CANADA enters the second winter of war with her economic policy meeting its first crucial test. Until now the Canadian Government has not found any great difficulty in adhering to its declared policy of pay-as-you-go. In September 1939 there was unused factory capacity and there were reserves of labor and raw materials. Indeed, a mildly inflationary policy was adopted during the early months to stimulate production. Now, after more than a year of war, full employment is clearly in sight; immense extensions of plant are under way; and expenditures are approaching 30 percent of the national income. These developments reveal that a critical moment in economic policy is at hand. The next few months will demonstrate whether or not the Government has the courage to impose the taxation and controls necessary to avoid inflation, and whether or not the people will accept a parallel reduction in the standard of living. What can be said today is that the Government shows no sign of faltering in its policy of pay-as-you-go and that the people of Canada have thus far revealed a truly heroic eagerness to sacrifice now to attain ultimate victory.

That Canada is already in a critical phase of her war economy reveals the extent of her war effort. This effort has two objectives -- to give all possible aid to Britain, and to strengthen Canadian home defense. Every last impulse of Canada's power in men and resources is being given to these ends. There is no disposition to rely upon the United States for the defense of Canadian territory. On the contrary, the Canadian Government, with the full approval of parliament and the people, is making a supreme effort to achieve Canada's own salvation. Some of the gravest weaknesses in the war program arise out of this new manifestation of nationalism. Canada is trying to do so much, she is spreading her limited resources over so wide an area, that there is some reason to doubt if she can carry the present program through in its entirety.

In the First World War the Canadian war effort was comparatively simple. Canada put 600,000 men in khaki and sent an army to France. At home, she enormously expanded her acreage and concentrated on the production of foodstuffs. In addition, she developed a great munitions industry, concentrating chiefly on shells. The value of her munition production totalled approximately $1,000 millions, and it is estimated that one-third of all the shells used in the British armies in 1918 were made in Canada. Canada's expeditionary force, the production of foodstuffs and shells were the features of her 1914-18 effort. The Dominion had no air force at that time and the Canadian navy was negligible.

War came in 1914 at a moment when Canada was uniquely fitted to meet British demands. The great era of expansion was just ending. During the previous seventeen years, Canada had been developing her West. Transcontinental railways had been built, vast agricultural areas had been made available for settlement, floods of immigrants had poured in, cities and towns had sprung up on the virgin prairie. All this entailed heavy capital imports, which in 1913 exceeded $500,000,000,000, or nearly one-fourth the national income. By the eve of the World War, Canada's problem was to take people out of construction or development (in 1912-13 about one-fourth of the country's labor and productive facilities were directly or indirectly engaged in construction) and to get them into production. Jack Canuck had to quit being a railway builder and become a farmer. Ordinarily this adjustment would have been long and painful. But war demands for wheat and other raw materials eased the problem of readjustment.

It is easy to look back on the first war experience and say that problems were simpler then than now. Perhaps this is true for production; it distinctly is not so in the realm of finance. Twenty-five years ago Canada had no broad tax structure to build on and there was no domestic money market from which to borrow. There was no machinery by which surplus purchasing power -- the propelling force in inflation -- could be siphoned back into the war treasury. There was no central bank to control and coordinate the economy of the country. In fact, the Canadian Government had never raised as much as $5,000,000 in Canada by a public loan; and it is estimated that less than $1,000,000 of Canada's funded debt in 1914 was held by Canadians. Canada had always borrowed from London. The tax structure was a primitive thing of import duties and excise duties on such commodities as spirits and tobacco. The national peacetime budget barely exceeded $100,000,000 and the national income was estimated at $2,200,000,000.

Between 1914 and 1920 Canada's war expenditure rarely exceeded 10 percent of the national income. What proportion of the war expenditure the Dominion raised by war taxation is a matter of dispute. The outlay on the fighting services in those years was $1,672,000,000 and war taxation covered an insignificant part of it. If the increase in revenues due to war prosperity is included, the total becomes larger but still is unimportant. Although the British Government did take over the financing of Canada's army abroad, London was unable to finance purchases of foodstuffs and munitions in Canada. Ottawa had to find this money. All told, Canada as a result of the war added $2,200,000,000 to her debt. Despite the fact that the national money income rose from $2,250,000,000 to $4,408,000,000, no real effort was made to pay-as-you-go. It is doubtful if such a policy would have been possible with such a primitive financial and tax machinery.

In the early stages, Canada financed the war by borrowing from London and by outright additions to the note circulation. Then the pound fell to a discount and Britain was no longer able to finance either Canada or her purchases in Canada. In desperation, Canada turned to New York, and the first Canadian loan ($45,000,000) was sold there in 1915. But the best alternative was borrowing at home. This was done with unexpected success. The Government first asked for $50,000,000 and was amazed to get $100,000,000. Thereafter domestic loans were issued in rapidly rising amounts until in the final years of the war period loans of $600,000,000 were raised without difficulty. British purchases of munitions and foodstuffs were financed in a different and more inflationary way, i.e., by establishing bank credits for the British purchasing authorities.

In the early years, the inflationary effects of this policy were checked by the fact that there was a surplus of labor and plant. But full employment was reached by 1917; and thereafter there existed no unused resources of labor, plant or materials which could be tapped to meet the increasing demand for war supplies. Increased war production had to come at the expense of consumption and out of maintenance of plant and longer hours of labor. It is a matter of controversy whether or not the government of the day consciously or unconsciously allowed inflation to diminish consumption. In any event, inflation had that effect. More important, it redistributed the national income in such a way as to concentrate wealth in the hands of relatively few men -- the war profiteers -- from whom, in turn, the Government succeeded in borrowing the very large sums required to finance the war. While war loans were sold to great numbers of people, the evidence is fairly conclusive that 80 percent of the amounts subscribed came from the small group that benefited from inflation. There were in Canada, in Lloyd George's phrase, many men whose hands were dripping with the fat of sacrifice.

The responsibility for this inflationary policy rests on the government of the day. The evidence shows that the chartered banks were dubious and hesitant partners. Professor J. J. Deutsch, of Queen's University, one of the advisers on the Royal Commission on Dominion-Provincial Relations of 1937-40, has stated: "It is clear that the war-time price inflation in Canada was more the result of domestic policies than the result of forces operating from abroad."[i] However, it is doubtful if the Government, having few if any economic and financial controls at its disposal, could have followed any other course. Inasmuch as practically all borrowing was done at home, it is true in a sense that the nation-at-large paid for the war as it proceeded. Food, equipment and munitions came out of current production. But the cost was distributed most unjustly and unevenly. The inevitable results were tension, pressure groups, and sectional disputes which shook the Dominion to its foundations and were still unsolved when the second World War began. Indeed, the Royal Commission mentioned above was the first courageous effort to solve the problems created by the last war.

II

Obviously Canada cannot repeat in the present war the do-nothing economic policy pursued in the last one. A nation may get away with inflation when war costs do not exceed 10 percent of the national income in any one year; but it becomes impossible when war costs exceed 30 percent and may well reach 50 percent. Moreover, the demands in this war are different from those of twenty-five years ago. Then it was men, foodstuffs, and munitions. Now the cry is for airplanes, tanks, guns, mechanized equipment -- all requiring specialized capacity and skilled workmen. The Canadian economy is not so well geared to meet these demands as it was the demands of 1914-18. Canada can only reach her real stride in this war if she plans, directs and controls her economy in such a way as to make the utmost use of her resources. Meanwhile great industries -- like the wheat industry -- though not needed at the moment must be maintained.

The danger of inflation was recognized at the outbreak of the present war. The Government announced its financial policy in the first war budget of September 12, 1939. The mistakes of 1914-18 were to be avoided -- specifically, the Government planned for a long war, not a short war as it did in 1914. In the early months, while production was getting under way, a mildly inflationary policy would be followed and heavy taxation avoided. Later, after full employment had been reached, the Government would enforce as rigorous a pay-as-you-go policy as possible. On this the acting Minister of Finance spoke as follows:

Because we believe it is the part of wisdom, we shall follow as far as may be practicable a pay-as-you-go policy. In imposing the new tax burdens which this policy will require we shall be guided by the belief that all our citizens will be ready to bear some share of the cost of the war, but we shall insist on the principle of equality of sacrifice on the basis of ability to pay. We shall not of course be able to meet all war costs by taxation, because . . . there is a limit to the taxes that can be imposed without producing inefficiency, a lack of enterprise, and serious discontent . . . . We cannot carry taxes beyond the point where they seriously interfere with production. But we are not prepared to be timid or lighthearted in judging where this point lies . . . . What we cannot meet by taxation we shall finance by means of borrowing from the Canadian public at rates as low as possible.

The general features of the budget have already been summarized. From the outbreak of war to the beginning of 1940 the policy was deliberately inflationary, the principal means of pump priming being a $200 million short-term note issue to the banks. In January 1940 the pool of savings was judged deep enough to be tapped. A $200,000,000 bond issue at 3¼ percent was sold at popular subscription. In September a $300,000,000 issue at 3⅛ percent was also taken by the public. Tax increases have been imposed which will bring in $342,000,000 per year. Since national income is estimated to have risen from $3,800,000,000 in 1939 to $4,500,000,000 in 1940, it is obvious that by borrowing and taxing the Government has taken back the increase in purchasing power.

Beyond doubt the Government has applied its war policy with great courage. But any complacency regarding the future will be chilled by the rate at which war expenditures have increased. For the fiscal year ending March 31, 1940, Canada's war expenditure was $118,000,000; for the current fiscal year it is estimated at $940,000,000; and for 1941-42 it will be at least $1,250,000,000. (Multiply these figures by ten and you have something meaningful in terms of United States standards.) In addition, Britain's purchases in Canada will have to be financed and the ordinary costs of government must be met. The coming budget therefore will run to $2,200,000,000, or 48 percent of the 1940 national income, and the gap between tax revenue and expenditure will exceed $1,000,000,000.

It is true that these figures demonstrate Canada's determination to play her full part in the war in Europe and provide defenses at home. But the threat to the Canadian economic structure is none the less real. Further and drastic tax increases will be inevitable if inflation is to be avoided. To be sure, prices have thus far been held down and the increase in national income represents an actual increase in production. The cost of living in the first year of war advanced hardly 6 percent, due in part to the measures applied by the Foreign Exchange Control Board, the Wartime Prices and Trade Board and the commodity controllers (steel, timber, power, etc.) of the Munitions and Supply department. But all along the line prices are tending to rise in response to real or prospective shortages and as time goes on control will become increasingly difficult.

The most serious problem at the moment is the shortage of manpower. The basic facts are not available, except in rudimentary form, and will not be until the national registration of last August can be analyzed. But the following indices (1926 = 100) on the increase of business activity pretty clearly tell the story:

Sept. 1939 Sept. 1940
Physical volume of business 125.8 155.4
Industrial production 128.3 167.
Manufacturing production 121.3 159.7
Iron and Steel production 98.2 242.9
Textile production 150.  182.9
Construction 48.6 127.

Full employment is only a month or two away. The total estimated reserve of workers last July was 238,000. Since then the fighting services have taken 57,000 men and ordinary employment has absorbed another 114,389. In addition, the services will need approximately 100,000 men to complete the military establishment now envisaged; and apart from the demands of nonwar industry, the war plant now being built will require about 100,000 workers. Existing bottlenecks in the skilled trades have already compelled the Government to prohibit employers from competing for each other's employees. The penalty for "enticing" is $500, and newspaper advertisements for skilled labor have been banned.

A series of strikes in war industries -- chiefly in shipbuilding -- has brought fairly generous increases in wages. They are significant because they proclaim labor's dissent from the economic policy of the Government. Labor prefers the British policy of allowing wages to rise and of preventing inflation by rationing and price fixing. The government, on the other hand, has implicitly rejected this alternative. In September 1939 it outlined three possible policies of war economy, each of which would have a different effect on the wage scale: 1, an inflationary policy similar to that of the last war (allowing wages and prices to rise without control); 2, avoidance of inflation by rigid and comprehensive price fixing and by rationing essential commodities (the present British policy); 3, siphoning back to the Federal treasury, by taxation and loans, the increased purchasing power created by the war boom. The Government, as already noted, rejected the first and second policies and chose the third. The reasons for rejecting the second policy were never given in detail until November 21, 1940, when Mr. Ilsley, the Minister of Finance, explained the Government's choice to the House of Commons. The core of his detailed argument was that universal price fixing cannot stand alone -- it ipso facto entails universal rationing and regimentation. Although the German people have accepted such a discipline, he was quite sure it would not work in Canada.

The problem of manpower would not have arisen in such acute form if the demands of the fighting services had been held down -- or at least coördinated -- and if a large-scale program for training labor had been launched early in the year. But labor was overlooked and neglected in the first year of the war, and thus there unexpectedly developed the first serious challenge to the Government's economic policy. Back of the labor problem there is considerable confusion in general war policy. Many Canadians have been shocked to learn that the army alone absorbs more than half of the war appropriations. There are some 167,000 men in the army (ignoring the 30,000 men per month being trained under the home defense plan), some 13,000 in the navy, and 31,000 in the air force. The latter was expected last year to take two-thirds of all the money Canada spent on the services. There is a feeling in some quarters that Canada should have avoided a big army and specialized in an air force. Britain has more men in her army than she can equip, but sorely needs airmen. Thus far Ottawa has failed to coördinate the three services -- its policy has been one of indiscriminate expansion. The public at large is curiously indifferent to this weakness. The indifference may perhaps be explained by the fact that the average Canadian is still thinking in terms of the last war, when Canada had no air force and only a negligible navy.

There remain two other economic matters of great importance to the war effort. Britain's purchases from Canada far exceed her sales, and the adverse balance is being met largely by the repatriation of Canadian securities. This adds greatly to Canada's difficulties in meeting exchange requirements in the United States. In normal times Canada transferred large favorable balances in sterling to the United States and thus was able to meet the normal adverse balance in United States funds. When the war broke out this transfer was no longer possible. A part of the favorable balance in sterling is being made available to Canada in gold, but we can assume that it is a very small part. Meanwhile Canada needs United States dollars more than ever before. Imports from south of the border have increased, due to purchases of essential war materials and equipment. The adverse balance has grown rapidly, as the following table shows (in millions of Canadian dollars):

Debits 1939 1940
Merchandise balance 161 300
Interest, dividends, profits 250 250
Freight, films, etc 35 45
--- ---
446 595
Credits
Gold 185 205
Tourist Trade 167 150
--- ---
352 355
--- ---
  Net drain 94 240

The figures for receipts from tourist trade given above are the estimates of the Dominion Bureau of Statistics. The 1940 figure is commonly believed, however, to be considerably too high. More probably, then, the net drain in 1940 will be $300,000,000. This is a figure which Canada cannot sustain indefinitely. The most obvious way to reduce it is to eliminate unessential imports such as citrus fruits, gasoline, etc. This would not mean a reduction in total trade, inasmuch as Canada would still be buying more from the United States than in prewar years; but it would mean a great shift in the items of trade and a consequent dislocation for certain American exporters. Alternatively, the United States might amend the Neutrality Act and permit Canada to borrow the money to buy such materials and equipment for home defense as were certified by the Joint Board on Defense. Or Canada's investments in the United States could be liquidated.

During the coming months, the financial burdens will be very great. But they can be borne. The Government adheres to the maxim that whatever is physically possible is financially possible. There will be difficulties, however, in dividing the financial burden fairly among the people -- in keeping with the express pledge of the Government -- unless the scope of Dominion taxation is greatly extended. Theoretically the Dominion possesses unrestricted powers of taxation. But thus far, as in times of peace, the Dominion has not seriously encroached on Provincial sources of income. A settlement with the Provinces on this issue is essential if war taxation is to be equitable; and the only available means of obtaining such a settlement is that recommended by the Royal Commission. A conference between the Dominion and the Provincial authorities to consider the Report has been called for mid-January.

A more fundamental problem, which only now is beginning to attract attention, concerns the extent of Canada's war production. Is too much being attempted?

Most Canadians have no idea of the size of the war industry that is being created in their country. War orders of $540 millions have been placed on Canadian account and $309 millions on British account. Aside from this, $255 millions is being invested in factory expansion and $89 millions in military construction projects. Upwards of 146 new factories or extensions to existing plants are being built, and of this new construction 70 percent is on British account. Nor do Canadians realize the diversity of the new war industry. Already shells are being produced in eight plants, while nineteen others are producing component parts; thirteen new shell plants are under construction. Canada is manufacturing the following types of shells: 40 millimeter, 18-pounder, 25-pounder, 3.7-inch, 4.5-howitzer, 4.5-quick firing, 4.5-inch 60-pounder, 4-inch, 6-inch howitzer, 9.2-inch. Existing and planned production calls for an output of two million shells per month. In guns, the production present and planned includes: Bren, 40 millimeter, Bofors barrels and guns, 3.7-inch AA, 25-pounders and carriages, Colt-Browning aircraft, Colt-Browning tank, 6-pounders, 2-pounders, 4-inch guns and mountings, 12-pounder guns and mountings, 4-inch naval guns and Lee-Enfield rifles. The Government announced on November 20 that "Canada will shortly be making practically every type of gun in use in the present war." In addition Canada is producing -- or preparing to produce -- small warships (181 delivered) and cargo vessels, motor trucks and cars, tanks and universal carriers, air frames, chemicals and explosives. Initial steps have been taken to launch an aëro-engine industry.

Might it not be wiser to concentrate on fewer kinds of equipment and materials, as was done in 1914-18, and produce them in large quantities? The Canadian nationalists have already answered this question with a decisive "no." Since Dunkirk they have insisted that Canada have a self-sufficient and well-rounded military establishment. They favor, of course, all possible aid to Britain; but fear has prompted them to demand a well-equipped force for home defense. Likewise they favor military collaboration with the United States, but pride has caused them to insist on an adequate defense force so that Canada can defend herself. It is largely at the insistence of this group that Canada has adopted a big-army policy (proportionately, her army is equivalent to one of nearly two million men for the United States) as well as diversity rather than specialization in her war production. Parenthetically it is interesting to note that a big-army, and all that such a policy implies, has traditionally been associated with the Imperialists. Now it has become the banner of the nationalists, the Imperialists tending to favor more specialized aid to Britain. Thus far the Canadian nationalists have had their way and there are plenty of indications that they will wage a lastditch fight rather than see their program curtailed.

The growing diversity in Canadian war industry has received stimulus from another direction. On numerous occasions in recent years we have heard statements that Canada might become the arsenal of the Empire, that repeated bombings of British industrial areas would result in a migration of vital war industries to other parts of the world. That migration has already begun. Britain, who is financing 70 percent of all plant construction in Canada, does not seem adverse to the mushrooming of a diversified munitions industry there. To be sure, all this is still on a small scale. Whether it increases and whether this kind of industry becomes a permanent part of the Canadian scene, rests on a number of circumstances which cannot be foreseen. It is sufficient to record that the first steps in making Canada the arsenal of the Empire have begun.

The honeymoon period in Canada's war effort is definitely over. Problems of real magnitude are rapidly reaching the point where a showdown is inevitable. First, and most pressing, is labor. Will the Government acquiesce in letting wages rise or will it stabilize wage rates? And quite apart from wage rates, how will it correct the ever-increasing labor shortage? If the Government endeavors to divert the stream of manpower which in recent months has gone to the army, there is likely to be opposition from the nationalists. From whatever source the spark may come, in one form or another Canada will have to decide which of her two war efforts will take priority in manpower, industrial resources, and raw materials. Will she produce enormous amounts of certain types of matériel for Britain, or will she spread herself -- spread herself thin, perhaps -- by curtailing volume so that she can produce as many different kinds of equipment as are necessary for a well-rounded home defense force? For the conclusion is inescapable that a small country such as Canada cannot produce highly fabricated equipment in both quantity and diversity.

As for the financial problem, it is not serious by itself. But in attempting to divide the burden of taxation equally among all the people, the ripples have already reached the farthest shores of the Dominion. For a more equal division of the burden presupposes a new division in the balance of power between the Dominion and the Provinces. The respective leaders will assemble in Ottawa early in the new year to debate this course. If reform is carried, it will be the greatest constitutional change in the balance of power in Canada since Confederation in 1867.

[i] J. J. Deutsch, "War Finance and the Canadian Economy," The Canadian Journal of Economics and Political Science, November 1940, p. 534.

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