The Ill Wind that Blows from Europe: Implications for Canada's Economy

Abstract

Speculation about the consequences of a break-up of the eurozone, a worsening sovereign debt crisis or a prolonged recession in the European Union have all in recent years made the headlines. At first glance, the effect that such events might have on the Canadian macroeconomy might appear small. After all, Canada’s trade in goods and services and financial flows to and from the euro area are dwarfed by our economic relationship with the United States. Significant spillover effects, however, likely would arise out of any major economic or financial shock originating from the globe’s largest economic block (as measured by gross domestic product, GDP). The sovereign debt crisis in the eurozone exposed major fault lines in the economic stability of the common currency area. The indirect exposure of Canadian banks – and of the Canadian economy more generally – from a eurozone economic shock ought to represent a pressing source of concern for Canada’s policymakers. The continued uncertain outlook for the global and US economy also suggests that there is a real danger of another “perfect storm” such as the one that affected the world economy in 2008 and 2009. Canada might not escape next time around with only a short-lived recession, nor is it a given that its financial sector would emerge largely unscathed, notwithstanding Canada’s reputation for the quality of its financial regulation and supervision. This Commentary estimates a small macroeconomic model for Canada that explicitly incorporates financial sector influences. Then, foreign shocks with real and financial elements from the eurozone and the United States are added to the model to investigate the potential for spillover effects. The study also considers some counterfactuals, by imagining a large, negative and permanent economic shock from the eurozone, and compares the results with estimates based on observed data. The Commentary concludes that negative shocks from the real and financial sectors of the US and eurozone economies do spillover into the Canadian economy. Clearly, US shocks dominate, but eurozone shocks cannot be ignored. Counterfactual experiments suggest that, under eurozone worst-case scenarios, Canada’s economy would suffer a substantial drop of almost 8 percent in real GDP after two and a half years.