The Broadbent Blog

Wage suppression and the Federal Balanced Budget Act


In the October 2013 Speech for the Throne, the Canadian government announced it would introduce balanced-budget legislation. At the time this vague proposal attracted little interest from anyone, although a year later the Parliamentary Budget Office (PBO) did produce a substantial document analyzing the benefits and costs of such a proposal. 

Broadly speaking, the PBO seemed to see more disadvantages than advantages in such legislation, arguing that in all likelihood it would reduce the ability of the federal government to pursue proper counter-cyclical fiscal policy, and feared as well that the federal government might be tempted to shovel its deficits towards provincial governments or else engage in the kind of creative accounting that was pursued by the Greek government in the 2000s.

The PBO concluded that if balanced-budget legislation were to be introduced it would need to be a flexible one. As a follow-up to this, I wrote a blog (in French) criticizing the few presumed advantages that had been identified by the PBO.

Implications of the Act:

The Federal Balanced Budget Act that was included in the omnibus Bill C-59, and which passed third reading in June 2015, does not seem to have attracted much engagement either. The Act does not force the federal government to adopt a balanced budget – it has some of the flexibility advocated by the PBO. But it includes measures that discourage the federal government from taking expansionary fiscal measures pre-emptively before a recession is declared. Furthermore, it will induce the federal government to attempt to minimize budget deficits during recessions and to quickly achieve a balanced budget or budget surpluses.

My understanding of this law is as follows: first, if there is a budget deficit or if one is projected while the country is not in a recession (or in an extraordinary situation), the operating budgets to fund annual wage increases are to be frozen and the salaries of ministers and deputy ministers are to be diminished by 5 percent until the budget is back to balance. Second, if there is a budget deficit or if one is projected while the country is in a recession (or in an extraordinary situation), the operating budgets to fund annual wage increases and the salaries of ministers and deputy ministers are to be frozen as soon as the country is out of recession, until the budget is back to balance.

To provide some intuition of what this entails, recall that the last recession went from October 2008 to May 2009. The Act considers that "a recession ends in the fiscal year in which the second consecutive quarter of positive growth in real gross domestic product in Canada is recorded." This implies that the recession would have officially ended in March 2010. A freeze on the government operating budgets to fund annual wage increases would thus have been in place starting in April 2010 until the federal budget is back in balance, that is, until at least now.

Furthermore, since the Act defines a recession in the standard way, that is, "a period of at least two consecutive quarters of negative growth in real domestic product," the cabinet would have been encouraged to stand still until the recession had been officially declared, sometime after April 2009, and hence the stimulus program would not have been announced as early as January 2009.

Thus, roughly speaking, what the Act means is that: budget deficits can occur when a country experiences a recession, a war, or some large catastrophic event; when out of recession, consolidation should occur as fast as possible (the country should come back as soon as possible to a balanced budget); in other time periods, the government should run budget surpluses or balanced budgets.

This view of fiscal policy is what my colleague Mario Seccareccia has called new fiscalism: counter-cyclical fiscal policy should only be used when things are really bad, in particular when monetary policy seems to be running out of ammunition; otherwise, governments should achieve balanced budgets or surpluses. New fiscalism helps explain why, one year after the 2009 global expansion in government expenditure designed to fight the Great Recession, international organizations such as the IMF or the G-20 exhorted national governments to consolidate their budgets and implement austerity measures.

The Act has two obvious consequences. First, it is a wage control policy: consolidation occurs to a large extent by freezing the wages of civil servants or the overall government wage bill.  In effect, we now have two income policies in Canada (which more accurately should be said to be wage control policies). First, we have this new Federal Balanced Budget Act, which directly targets the wages of federal employees. Second, we also have the inflation-targeting policies of the Bank of Canada, which, in agreement with the federal Department of Finance, indirectly target the wage increases of all employees.

Labour unions and employers know that the Bank of Canada can always use the stick by means of what is an incomes policy of fear, because the central bank can always slow down the economy through appropriately large doses of high interest rates and greater unemployment. The effect of both incomes policies is to reduce the wage share in national income, which has a negative effect on domestic demand.

The second obvious consequence of the Act is that it weakens the federal role in economic stabilization. For example, the Act will reduce the desire of the federal government to pursue strong counter-cyclical measures in case of a recession. It will also weaken the desire of the federal government to pursue strong counter-cyclical measures when the Canadian economy has zero or low growth, while not being technically in a recession. And as pointed out earlier, the Act is likely to induce the federal government to shovel its deficit towards the provinces and thus provincial governments will encounter larger swings in their budget balances. 

This is bad news, because it has long been a tenet of public finance that the federal government is the institution best placed to pursue counter-cyclical fiscal policies. For instance, Richard A. Musgrave, the best known author of textbooks in public finance, has long pointed out that ‘responsibility for stabilization policy has to be at the national (central) level. Lower levels of government cannot successfully carry on stabilization policy on their own’. Musgrave added that ‘stabilizing fiscal policy requires periodic budgetary deficits or surpluses with corresponding borrowing and debt repayment. These pose a more serious problem for provincial governments, which have less ready access to the capital markets and no control over supporting monetary policy’.

While the Bank of Canada Act allows the Bank ‘to buy and sell securities issued or guaranteed by Canada or any province’, and while the Act allows the Bank to make loans to the federal government or to provincial governments, in practice the Bank only buys securities issued by the federal government. Indeed, the Bank currently buys 15 to 20 per cent of any new security issues of the federal government on the primary market. Thus if any level of government should encounter budget deficits, it should be the federal government because it benefits from a purchaser of last resort – the Bank of Canada – which has unlimited capacities to purchase bonds or bills issued by the Canadian government.

If investors were to lose confidence in the debt issued by the federal government – something that still needs to happen in the US and in Japan despite their enormous debt – the Bank of Canada, just like the Fed, the Bank of Japan, the Bank of England or the Reserve Bank of Australia, has the power to control the prices of securities issued by the federal government. These countries are thus immunized from the kind of problems that plagued some of the countries of the Eurozone (the GIIPS), as the European Central Bank declined to perform its duty of purchaser of last resort before 2012.

New fiscalism:

As implied earlier when discussing the new fiscalism, since the early 1990s until 2008, mainstream economists had relegated fiscal stabilization to the dustbin. It was believed that monetary policy was good enough to counter slowdowns or recessions, that fiscal policy was unable to stabilize the economy, and hence that fiscal policy should content itself to balance budgets, run more efficient programs, and possibly reduce tax rates.

This view, sound finance, modified somewhat by the new fiscalism view, is endorsed by the Federal Balanced Budget Act, which argues that ‘a sound fiscal position is crucial to economic growth and job creation over the longer term’, and thus that the federal government should ‘achieve annual balanced budgets and reduce debt, other than when a recession or extraordinary situation occurs’. It is said that such a sound fiscal policy will ‘instill confidence in consumers and investors’.

This is the confidence fairy that Paul Krugman has criticized so often in his blogs. The confidence fairy is the belief that despite a fall in aggregate demand, due to a contractionary fiscal policy that intends to bring the budget back in balance, falling sales will still induce firms to produce or invest more. Pundits like to give the Canadian federal budget of 1995 as a counter-example: but they forget to mention that the federal government did shovel its deficit to the provinces, that the Bank of Canada brought interest rates down after having produced our first home-grown recession in 1990-1992, that the exchange rate fell to almost 60 American cents, and that the Clinton boom in the US pulled up our exports.

Apart from the mainstream, there have always been economists who have held a different vision of what sound finance stands for. Michal Kalecki (in Selected Essays in the Dynamics of the Capitalist Economy) like Keynes, argued that with capitalism ‘the level of employment depends on the so-called state of confidence’, but he further contended that this gives ‘to the capitalists a powerful indirect control over Government policy: everything which may shake the state of confidence must be carefully avoided because it would cause an economic crisis. The social function of the doctrine of “sound finance” is to make the level of employment dependent on the “state of confidence”.’ This alternative view is thus that sound finance, like free trade agreements, is just another trick in the hands of powerful vested interests to gain more traction in society.

An alternative view:

The alternative to sound finance is functional finance, as proposed by Abba Lerner in 1943, which says that a government deficit or surplus, in and of itself, is neither good nor bad. While the proponents of new fiscalism came to recognize the ability of fiscal policy to achieve economic stabilization when the monetary authorities reached the zero-interest lower bound in 2008, the proponents of functional finance never doubted that counter-cyclical fiscal policy was an appropriate tool.

While their mainstream colleagues were all getting in the bandwagon of sound finance in the 1990s, several heterodox economists were fully endorsing functional finance, reiterating that counter-cyclical fiscal policy is a highly effective tool. This was done at the time, among many others, by James Galbraith , the son of John Kenneth Galbraith, and by William Vickrey, the 1996 Nobel prize recipient. More recently, neo-chartalist authors have been quite active in promoting functional finance and the renewed interest in fiscal policy, both in academia and in the blogosphere.

Despite functional finance being out of fashion in the 1990s, Steve Fazzari, a former colleague of the late Hyman Minsky, was also been quite adamant about the effectiveness of fiscal policy arguing as follows: "Conventional claims about the impotence of Keynesian fiscal policy are largely unfounded…. Our current state of knowledge provides no reason to reject Keynesian demand management principles as the appropriate response to an economy operating with substantial idle resources. Furthermore… effective Keynesian fiscal policy may raise potential output, as well as addressing problems of underutilized resources." This is now recognized to be true by a number of mainstream economists, such as Larry Summers the former Secretary of the US Treasury, and economists at the IMF.

Another subprime financial crisis?

Besides these arguments in favour of a fiscal policy unhindered by sound finance considerations, there are a couple of further arguments against a Federal Balanced Budget Act. First, investors and pension funds are always on the look our for super-safe assets. If the federal government keeps running balanced budgets or budget surpluses, the financial system will run out of a sufficient amount of safe assets and will engage in the kind of dicey operations that led to the subprime financial crisis.

Second, as much as it may seem bizarre, in a growing economy, balanced public budgets are conducive to more financial instability. This can be shown by looking at flow-of-funds identities, which were used by many of those who predicted the global financial crisis, but which are ignored by advocates of sound finance. If households wish to accumulate net financial assets such as RRSPs or pension funds, (in a closed economy) this can only be done either because the corporate sector is accumulating net financial debt or because the government is running budget deficits.

For a given desire of households to accumulate net financial balances, balanced public budgets imply a larger accumulation of corporate liabilities. If corporations are accumulating cash reserves, as they have in most years of the recent past, balanced public budgets imply less additions to household financial assets or more additions to household financial liabilities  – hence less financial stability.

Thus, to conclude, the federal government is not a province, and is not subject to the same budgetary constraint. If there is a level of government that can afford to pursue substantial counter-cyclical policies and run large deficits, it is the federal government, as it can always benefit from the support of the Bank of Canada and thus runs no risk of default as long as its debt is denominated in Canadian dollars.  No law should hinder the federal government from running budget deficits to achieve the full employment of Canadian citizens.

Clearly, the Federal Balanced Budget Act should be repealed now that the Conservative government is out of power.

Marc Lavoie is Professor in the Department of Economics at the University of Ottawa and Broadbent Institute policy fellow. 

Photo: D.Neuman. Used under a Creative Commons BY-SA.2.0 license.