STEPHEN GORDON ON A DIVERSIFIED ECONOMY,

Politics is alive with the praises of a diversified economy. Some say that Canada should have one; others say that it already does, but both sides agree that it’s a goal to which Canadians should aspire. There’s even a homespun metaphor: “Don’t put all your eggs in one basket.” It’s just basic economics, right?

Well, no, it isn’t. In fact, it’s the exact opposite of basic economics. Adam Smith’s observations of the workings of a pin factory taught him — and us — the benefits of specialization. David Ricardo taught us that instead of aiming for a diversified economy in which 19 th-century England produced both wine and cloth, it should specialize in the production of cloth — for which it had a comparative advantage — and import wine from a country such as Portugal, which had a complementary comparative advantage.

This is at times a difficult concept to grasp, but if there’s any idea that can claim to be “basic economics,” then surely it must be comparative advantage. In a large economy, diminishing returns will prevent the complete concentration to a single industry, but there is no inherent advantage in adopting policies whose goal is to avoid the gains from specialization.

If the eggs-in-a-basket metaphor has any meaning, it has to do with risk, not the composition of output. Fluctuations in world prices will generate corresponding variations in the income generated by selling exports on world markets. Here, basic economics tells us to manage risk by means of capital markets: a diversified asset portfolio offers at least partial protection from the vagaries of world markets. This instrument isn’t always available — particularly in developing countries — and in these instances diversifying the domestic mix of out- put can act as a crude hedge against these risks. But of course Canadians have ready access to international financial markets and are making increasingly heavy use of them.

It’s instructive to look at how Canadians have been using capital markets to hedge against recent events. The first thing to note is that contrary to a popular meme, the benefits of the oil boom were not entirely frittered away. Even though the Alberta government does not have a Norway-style sovereign wealth fund — a decision that seems to be more popular among Albertans than it is outside Alberta — a significant portion of the extra income was in fact saved. Statistics Canada’s data for national net worth — household, corporate and government sectors — stagnated at around 330% of Gross National Income (GDP plus a correction for income earned outside Canada) between 1990 and 2005. Since then, the ratio of net worth to income has jumped above 400%. You hear a lot about the increase in debt loads, but not so much about the significantly larger increase in asset holdings.

The other point is how Canadians have been hedging against exchange rate risk. According to the Bank for International Settlements, Canada’s real effective exchange rate — an index that includes our major trading partners and corrects for changes in price levels — increased by almost 50% between 2002 and 2012. This increase in the buying power of our dollar on world markets provided a significant boost to Canadian incomes. Of course, there was always the chance that these gains would be reversed — and indeed the real exchange rate has depreciated by 10% since 2012.

A simple hedge against depreciation is to buy foreign assets: if the dollar falls, then the value of assets denominated in other currencies will automatically rise. And buying foreign assets is what Canadian investors have done. Even as the exchange rate appreciation sharply reduced the value of foreign holdings, Canadian purchases expanded even faster so that holdings of foreign assets kept pace with GNI. This strategy has already begun to pay dividends: the decline in the Canadian dollar has already increased the value of foreign holdings by almost 40% of GNI over the past two years. It’s probably not a coincidence that estimates for national net worth have also increased by more than 30% of GNI during this time.

Diversification makes eminent sense as a principle for asset management — and asset managers, public and private, have already learned this lesson. Given the current circumstances, many Canadians would probably be relieved to learn that some 69% of the assets managed by the Canadian Pension Plan Investment Board are located outside Canada.

But the eggs-in-a-basket metaphor is a much less useful guide for economic policy. Diversification has been the driving force behind any number of ill-conceived ‘“industrial policies” whose effect is to divert labour and capital away from the sectors where they are most productive. These efforts may succeed in producing an economy that is more diversified — but also less prosperous. It’s just basic economics.

There is no inherent advantage in adopting economic policies whose goal is to avoid the gains from specialization