Developments in the Canadian economy have forced an important re-thinking of the respective roles of monetary and fiscal policy in supporting stable growth and job creation. But mainstream thinking about monetary policy has evolved much further than that on fiscal policy.
Before the great recession of 2008, fiscal policy had fallen greatly out of favour as a tool for macro economic stabilization. The conventional wisdom was that central banks could adjust short term interest rates to keep the economy growing more less at potential with low inflation, and indeed there was no recession from the early 1990s until the financial crisis of 2008.
In retrospect, the so-called Great Moderation set the stage for the crisis since the driving force of growth, especially in the United States, was consumption and a housing bubble driven by excessive growth of household debt. The flip side of over leveraged households was an accumulation of bad credit risks by the financial system.
Fiscal policy came to the rescue in 2008-09 when stimulus policies played a major part in jolting the economy back to life. But governments soon reversed course and turned to austerity policies to deal with a temporary build up of public debt. The hope was that continued low interest rates would fuel a sustainable private sector led recovery.
In the event, this has failed to happen. Almost a decade on from the financial crisis, global and North American growth remain very sluggish despite continued ultra low interest rates.
Central banks have become much more aware of the limits of monetary policy. As recognized in an important speech on February 8 by Tim Lane, Deputy Governor of the Bank of Canada, “prolonged monetary policy stimulus may result in an excessive build up of private sector vulnerabilities.”
The Bank is clearly concerned about the increase in Canadian household debt and makes the case for “macro-prudential” policies such as limits on mortgage borrowing and increased surveillance of bank lending. These tools are much more effective and less damaging than raising interest rates to deal with excessive risk taking by the private sector.
It is also increasingly recognized by economists that even prolonged ultra low interest rates are insufficient to boost business investment and thus effective demand in a context of great uncertainty and perceived over-capacity.
Short term interest rates set by the central bank influence long term borrowing costs for corporations, but credit risk is still a factor and availability of funds does not mean that firms will borrow to invest. As the old saying goes, you can lead a horse to water, but you can't make it drink.
Deputy Governor Lane went so far as to argue that fiscal policy may be a more appropriate way to stimulate growth than monetary policy under current conditions. “In a situation of sustained weak aggregate demand, relying primarily on monetary policy to provide stimulus may lead to financial vulnerabilities that macro prudential policy cannot, or should not, offset. In such circumstances, fiscal policy may be called upon to provide stimulus, particularly since it is likely to be more effective at low interest rates.”
The case for fiscal stimulus, especially to deal with outright recession and to fund long term productive public investments, is now widely supported. But there is little agreement on what principles should apply.
One widely proposed rule, embraced by the federal government, is to allow temporary deficits so long as they do not increase the net federal public debt to GDP ratio. But there is no consensus among economists as to what ratio is too high, and econometric studies have failed to establish any specific tipping point.
A high public debt ratio is of less concern if interest rates are very low, if the debt is denominated in the national currency (meaning that there is no risk of default), and if the private demand for credit is weak. All three conditions apply in Japan which currently has a very high net debt to GDP ratio more than three times as high as Canada (132% compared to 41%.)
It is also worth noting that running a deficit is not the same thing as providing economic stimulus. Economists would generally agree that a budget boosts GDP if it changes the “cyclically adjusted” budget balance, usually measured as a share of potential output. Deficits caused by a decline in revenues due to slowing growth (very much the case in Canada today) are not stimulative, whereas deficits used to fund an increased public investment program would be stimulative.
To add to the complexity, a budget could be stimulative even if it did not increase the deficit so long as it increased spending in areas which give a big boost to GDP (such as higher unemployment benefits and public investment) and financed such measures from tax changes which have only a modest negative impact of GDP.
We live in a world in which even central bankers say we should rely more on fiscal policy to deal with slow growth. But that leaves plenty of room for disagreement on what rules should guide fiscal policy.
Andrew Jackson is Adjunct Research Professor in the Institute of Political Economy at Carleton University, and senior policy adviser to the Broadbent Institute
