Politicians should aim for growth, not diversification

For decades, Alberta politicians have waved the wand to diversify the economy in various ways and have generally failed to do so.

It is hard to overcome market forces since profitability has a lot more to do with millions of individual interactions than any one public decision. King Canute tried to sit by the shore to turn away the tide, but his legs got wet anyway.

No doubt energy is the dominant industry in Alberta, even more so today. It involves not just extraction, but many manufacturing and service firms that are tied to the success of the oil and gas industry. About half of the Alberta economy relies on the energy industry and most of the product is sold in North America.

Yet, politicians keep focusing on diversification as an objective, whether achievable or not. Some push for upgrading of bitumen into synthetic oil or refined products for export — in other words, product diversification.

Politicians have sought industrial diversification by investing in alternative industries unrelated to the oil and gas sector. Others argue for geographical diversification by developing alternative markets besides the United States.

So how do we evaluate whether diversification can be successful or not?

Take first the argument for upgrading, which is typically based on job creation. Upgrading is very capital intensive, requiring billions added in new capacity. It is cheapest to upgrade product in existing refineries such as Quebec and New Brunswick, or the U.S. Gulf Coast, compared with building new capacity.

Thus, at present, very few firms are willing to build upgraders in Alberta except for the North West project, with the private producers being paid a toll (up to a limit in operational and capital costs), leaving to the Alberta government market risks associated with uncertain refining margins.

If the provincial government subsidizes or regulates upgrading in Alberta, it is presumed that the “value-added” jobs created in the sector will create indirect jobs elsewhere, assuming such resources are freely available to grow the economy. The problem with typical analysis of this sort is that it ignores economic resource constraints. Clearly, this is not the case in Alberta with a very low unemployment rate and skilled labour shortages.

More upgrading of energy product will require additional labour and other productive inputs taken away from other sectors of the economy. This will bid up costs, not just in the upgrading sector, but other sectors of the economy. In other words, additional upgrading could undermine industrial diversification.

If businesses determined that it is best to reallocate resources from other sectors to the energy sector, this could increase incomes in the economy since more profitable opportunities are being pursued. However, if King Canute-like governments try to redirect resources from one sector to the other, beyond what is achievable in markets, it will force labour and other resources to be deployed in less profitable opportunities.

This argument carries over to policies aimed at diversifying the industrial structure. Governments bear considerable risk if they try to push for sectors that are not viable. Whether Newfoundland cucumber plants, Nova Scotia auto plants or Alberta hazardous waste treatment centres, the world is awash with industrial diversification policies that failed, costing taxpayers billions of dollars as well as lining the pockets of industrialists pushing for subsidies. Even if the sector grows jobs, resources are not being put to their more economic use.

Geographical diversification of product markets is similarly difficult to achieve in the presence of transport and communication costs. It is cheapest to export oil to the United States compared with Asia since prices net of transport costs can be highest for Alberta producers. Nonetheless, transport infrastructure is costly to build and market pricing can result at times in better returns by exporting to some far away markets than closer ones.

There are policies that can help build a more diversified economy without governments trying to pick the winners (and more likely, the losers).

For example, a general tax reform that reduces taxes on investment and savings can help diversify the economy substantially through market forces responding to lower taxation. The removal of regulations that impede sectors from growing would also be sensible to achieve.

Much of the growth would leverage off the skills of Albertans, including those developed in the energy industry. Thus, supporting innovation and education can help spur new industries eventually.

The recent cutbacks and tuition fee freezes in post-secondary education are not the way to achieve diversification.

At times, other considerations are involved. One argument that I have made in favour of geographical diversification of Canadian trade is to better our negotiation stance with respect to the U.S. With alternatives, we have a credible threat to withstand disputes, whether in softwood lumber or “Buy American” policies.

Diversification itself should not be a politician’s objective. Instead, it should be growth and better incomes for Albertans.

It is better to put in place the right macro-environment and let businesses sort out market opportunities