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Fiscal Austerity Causing Long Term Economic Damage


While Canada's short term economic prospects are pretty gloomy, longer term projections are even worse. A major reason is that policy-makers here and in all of the advanced industrial countries have been content to settle for a very slow recovery which undermines our longer-term economic potential.

The April 2015 World Economic Outlook of the International Monetary Fund (IMF) forecasts a significant decline in potential growth in the advanced economies compared to pre-recession levels. Potential growth in the United States is pegged at just 2.0% per year, less than the modest forecast growth rate of 3.1% for this year and next.

The potential growth rate is determined mainly by estimates of future labour force growth and productivity growth, and reflects an economy's capacity to increase output without high inflation once economic slack has been used up.

Estimates of potential are probably conservative, but they largely determine monetary policy.

The IMF judges that potential growth has fallen because of a decline in business investment in new capital during the recession and recent weak recovery, slowing labour force growth due to ageing, a declining labour force participation rate, and (less certainly) a slowdown in innovation.

Here at home, an appendix to the latest Monetary Policy Report from the Bank of Canada pegs potential economic growth at just 1.8%, again even less than the already low 2.0% average private sector forecast for 2015 cited in the recent federal budget. The Bank of Canada places a lot of the blame on weak business investment which has reduced the capital stock and potential productivity growth.

The IMF report devotes a whole chapter to a study of low rates of business investment, and concludes that the key reason is a weak recovery. Businesses have the means to invest, not least with ultra low interest rates and buoyant stock markets, but do not see the growing market needed to justify increases in productive capacity.

The IMF also notes that a continued slack job market has led to a falling labour force participation rate, as has been experienced in both Canada and the United States where significant numbers of workers have given up looking for jobs.

The key problem is that growth in the advanced economies, especially in Europe, has been very feeble ever since the effects of the fiscal stimulus program of 2008-10 had run their course. Weak growth has in turn undermined the potential to grow faster down the road.

In his recent book, Hall of Mirrors, comparing the Great Depression to the Great Recession, Barry Eichengreen of the University of California, Berkeley reminds us that the United States really only emerged from a decade long Great Depression during World War Two. The New Deal was insufficient to spark a lasting recovery, especially after FDR attempted to balance the budget in 1936 and tipped the American economy back into recession..

Eichengreen, like Paul Krugman and even IMF economists, argues that the unprecedented fiscal and monetary stimulus given to the global economy by governments working through the G-20 was enough to stop the Great Recession from turning into another Great Depression, but that the premature turn to fiscal austerity since 2010 has left us with a very weak recovery.

Mr. Eichengreen argues that policy makers learned enough from the Great Depression to avert catastrophe following the financial crisis of 2008, but not enough to set the stage for a real recovery.

In his Foreword to the IMF report, Chief economist Olivier Blanchard notes that monetary policy has done all it can to sustain growth.  He argues that there should be more focus on public investment, particularly in those countries which do not have large deficits and high levels of public debt.

That group of countries would certainly include Canada, Germany, which could help spark a meaningful European recovery, and arguably the United States where the deficit is now falling rapidly.

The question is whether we should be content with dismal prospects, both now and down the road, or heed the lessons of history.

Andrew Jackson is Adjunct Research Professor in the Institute of Political Economy at Carleton University, and senior policy adviser to the Broadbent Institute.

This column originally appeared in the Globe and Mail.

Photo: John LeGear. Used under a Creative Commons License.