, by that of Germany. That would mean, in turn, that in the calculation of the correlation coefficient that provides evidence for the argument of Barber and McCallum, the U.S. is being counted twice and Germany between twice and five times, depending on the degree of economic integration of its small contiguous trading partners.

Small country dependency and macroeconomic performance To what extent can Canadian governments run a macroeconomic policy autonomous from that being run in the U.S.? Under a fixed exchange rate regime there is very little room to do so. If under a fixed exchange rate regime the U.S. government were to provide an inflationary stimulus to aggregate demand and Canada attempted to avoid a parallel increase in inflation through restrictive fiscal and monetary policies, other things being equal, the Canadian dollar would tend to appreciate relative to the U.S. dollar. It would do this principally because restrictive fiscal and monetary policies tend to raise interest rates. Higher interest rates would attract American funds into Canada and, in doing so, bid up the value of the Canadian currency. If the U.S. deflated and Canada tried to maintain a policy of greater stimulus, the reverse would occur. But if the government is committed to a fixed exchange rate regime it cannot allow either thing to happen and must adjust its fiscal and monetary policy to keep the

12. Barber and McCallum's treatment of other countries is not convincing. For example, their stress on employment security in Japan neglects the fact that such conditions of work only apply to a portion of the labour force (cf. Dore, 1973: 305). In addition, one well qualified observer of the macroeconomic response in Japan to the oil price shock of the early 1970s has argued that inflation was brought down by stringent monetary restraint. See Nakamura (1981: 229-30). Note that Japan is one case in which a fairly high social consensus country according to Barber and McCallum's industrial conflict measure falls into Crouch's "liberal" industrial relations system category. For the most part, the industrial conflict scores coincide with the "corporatism" scores from Crouch's draft paper. The correlation between the two indicators is, in fact, .76.

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Canadian dollar within the agreed upon ranges. Canada had fixed exchange rates with the U.S. from 1962 to 1970 and imported inflation from the Vietnam war stimulated U.S.

economy. The degree of integration of the Canadian economy with that of the U.S. during the period of fixed exchange rates is well captured by Dunn (1978: 34-5). "When Canada had a fixed parity in 1962-70, it was known as the 'Thirteenth Federal Reserve District' in some circles in the United States.""3 That the macroeconomic perfomance of Canada during this

period is principally explained by the macroeconomic performance of the U.S. is indisputable.14

Starting in 1971 the world currency order underwent fundamental changes (Block, 1977; Williamson, 1977) and the Canadian dollar exchange rate became flexible. Did this free the Canadian economy from American business cycles? Certainly there has been a substantial tradition of economic writing in Canada that advocates flexible exchange rates on precisely this ground. With flexible exchange rates, it is argued, Canada could insulate itself from a deflation originating in the United States; Canada could stimulate its economy and would not be constrained in doing so by the need to protect the par value of the two currencies. Or, it could resist inflation originating in the U.S. and simply allow the Canadian dollar to

appreciate (Dunn, 1978: 105-6; Dunn, 1971; Wonnacott, 1965). To the extent that this is a correct analysis, part of the explanation for variations in the rate of inflation in Canada would lie in the reasons why Canada switched to fixed rates in 1962. But, in fact, things are a little more complicated than this. An experienced observer and participant in the conduct of Canadian monetary diplomacy has written that "Canadian financial policy is not and can never be independent of financial conditions and financial policies abroad, particularly those in the United States" and 'The freedom that flows from a floating exchange rate can be and often is exaggerated" (Plumtre, 1977: 226). In fact Dunn, a strong advocate of flexible

exchange rates, has conceded as much (Dunn, 1978: 108-11).15 Why?

13. The constraints on Canadian macroeconomic policy imposed by a commitment to fixed exchange rates were reinforced by the "reserve ceiling agreement" with the U.S. which was in effect from July 1963 to December 1968. In exchange for exemption from a variety of American laws restricting capital exports from the U.S., the Canadian government agreed to maintain its official foreign exchange reserves below various agreed upon levels. This imposed a still tighter limit on the discretion of Canadian governments with respect to interest rate policy in that Canadian interest rates had to be kept below a level that would attract more capital from New York than was necessary to meet the current account deficit (Dunn, 1971: 31). Nonetheless, Dunn concludes that this

agreement only constituted a supplementary hindrance on policy and that "the main restraint on an

independent Canadian monetary policy remained the simple logic of a fixed exchange rate system" (p. 41).

14. Clearly, the argument that I am making here assumes substantial asymmetry in the relationship between the U.S. and Canada with the former's policy decisions having a substantial effect on the latter rather than vice versa. I take it that this is not a controversial assumption. For a general discussion of the distinctive position of the U.S. in the world monetary system see Flemming (1976: 38-9).

15. At this point it is worth stressing that these arguments with respect to constraints on Canadian

autonomy only apply to macroeconomic policy. Clearly, the Canadian government has been able to generate a health care system and balance of public and private enterprise which is quite different from that in the U.S.

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Suppose that the American economy were to contract and the Canadian government decided to take counteeasures in order to protect employment. he relatively higher economic stimulus in Canada would reduce Canadian interest rates, investment funds would flow to the U.S., and the value of the Canadian dollar would fall. What would be the effect of this on economic activity in Canada (cf. Laidler, 1981: 184-5)? Prices paid by producers for imported goods would rise and that would reduce profitability. he prices of a range of imported consumer goods would rise and that would stimulate a round of wage claims also tending to reduce profitability (Purvis, 1979). As money flowed out of the country, attracted by higher American interest rates and in payment for higher priced foreign goods, domestic demand would fall. Declining profitability and demand all act to reduce the economic activity that the initial stimulus was designed to secure.

The mechanisms described above would occur in any country which stimulates its economy and depreciates its currency. Yet it is possible to envisage some circumstances in which there might be some employment benefits from such a policy. For a declining exchange rate will both boost exports and encourage a shift in consumption to domestically produced goods, including import substitutes. The net effect on economic activity of a depreciation, then, depends on the relative magnitude of all of the effects listed above (the slopes of the curves that I mentioned at the beginning of this paper). The point is that there are good grounds for anticipating that, in the case of Canada, the net effects would not be positive. This is because Canada is a relatively small country with capital and product markets extremely closely integrated with those of the U.S. and with wages which, controlling for variations in the demand for labour, tend to be quite responsive to variations in the cost of living (Auld et al., 1979: 66-74; Riddel, 1983; Bond, 1983).6 Because the Canadian capital market is so closely integrated into that of the U.S., the interest and exchange rate adjustments to policy differentials are almost instantaneous. Because the Canadian economy is relatively small, Canada does not have the range of industries or the industrial capacity that would allow extensive import substitution from domestic production. Because changes in the cost of living have an independent effect upon Canadian wages (net of the level of demand for labour), costs of production for businessmen rise rather promptly as wages are renegotiated to compensate for the rise in the cost of living brought about by the depreciation of the Canadian dollar. These factors particular to relatively small countries like Canada have to be added to the general tendency for stimulative economic policies in one country to be offset by both rising imported component and raw material prices and the flight of capital towards the higher interest rates available in countries pursuing less stimulative policies. The lesson of all this is that if the Canadian government chooses to run a relatively stimulative policy in an attempt to insulate itself from recessionary tendencies in the U.S., it is likely to end up with more inflation but no certain improvement in employment.

Now, any change in the exchange rate is likely to be economically disruptive. Rising import prices as a result of a declining exchange rate will damage industries depending on

16. That Canada is somewhat extreme in the integration of its capital market into that of another country is suggested by the evidence on European capital immobility in Kopits (1982). It is worth noting that Canada is not as dependent on foreign trade as the smaller European countries. On this see Salant (1977). What is distinctive about Canada's foreign trade is its dependence on a single trading partner - namely, the U.S.

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imported components and will disrupt wage negotiations. A rising exchange rate as a result of an attempt by a Canadian government to insulate itself from inflation originating in the U.S. will also be disruptive. As the value of the Canadian dollar rises relative to the American dollar, exports will be priced out of American markets and people will lose their jobs. In the long run, in an ideal neoclassical world, the distribution of production would simply rearrange itself so that all resources are fully utilized. But the inertias built into the real Canadian economy mean that jobs and production will be lost as the economy adapts itself (Laidler, 1981: 186).17

Consider the problem from the point of view of a Canadian government interested in getting re-elected. Under a flexible exchange rate regime it has the option of attempting to insulate itself from the American business cycle by allowing the exchange rate to vary. But the pay-off from doing so is highly uncertain. In general (I will discuss exceptions in the next section), running a more stimulative policy cannot be counted on to yield higher employment levels. Running a less stimulative policy will disrupt export industries. Any economic benefits, in other words, are at best uncertain. But, not only is there the problem of uncertain economic benefits, in addition, there are other risks in such a policy. Frst of all, there are good grounds for thinking that a depreciating dollar is politically unpopular in its own right; certainly, there is evidence of politicians considering it to be so (Stursberg, 1975: 251-64). Second, the effects of exchange rate fluctuations tend to be region specific. An appreciating currency would damage all primary product exporting parts of the country but particularly the West. A currency depreciation would harm finms producing for the Canadian market but relying on imported components, largely concentrated in central Canada (Dunn, 1978: 108). All Canadian goverments have to be regionally sensitive and government initiated shifts in the exchange rate in one direction or another are likely to lead to serious political difficulties.'8

Laidler has said that "The only degree of freedom that domestic policy makers get from adopting a flexible exchange rate is the ability to choose the long-run value of the domestic inflation rate" (Laidler, 1981: 184). I have argued that, at best, any advantages from a flexible exchange rate only accrue in the medium and the long term whereas the disadvantages are immediate. Furthermore, that there are any advantages at all is quite uncertain, as Laidler's remark makes clear. Allowing the exchange rate to vary brings political costs too. It is the uncertainty of the benefits and the certainty of the costs of an autonomous policy that accounts for the close association between Canadian and American rates of inflation. This means, in turn, that Canada's rate of inflation after 1971 is substantially accounted for by the rate of inflation in the U.S. rather than the absence of a social democratic government, as Barber and McCallum would have it. The further implication of this is that in examining Canada's

17. If one accepts the lessons of Keynesian theory, moreover, there is no guarantee that the economy will naturally return to full employment.

18. It might be argued that the fact that past Liberal goverments have adopted policies which left them, until September 1984, bereft of representation west of Winnipeg indicates indifference to the question of regional support But I do not believe that is so. At the least it can be argued that ignoring the interests of a large region constitutes a high risk electoral strategy. And there is an abundance of evidence of concern with regional representation starting with the choices of ridings in which to run in the last election by the current leaders of the Progressive Conservative and Liberal parties- but by no means ending there

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inflation rate, the shift from floating to fixed rates of exchange and vice versa is not a central event. Even under flexible rates, the Canadian currency tends to be aligned with that of the U.S.

It is true that an incomes policy of the sort advocated by Barber and McCallum might reduce some of the wage effects of a currency depreciation.9 But the damage to industry using imported components would remain as would the limited advantages from the production of domestic substitutes. Were a New Democratic Party government to come to office its resolve to stimulate employment at all costs would only last, I submit, as long as the first currency exchange crisis. Its resolve would certainly not last longer than did that of the recent socialist government of the much larger country, France.20

All this is not, of course, to argue that the exchange rate of Canadian into American dollars has remained unchanged throughout the postwar period. In fact, since the Korean War, there have been four major periods of adjustment. I will briefly examine what lay behind these adjustments in the next section. The important point here is that these exchange rate adjustments have usually not been part of regular and routine countercyclical policy by the Canadian govemment. In fact, that there have been only four such adjustments suggests strongly that the Canadian government has been acting rather as it might when subject to a fixed exchange rate regime. That is, it has approximately maintained some par value of the Canadian dollar and then, when circumstances made it inevitable, allowed a major adjustment.

My argument is, then, the following: Because whatever advantages might be attached to allowing the Canadian dollar to float with respect to the American dollar are uncertain and long term while the costs are immediate and certain, Canadian governments are normally likely to opt for a policy of exchange rate stability; maintining a stable exchange rate means maintaining a rate of inflation that is approximately aligned with that of the U.S. Furthermore, I would extend this argument to other small countries which trade heavily with a neighbouring large country, including the small country superior macroeconomic performers located at the other end of Barber and McCallum's least squares line from Canada and the U.S. This macroeconomic alignment of small countries with larger trading partners is illustrated in the next four tables.

Table 1 gives a sort of "league table" of national rates of inflation for the eighteen countries in Barber and McCallum's sample for selected postwar periods. Germany and its four small neighbours cluster in the upper part of the table for each period. Canada and the U.S., on the other hand, are located among the superior performers for the first two periods but move down below all five of them (and Japan) for the last period. This table simply shows how the inflation performance of these smaller countries tends to be aligned with that of their larger trading partner.

19. The AIB experiment in Canada does seem to have been quite successful in restraining wage growth and the growth of those prices to which its regulations applied. See Wilton (1984). But this is not typical of the record of incomes policies and I do not believe that success can be routinely counted upon. Cf. Brittan and Lilley (1977) and Lipsey and Parkin (1970).

20. The exchange rate depreciation induced retreat of the French goverment from its relatively inflationary and expansionary policies is chronicled at length in articles in Le Monde. See, for example, Duhamel (1984: 1)

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Table 1. National rankings of average annual rates of inflation for selected periods (rates in parentheses).

1953-60 1961-72 1973-82 Switzerland (0.86) Canada (2.88) Switzerland (4.88) Germany (1.14) U.S.A. (2.94) Germany (5.21) Canada (1.16) Australia (3.05) Austria (6.47) Belgium (1.18) Germany (3.14) Netherlands (7.06) Austria (1.21) Belgium (3.32) Belgium (8.08) U.S.A. (1.37) Switzerland (3.89) U.S.A. (8.53) Denmark (2.00) Austria (3.91) Japan (8.86) Italy (2.16) Italy (4.14) Canada (9.57) Japan (2.38) France (4.32) Norway (9.63)

Median Norway (2.61) Sweden (4.50) Sweden (10.01) Netherlands (2.72) New Zealand (4.50) Denmark (10.91) Ireland (2.80) Netherlands (4.63) France (11.03) U.K. (2.82) U.K. (4.77) Australia (11.30) Australia (3.00) Norway (4.89) Finland (12.06) Sweden (3.07) Finland (5.32) U.K. (14.08) New Zealand (3.44) Ireland (5.43) New Zealand (14.09) France (3.73) Japan (5.76) Ireland (16.21) Finland (4.06) Denmark (5.97) Italy (16.63)

Sources: 1953-59, Maddison (1982); 1960-82, OECD Economic Outlook.

Table 2 gives the intercorrelations between annual rates of inflation from 1953 to 1982. It shows that Canada's rate of inflation is closely correlated with the U.S.'s while the rates of Austria, the Netherlands, Switzerland, and Belgium, are closely correlated with Germany's. Countries can have rates of inflation which are closely correlated over time but are at quite different levels. (The correlation between a series of numbers and any positive linear transformation of that series - say a doubling - is, of course, 1.0.) This is the case for Denmark, where the rate of inflation is more closely correlated with Germany's than is that of the Netherlands while the level of inflation over the last decade has been about twice that of Germany. The case of Denmark is particularly interesting since it is a small country contiguous with Germany which has been, as Table 1 shows, a poor inflation performer over the last twenty years. I return to this case shortly.

A country cannot normally inflate at a higher rate than a trading partner and maintain a constant rate of exchange. Table 3 gives the coefficients of variation with respect to the German mark and the American dollar of each of the countries in the sample. The lower the coefficient, the more closely tied the currency. The figures on coefficients of variation with

respect to the American dollar demonstrate the close exchange rate tie between Canada and the U.S. The figures on coefficients of variation with respect to the German mark show how closely tied to the mark have been the currencies of Austria, Belgium, the Netherlands, and Switzerland. These four small contiguous countries have maintained rates of inflation which

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Table 2. Correlations between annual rates ofinflation amongst 18 industrial countries, 1953-1982.

2 3 4 5 6 7 8 1.Australia .67 .90 .85 .76 .66 .71 .89 2. Austria .82 .73 .76 .69 .62 .89 3. Belgium .87 .78 .85 .69 .82 4. Canada .84 .74 .82 .78 5. Denmark .63 .63 .80 6. Finland .63 .68 7. France .69 8. Geany 9. Ireland 10. Italy 11. Japan 12. Netherlands 13. New Zealand 14. Norway 15. Sweden 16. Switzerland 17. U.K. 18. U.S.A.

9 10 11 12 13 14 15 .88 .56 .70 .86 .76 .84 .49 .67 .69 .58 .76 .59 .73 .64 .88 .83 .67 .84 .77 .82 .75 .90 .90 .45 .70 .87 .84 .83 .75 .83 .54 .57 .73 .73 .74 .74 .72 .54 .69 .62 .68 .65 .75 .77 .32 .49 .73 .73 .70 .75 .73 .53 .75 .64 .73 .72

.91 .46 .67 .92 .89 .80 .52 .62 .90 .84 .86

.59 .32 .44 .41 .58 .60 .59

.83 .82 .79

16 17 18 .91 .78 .74 .70 .65 .70 .87 .78 .59 .82 .92 .63 .77 .78 .52 .76 .68 .45 .69 .81 .85 .73 .72 .55 .88 .84 .48 .87 .85 .62 .56 .51 .69 .71 .64 .37 .85 .82 .57 .78 .80 .45 .81 .83

.48 .54 .83

Sources: 1953-59, Maddison (1982); 1960-82, OECD Economic Outlook



move in parallel with Germany's and which are at a similar level with the result that their currencies have remained stable with respect to the mark

Table 3. Coefficients of variation of exchange rates.

Against U.S. dollar Against German mark 1951-82 1971-82 1951-82 1972-82

Australia .065 .100 .310 .244 Austria .201 .204 .087 .013 Belgium .153 .161 .134 .085 Canada .071 .089 .379 .259 Denmark .097 .143 .253 .163 Finland .208 .079 .467 .204 France .159 .139 .372 .180 Germany .245 .201 Ireland .213 .189 .518 .290 Italy .242 .285 .549 .374 Japan .162 .159 .126 .093 Netherlands .186 .171 .080 .034 New Zealand .186 .183 .492 .300 Norway .123 .116 .173 .119 Sweden .086 .127 .265 .195 Switzerland .271 .321 .085 .133 U.K. .169 .136 .477 .254 U.S.A. - - .318 .193

Source: IMF Iernatioal Financial Statistics, Selected years.

A closer examination of all five small countries contiguous to Germany provides considerable support for my interpretation. Table 4 presents some figures on trade concentration for these countries as well as the difference in inflation between 1971-72 and 1973- 79 (Barber and McCallum's measure). The five nations can be divided into two groups: Austria, the Netherlands and Switzerland did not experience substantial increases in their rates of inflation after the oil price increase of 1973; Belgium and Denmark did (but Belgium remains, compared to most countries, a superior performer). The three superior performers within this group offive share the common characteristic of considerably greater trade with Germany than with their next most important trading partner. Their principal export destination is, in other words, a market with relatively stable prices; were they to allow their export prices to significantly rise they would have real economic difficulties. At the same time, they principally import from a country with stable prices which would also assist in

maintaining price stability. It is probably fair to say that the constitutional limits on Swiss central government spending and the autonomous central bank would, in any case, ensure Swiss price stability. But trading heavily with Germany both encourages the national penchant for price stability and facilitates the task of securing it

Now compare the situation of the contiguous small countries which were less successful in maintaining price stability. In Belgium, the rate of inflation was, on average, over three percentage points higher after 1973 than it had been in the two years preceding the oil price

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Table 4. Trade concentration with German Federal Republic of small contiguous capitalist nations.

% of each nation's % of each nation's % of each nation's % of each nation's Mean inflation exports to Germany imports from exports to next imports from next 1973-74 minus

Germany most important most important 1971-1972 export destination source

Mean Mean Mean Mean 1970 1982 1970-82 1970 1982 1970-82 1970 1982 1970-82 1970 1982 1970-82

Austria 23 29 25.5 41 41 41.0 10 9 9.9 8 9 8.2 1.09 Belgium* 25 20 20.9 23 20 22.7 20 19 19.6 17 18 17.2 3.37 Denmark 13 18 14.9 19 21 19.4 19 14 16.6 16 12 13.9 5.78 Netherlands 33 29 31.5 27 22 25.7 14 20 14.7 17 11 13.6 -0.31 Switzerland 15 18 16.5 30 30 29.3 9 9 8.9 12 12 12.8 -1.94

* Including Luxemburg Next most important export destinations: Austria (Switzerland 1970-75, Italy 1976-82); Belgium (France); Denmark (U.K. 1970-76, 78-82, Sweden 1977); Netherlands (Belgium); Switzerland (Italy 1970-71, France 1972-82). Next most important import source: Austria (Switzerland 1970-73, Italy 1974-82); Belgium (France 1970-78; Netherlands 1979-82); Denmark (Sweden); Netherlands (Belgium); Switzerland (France). Source: Economist Intelligence Unit Quarterly Report (selected issues).



shock. About 20 percent of its trade is with Germany. But an almost equal amount is with France! Belgium, in other words, is equally integrated with the economies of a superior and a mediocre inflation performer and its record reflects that fact. The case of Denmark is still more striking. Until 1976 its largest single export destination was the U.K. and throughout the period considered here its principal source of imports has been Sweden. In general, its trade is almost equally divided between Germany, the U.K, and Sweden; that is to say between a good, a wretched, and a mediocre inflation performer. Of the five small countries considered here Denmark, then, is the least closely integrated into the superior performing German economy. It is, on the contrary, equally integrated into the economies of relatively high inflation nations and, correspondingly, its average inflation rate increased after 1973 by almost six percentage points. As one would expect, Table 3 shows that the coefficient of variation of the Danish currency with respect to the German mark is considerably higher than the coefficients for any of the other small countries contiguous with Germany.

My interpretation is also reinforced by a closer examination of the case of Austria which, along with Sweden, is the favourite exemplar of the beneficent effects of neocorporatism on macroeconomic performance. Here is a country with "a sophisticated incomes policy based on the concept of a 'social partnership' between labour and industry and an emphasis on reaching a social consensus on major macroeconomic issues" (Barber and McCallum, 1982: 43). Its macroeconomic performance has been superior (Tichy, 1984: 367). I would not wish to deny that the negotiations in the much celebrated chambers of commerce and labour play a role in the formulation of economic policy (cf. Katzenstein, 1984: 59-73). But their existence has not prevented the kind of wage responsiveness to aggregate demand that one finds in non-neocorporatist (or "neo liberal") economies (Flanagan, Soskice, and Ullman, 1983: 52-6). And, most important of all, as the Austrian economist Tichy makes clear, the context of centralized bargaining is a "hard currency option" in which the Austrian schilling is tied to the German mark. Devaluation as a policy is excluded because "exchange rate policy in a small open economy affects the price level earlier and stronger than the current account" (Tichy, 1984: 370). In other words, the assumptions of officials choosing economic policies in Austria is that, given the relative size of their economy and its degree of integration into that of Germany, a flexible exchange rate with respect to the mark would serve no useful purpose. But if the schilling/mark exchange rate is effectively fixed, then Austria's rate of inflation is tied to that of Germany. The economic authorities consciously and deliberately exploit the tie with Germany: "Austria can use exchange rate policy to achieve price stability" because "Germany pursues a policy of strict price stability - which Austria imports via the stable exchange rate" (pp. 371-2). In other words, for all that centralized bargaining in Austria is an important aspect of that country's economic workings, its precondition is the economic tie to Germany and the "hard currency option" that goes with it. The chambers of labour and industry would be considerably less likely to produce such impressive economic outcomes without it.

The drift of my argument should by now be obvious. These countries have superior performance because, in each case, they are closely tied by trade to a larger economy which has had superior performance. If the govemments of these countries tried to follow an autonomous macroeconomic policy, they would be subject to the same economic constraints as Canada. But, given West Germany's performance, there was no incentive to do so. In addition, stable prices in Germany meant stable prices for an important component of the

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imports of each of these countries - which in turn would have assisted them in maintaining domestic price stability and full employment And whereas these countries had the good fortune to be tied to a country which has had a superior economic performance, Canada had the misfortune to be tied to a country which in the 1970s had a deteriorating inflation record. That is why Canada followed the U.S. in slipping down the inflation league table from the 1950s and 1960s to the 1970s, as Table 1 shows.21

Some divergences I have argued that, in general, variations in the rate of inflation in Canada are explained by variations in the rate of inflation in the U.S. and that this is so because it is sensible for Canadian governments which want to be re-elected to run a macroeconomic policy which approximately aligns the Canadian rate of inflation with that of the U.S. One major reason that such a policy makes sense is that there are costs associated with shifts in either direction in the American dollar value of the Canadian dollar. And, as Tables 2 and 3 show, Canadian prices and exchange rates have in fact been closely aligned with those of the U.S. But there have been periods when the rate of inflation in Canada diverged from that in the U.S. and periods of major exchange rate realignment. There is certainly not space in this paper for a complete history of macroeconomic policy and performance in the postwar period. But I can use these divergences to indicate what sorts of other factors affect the Canadian rate of inflation and to round out this political account of Canada's postwar inflation.

Table 5 shows that there were some substantial oscillations in the relative rates of inflation from 1951 to 1953, with a markedly higher rate of inflation in Canada in 1951 and amarkedly lower one in 1953. Then, from 1954 to 1968, things settled down and there was always less than a one percentage point difference in the rates of inflation of the two countries. In only three years in this period did the difference exceed half a percentage point From 1969 to 1971 Canadian rates were markedly below American rates then from 1972 to 1978 about one and a half percentage points above American rates in all but one year. After an oscillation in the opposite direction during 1979 to 1980, Canadian rates have been considerably higher than American rates since then (including 1983 for which the figure is not given in this table). The table shows that the magnitude of the differences in either direction have been generally larger since 1969. With respect to the exchange rate, the table shows that there have been four major shifts. There was a sharp depreciation of the Canadian dollar from 1959-1963, an appreciation from 1968 to 1972, a depreciation from 1976 to 1978 and then, episodically, further depreciation since the Reagan administration took power in the U.S. There are four main considerations that need to be taken into account in explaining these divergences in inflation rates and shifts in exchange rates. I will outline these in turn and then deal separately and briefly with the most recent depreciation of the Canadian dollar.

First, the context within which macroeconomic policy choices get made is substantially affected by shifts in the terms of trade and, more generally, the demand for exports. A sudden surge in the demand for Canadian goods will autonomously stimulate the Canadian economy. A collapse in demand will depress it. Such a boom and bust in commodity prices clearly produced the oscillations in relative prices during the Korean war. It has also substantially

21. The first period in Table 1 starts from 1953 to eliminate the distorting effects on average inflation rates of the Korean War. The second period goes up to the oil crisis and the third period from 1973 gives average inflation rates during and in the aftermath of the oil crises of 1973 and 1979-80.

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Table 5. Annual inflation rate and exchange rate records of Canada and the U.S.

Canadian American inflation inflation

10.4 2.5

-0.9 0.6 0.2 1.4 3.2 2.5 1.1 1.1 0.5 1.2 1.8 1.7 2.5 3.7 3.4 4.2 4.5 3.3 2.9 4.7 7.6

10.9 10.8 7.5 8.0 9.0 8.5

10.1 12.5 10.8

7.9 2.2 0.8 0.4

-0.3 1.4 3.5 2.8 0.7 1.6 1.1 1.2 1.3 1.3 1.7 2.8 2.9 4.2 5.4 5.9 4.3 3.3 6.2

11.0 9.2 5.8 6.4 7.6 9.0

13.5 10.4 6.1

Canadian inflation minus American

inflation 2.5 0.3

-1.7 0.2 0.5 0.0 0.3

-0.3 0.4

-0.5 -0.6 0.0 0.5 0.4 0.8 0.9 0.5 0.0

-0.9 -2.6 -1.4 1.4 1.4

-0.1 1.6 1.7 1.4 1.4

-0.5 -3.4 2.1 4.7

American dollar value of one

Canadian dollar .95

1.02 1.02 1.03 1.01 1.02 1.04 1.03 1.04 1.03 .97 .93 .93 .93 .93 .93 .93 .93 .93 .96 .99

1.01 1.00 1.02 .98

1.01 .94 .88 .85 .85 .83 .81

Sources: Inflation: 51-59 Maddison, 1982; 60-82 OECD Economic Outlook Exchange rate: IMF International Financial Statistics, selected years.

affected price and employment performance in the 1970s. At the beginning of the 1970s Canadian inflation rose relative to that in the U.S. because of both relatively more stimulative policy22 and growth in Canadian export revenues. These latter grew substantially because of

22. "By and large, fiscal stabilization policies in the two countries did not differ markedly until the 1970s." (Fortin, 1982: 506).

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51 52 53 54 55 56 57 58 59 60 61 62 63 64 65 66 67 68 69 70 71 72 73 74 75 76 77 78 79 80 81 82



a surge in car exports as a result of the Auto Pact (Robinson, 1980: 42) and as a result of a shift in the terms of trade in Canada's favour (Robinson, 1980: 46, 67; Barber and McCallum, 1980: 12-13, 30). The important point here is that in addition to being a source of stimulus in its own right, this increase in exports made possible the more stimulative economic policy pursued by the government. Without this rise of export revenues the government's more stimulative policy would have been subject to the kind of exchange rate constraints I described above. As it was, the boom in exports led to a currency appreciation.

Second, there are some grounds for thinking that Canadian monetary policy was particularlymishandled during the 1950s and that the depreciation of the Canadian dollar at the end of that period was the culmination of, and itself embodied, that mishandling (Dunn, 1971: 60-7; Caves and Reuber, 1969: 18-26). This was a period during which monetary policy was not under the control of the federal government. The Bank of Canada at the time ran monetary policy and at the end of the period, the then governor, James Coyne, simply defied the government of John Diefenbaker until he was, with some difficulty, forced out of office. Monetary policy in this period was being directed by an agency which did not have to run for re-election. Now, as Table 5 shows, the Canadian dollar appreciated rapidly during the Korean war. Subsequent Bank of Canada policy maintained it at this new higher parity. There were three reasons why the dollar was maintained at this higher parity. First, James Coyne had a great (and probably unreasonable) anxiety about the dangers of inflation. Second, he wished to make Canada less dependent on American capital by running a high interest rate policy designed to stimulate domestic savings which could in turn serve as a substitute for American capital. Third, he apparently regarded the maintenance of a high and stable par as a matter of prestige (Gordon, 1961; Johnson, 1967: 91-3; English, 1973: 67-70; Plumtre, 1977: 155-68; Robinson, 1980: 32-4). The result was a dollar which was overvalued because the high value reached during the Korean war oscillations came to be treated as the appropriate par value. The consensus of observers of the economic policy of the time is that the depreciation after 1960 constituted a belated adjustment to an overvalued Canadian dollar and a correction of a damaging error in macroeconomic policy.2

Third, in the 1970s, relative rates of inflation for particular periods were affected by the introduction of wage and price controls in the U.S. from 1971 to 1973 (Cagan, 1979: 157- 8; Blinder, 1979: 267) and in Canada from 1975 to 1978. Note, however, that while wage and price controls helped to reduce the American rate of inflation below that of Canada in 1972, despite the AIB, Canada's rate of inflation remained above that of the U.S. from 1975 to 1978. Since there is some evidence (Wilton, 1984) that the AIB was relatively effective, there are good grounds for thinking that without it Canada's relative rate of inflation would have been even higher during this period.

Fourth, and finally, the costs of allowing the exchange rate adjustments that go with an autonomous Canadian macroeconomic policy vary with the levels of inflation in the U.S. From 1969 to 1971, Canada's inflation rate lagged behind that of the U.S. and it did so in part as a result of deliberate government policy (Lamontagne, 1984: 66-7). Consider, however, the context within which the Canadian government of the time selected this policy. As Table

23. In addition, the Conservative government appears to have mishandled the process of devaluation itself and produced a greater devaluation than was warranted. See Dunn (1971) or Caves and Reuber (1969: 19).

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5 shows, the rate of inflation in the U.S. had risen from 1.7 percent in 1965 to 5.9 percent in 1970. It had, in other words, more than tripled in five years. This was, at the tim, an unprecedented shift. One would expect a cautious Canadian goverment to be reluctant to follow the U.S. into unprecedented levels of inflation. Canada could not insulate itself from these price movements and the government was certainly aware of that (Economic Council of Canada, 1969: 163). But it is surely neither suprising nor inconsistent with an argument to the effect that a cautious government would normally align its macroeconomic policy with that of the U.S. to find that that alignment breaks down where the neighbouring large economy moves into areas which, at the time, are uncharted.

Now, the Canadian dollar has substantially deprciated with respect to the American dollar over the last few years. If, as I have argued, a Canadian goverment seeking re-election has a strong interest in retaining approximate exchange rate staility, why has this happened? There is not space here for a complete analysis of the context of recent Canadian economic policy. But it is worth emphasizing that all OECD currencies have weakened with respect to the American dollar during the 1980s but the Canadian dollar has weakened by far the least and has been much more closely aligned with the American dollar than any other currency (OECD, 1984: 69). The extraordinary strength of the American dollar in recent years reflects special circumstances including American government monetary and fiscal policies which have produced extremely high real interest rates conjoined with an administration which looks exceedingly hospitable to foreign capital. That under these circumstances the Canadian dollar has, as compared to other currencies, remained relatively close to the American dollar, reinforces the arguments I have made.2

Conclusion Amongst sociologists and political scientists the relative postwar inflation performance of capitalist nations is most commonly explained in terms of the presence or absence of neocorporatist institutions.25 This more general approach has been applied to Canada by the economists Barber and McCallum. Their account of Canada's relative inflation perfomnce stresses the country's lack of "social consensus"; their prescription for better performance in the future urges the adoption of an incomes policy which can serve as a surrogate for "social consensus" (pp. 12-13). It is worthwhile juxtaposing this cross disciplinary near-consensus with a reading of Flanagan, Soskice, and Ullman's account of income regulation institutions in Europe. Within the context of an approach which is fairly sympathetic to incomes policies (cf. pp. 688-94) their accounts of macroeconomic policy and its outcomes record considerably more failures of incomes policies and centralized bargaining than successes. And, in their analysis, even ostensible successes (ike Austria) are, in fact, somewhat ambiguous.

How can we explain these divergent impressions? In my view the answer is that the neocorporatist accounts in general have some serious problems but that the particular versions of Barber and McCallum and of Crouch, from whom McCallum borrowed his "institutional" variable, are particularly defective.

24. Canada's vulnerability to the collapse in commodity prices associated with a serious recession and to the direction of economic trends in the U.S., showed up clearly during the 1930s. See Safarian (1970: 237-40).

25. This kind of analysis is usefully summarized in Goldthorpe (1984).

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Consider the methodological strategy that is common to all analyses of the political bases of macroeconomic outcomes. It involves comparing the inflation and unemployment record of countries with different institutional characteristics. The number of countries included in the analysis varies from 12 in Hibbs (1975; 1977) to 20 in Schmidt (1982). The methods of analysis vary depending upon the measures of the institutional variables that are used. Crouch and Schmidt compare means; Hibbs and McCallum look at correlations or, in McCallum (1983), a multiple regression equation. Now, it is inevitable that examining the institutional bases of inflation across countries requires comparisons of this sort But in such analyses there are two serious dangers. The first is that classification decisions might be incorrect; the second related danger is that cases which are in fact interdependent get treated as if they are independent.

Where you have a maximum of 20 cases, single cases can make a great deal of difference, whether you are comparing means or computing correlation coefficients. This is particularly so where the cases in question are located at the extremes of the range of scores of the dependent variable of interest. Gemany, for instance, has been a markedly superior macroeconomic performer and allocating it to the neocorporatist category does wonders for the results of Barber and McCallum. But Germany, in fact, is not by any means a clear example of the effectiveness of centralized bargaining both because the extent of centralized bargaining is problematic and because there are other factors that can better account for relative German price stability (ike an autonomous central bank, foreign workers, and somewhat repressive labour laws). British governments during the 1960s and 1970s, on the other hand, flirted with all the institutions that are supposed to produce superior macroeconomic performance and failed abysmally. To this one might respond that it is precisely because the corporatist institutions (including negotiated or imposed incomes policies, enhanced social welfare provision and legally strengthened labour unions, in the context of a relatively low level of income inequality) failed to "take" that the U.K. did so poorly. This is certainly possible (but not very likely given the serious objections to many other classificatory decisions). Consider, however, the difficulties that this position would imply for testing the neocorporatist's theory. It would say that corporatist institutions are good for macroeconomic outcomes except when they fail to work. Obviously, following this reasoning, in a country that has high inflation (and high unemployment) they cannot possibly have "taken." But, then, how could the theory be falsified? The classificatory decision would have shifted to the score of the country on the dependent variable. This approach would make the the theory of neocorporatism and macroeconomic outcomes true by definition!

The second problem with the method of analysis in these studies is that they assume that all cases can, macroeconomically Speaking, be treated as if they were independent But Canada, for example, cannot be taken to indicate the negative macroeconomic consequences of not having an incomes policy or a social democratic government if its inflation record is largely a consequence of its ties to the U.S. Nor can Austria be taken as an example of the advantages of an incomes policy or a social democratic government if its inflation record is largely a function of that of West Germany.

If a government wishes to pursue an independent macroeconomic policy it must be willing to be indifferent to what happens to the rate at which its currency exchanges with its trading partners. Such indifference may be feasible for the governments of large countries with a diversity of trading partners. The extreme case here is the U.S. It may also be true, to some

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extent, of larger economies, less dependent on a single trading partner, like those of Germany, France, Japan, and the UX - although the policy record of the current socialist government in France indicates the limits to the autonomy of even large countries like these. But, I have argued, such indifferelce is simply not feasible for the govemrnments of those small countries which are heavily dependent on trade with a particular larger economy - unless they are willing to take the political risks associated with choosing a policy the pay off for which is both uncertain and, at best, long term but the negative effects of which are immediate. Shifts in the rate of exchange between currencies of a large country and the small country for which the larger is the principal trading partner disrupt the small economy involved. Some industries will ultimately flourish as a result of the changing exchange rate but others will certainly immediately decline; overall, there is no guarantee that the attempt to secure macroeconomic autonomy will succeed since, as I discussed above, interest rate adjustments and capital flows will tend to act to offset the effects of government policies designed to shift the smaller country away from the macroeconomic direction followed by its larger trading partner. I would argue, in other words, that the governments of such countries will rarely choose such an electorally risky course of action.

It should be clear that the theory offered here makes sense of the available evidence in a way that is certainly not true of the theory of Barber and McCallum It makes sense not only of the close association between American and Canadian prices and exchange rates but also of the fact that one finds exactly the same pattem for Austia, Switzerland, and the Netherlands with respect to Germany. Further support is provided by the more mixed performance of Belgium, a country contiguous to and heavily trading with Germany, but with an almost equal trade dependence on its second most important trading partner, which is France. Belgium's more mixed macroeconomic performance reflects the fact that its economy is almost equally integrated into the economies of both a superior and an average macroeconomic performer. Still more support is provided by the relatively poor performance of Denmark which was, for most of the 1970s, more heavily dependent for an export market on the wretchedly performing U.K Barber and McCallum's account simply cannot make sense of the tendency to find the macroeconomic alignment between smaller countries and their larger principal trading partners that the data presented in this paper show.

Consider, once again, the case of Canada in light of the considerations outlined above. Canada's ranking approximately follows that of the U.S. and it does so because it is in the interests of a vote maximizing Canaian government to follow policies which have that outcome. Whether exchange rates are formally fixed or flexible, in practice, Canadian governments tend to align the Canadian dollar with that of the U.S. and they do so because the economic advantages of a genuinely flexible rate are uncertain and long term while the costs are both certain and immediate. Also, shifting exchange rates are directly politically disruptive since they disturb the balance of regional welfare and, when depreciating, are politically unpopular. Politically prudent governments will, as far as possible, align the Canadian with the American dollar and in doing so approximately tie the Car dian to the American rate of inflation. In order to increase employment an NDP goverment would probably attempt to break out of this alignment But the first exchange crisis or, at best, election, would lead to a return to the alignment This means, of course, that not only is Canada's international inflation rate ranking substantially explained by the ranking of the U.S. but that, in addition, the movements in the Canadian rate of inflation over time are

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explained by movements in the U.S. The correlation between the Canadian and American rates of inflation from 1953 to 1982

is 0.92. (cf. Table 2). This is the highest correlation amongst the eighteen countries for which I assembled data. Their positions in the international league table (Table 1) are consistently similar over the same period. It is true that there have been divergences in the Canadian and American rates of inflation and variations in the exchange rate between the two currencies. I have argued that these result from factors like shifts in the terms of trade, policy errors, wage and price controls, and the fact that at the end of the 1960s as well as recently the American economy lurched into uncharted areas of inflation or interest rates into which prudent, vote maximizing, Canadian governmets were disposed to follow with considerable reluctance and restraint. But, despite these factors, the overall patter is quite clear. The implication of all of this is that political accounts of inflation in Canada which ignore the constraints on political choices imposed by economic interdependence with the U.S. - like those of Barber and McCallum and of Crouch - are wholly inadequate.

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Documents

The Political Bases of Inflation in Postwar Canada