Winner of the New Statesman SPERI Prize in Political Economy 2016

Monday, 26 October 2015

Keynes never left Canada, and intends to stay

Nick Rowe has a post where he points out that the outgoing Conservatives did not abandon Keynes during the Great Recession. He takes a graph of government spending from an article by Matthew Klein, but we can make the same point be looking at the underlying primary balance. (As I have noted many times, no measure of fiscal stance is ideal. If you want a more detailed analysis of the Canadian macro position than I will give here, read the Klein article.) According to the OECD, this moved from a surplus of 2% of GDP in 2006 to a deficit of 3.2% of GDP in 2010. We saw a similar countercyclical swing in fiscal policy in the US, but whereas that swing was sharply put into reverse in the US, in Canada the deficit was still 1.8% in 2013. (The UK was like the US except the peak deficit was in 2009, and the reverse was well under way by 2010.)

So we saw a classic Keynesian fiscal policy in Canada. Partly as a result, Canadian GDP only fell by 2.7% in 2009 and grew strongly in the next two years. That in turn meant that short interest rates only stayed on their floor for just over a year, and rose to 1% during 2010. So it all looks like a textbook New Keynesian policy, and close to the one recommended in Portes and Wren-Lewis: fiscal expansion helped get interest rates above their lower bound.

That was then. More recently GDP has been falling, and interest rates have been cut to 0.5%. So is it time for a tight fiscal policy, or instead some additional deficit financed public investment? Ask the man on the escalator, the new Canadian Prime Minister. In the election Trudeau played a classic Keynesian card (Labour leadership please note). Both his two opponents criticised this deviation from a balanced budget policy. Trudeau won, so Keynes remains in Canada. While interest rates may not have yet hit their lower bound, it makes sense to borrow to invest when rates are low and when there is a significant risk rates could hit ‘zero’ (Osborne please note).

Unlike governments in Europe and the US, Canada did not dash for austerity just as the recovery was beginning and while interest rates were still on their floor. They had a clear choice a week ago to allow a deficit to finance investment or go for a balanced budget, and they chose the more sensible fiscal policy. I think there are two lessons beyond Canada. First, right wing governments do not have to make major macroeconomic policy mistakes with fiscal policy. Second, voters do not always suffer from deficit fetishism.


21 comments:

  1. Good post. As you suspect, I half agree.

    (New) Keynesians recognise that fiscal policy can run out of ammo, and it makes sense when above the ZLB to (slowly) bring the debt/GDP ratio down again to what it was before the recession, to replenish your "fiscal space"/ammo box ready for the next emergency. Now Canadian GDP has been weak recently, but the usual signals of a recession aren't all there, and the Bank of Canada has not called for help in keeping inflation at the 2% target. It looks more like a supply-side shock caused by low oil prices.

    Now the Bank of Canada could be wrong (and the 2% inflation target is wrong), but that's the rules of the game. So there is no reason not to expect full monetary offset of fiscal policy, especially since the exchange rate can be allowed to fall further, if needed.

    This does not mean there are not reasonable arguments for the government borrowing to invest at low real interest rates (though we are maybe running out of somewheres to build bridges to, given all the preponed investment in 2010) but I wouldn't call that a "Keynesian" argument. More like a Summersian argument.

    It's very difficult to know why people vote the way they do, so we can't say whether the Liberals won because of or despite their announced fiscal policy. The major motive is that after 9.5 years many voters were fed up with the Conservatives and hated PM Harper, and wanted Anyone But Harper. The Liberals are the centrist establishment "natural party of government". The NDP (sorta Social Democrats) put on a credible performance, and were even leading the polls at one point (I can't remember that happening before), but eventually were done in by strategic voting by the ABC voters. Liberal Paul Martin (who was the finance minister who turned a big deficit into a big surplus in the 1990's) accused Harper of being "King of Deficits" for having run big deficits during the recession, and the accusation resonated.

    ReplyDelete
    Replies
    1. Oh, and I really want to push my old post on the preponed government spending multiplier, my excuse being that it is very relevant in this case.

      In a very simple NK model at the ZLB, the transitory government expenditure multiplier is one. But the preponed government expenditure multiplier is *two*. You *bring forward* investment expenditure that you would have made anyway.

      http://worthwhile.typepad.com/worthwhile_canadian_initi/2011/03/the-preponed-government-spending-multiplier-may-exceed-one.html

      Delete
    2. " the Bank of Canada has not called for help in keeping inflation at the 2% target"

      I recently learned something interesting from the economist Jared Bernstein about the U.S.:

      "....since the late 1970s, we’ve been at full employment only 30 percent of the time (see the data note below for an explanation of how this is measured). For the three decades before that, the job market was at full employment 70 percent of the time."

      The "Great Moderation" started around the late 1970s where the Fed focused on keeping inflation low. We've seen the results. Wage stagnation and rising inequality. The economy is subjected to a more severe bubble/bust cycle.

      After Bill Clinton won his first election he was convince by Robert Rubin and Alan Greenspan to drop his middle class spending bill in exchange for lower rates. DeLong believes this was worthwhile. I disagree and believe it is partly to blame for the economic dysfunction that has followed: wage stagnation, increasing inequality, Tech stock bubble, housing bubble and epic financial crisis.

      Maybe Trudeau will pull a Clinton. I would hope not, but Trudeau goes ahead what does Nick Rowe expect to happen? The BoC raises rates to compensate?

      But wouldn't that be a good thing? The BoC would have more room to lower rates in the event of the next recession.

      The excessive focus on the debt-to-GDP ratio seems to be symptom of deficit fetishism. Once labor is sharing in productivity gains, yes pay down the debt and help the BoC fight inflation.

      Delete
    3. "There is no reason not to expect full monetary offset of fiscal policy" - really? So Canada won't be like everywhere else and discover that low inflation is far more stubborn than the central bank forecasts ... And anyway, if Canada miraculously experiences a return to trend growth and 2% inflation and the Bank of Canada "normalises" interest rates (is that the 'offset'?), will anyone be complaining. Sounds like financial stability, price stability and trend growth ... Well done, Canada.

      Delete
    4. WITH TRUDEAU IN POWER CANADA WILL GO INTO A RECESSION LIKE ITS NEVER SEEN BEFORE

      Delete
    5. Because if you type it in capitals, things always come true...

      Delete
  2. Minor follow-up:

    "First, right wing governments do not have to make major macroeconomic policy mistakes with fiscal policy. Second, voters do not always suffer from deficit fetishism."

    The first one I agree with. (The Conservatives did cut VAT ("GST") by 1% before the recession, which was a mistake, though maybe not a *major* one, since we still had a surplus and the debt/GDP was low.)

    The second is arguable. Canada ran big deficits under (Lib) Trudeau pere, and turning those big deficits into big surpluses in the 1990's under (Lib) Chretien/Martin (ironically, Chretien had been Trudeau pere's finance minister) was like a drunk going on the wagon. So "deficit fetishism" is still strong (the lefty NDP are not politically stupid, and promised to balance the budget to appease that fetishism.

    ReplyDelete
  3. Good for you, Canada! We have had a similar experience here in Sweden with both right and left acting like Keynesians in government although this was complicated by a law that limits the amount of deficits allowed during "an economic cycle". The former right-wing government pushed deficits as high as they could under this limit while the current left-wing is trying to repeal the law.

    I think Nick Rowe above may have a point though since both the left and right (in Sweden) talked like deficit hawks, at least during the run-up to the last two elections, even as their actions were Keynesian. Clearly they both felt a need to cater to deficit fetishism.

    ReplyDelete
  4. The trouble is you old "New Keynesians", are so far behind the curve as the hip kids say nowadays. DSGE printouts from those old Amdahl mainframes, are used as door stops before being shredded for horse bedding.

    Horse stable bedding is where those old IS-LM / AD-AS Models should be. I think the last eight years have conclusively proved them to be total horse***t, to be precise.

    May I suggest a couple of blogs on your way to the "Post Keynesian", non laissez faire, non neo-liberal world of Lerner; Godley and Minsky. http://fictionalbarking.blogspot.co.uk/2011/03/economys-flow-of-funds-is-closed-system.html . And; http://wallstreetpit.com/8568-the-sector-financial-balances-model-of-aggregate-demand/ .

    The test question to prove you are not a robot. "What is the basic difference between the way the Central Bank of Canada works with the Canadian Federal Treasury, compared to say, the BoE works with the UK Treasury? Answers on a post card to Governor Mark Carney at the BoE.

    ReplyDelete
    Replies
    1. Your test question:

      Canada is weird. Notes are a liability of the Bank of Canada, but coins are not. IIRC, the UK is even weirder, with neither notes nor coins a liability of the BoE. Weirder still, as a Crown Corporation, the BoC is an asset of a little old lady who lives in London England. Is that what you had in mind?

      Delete
    2. In economics, liabilities are not optional extras, in contrast to the idiosyncrasies of accounting convention. Nor does something which is not a liability (i.e. base money) become so by designation.

      Delete
    3. Nick,it was really because I had a similar discussion about the "smoke and mirrors" money-go-round, that keeps about 5,000 people employed at the BoE and UK Treasury.

      The major difference is that of the the Bank of Canada (BoC), buying government paper in primary auctions, while the BoE is strictly forbidden from doing the same. You will be aware that BoC is consulting on changing to a FED / BoE "reserves" system. It will make operating a QE type monetary intervention easier.

      A recent thread started with the publication of the WGA in the UK. Interested persons started noticing that WGA, compiled under IFRS, like any large multinational; was "letting the cat out of the bag" and that a sovereign fiat currency issuing government works exactly how MMT says it works.

      http://www.bondeconomics.com/2015/06/how-should-bank-of-canada-operate.html

      http://www.3spoken.co.uk/2014/03/uk-whole-of-government-accounts-some.html

      All the best Acorn.

      Delete
  5. "The Conservatives did cut VAT ("GST") by 1% before the recession, which was a mistake, though maybe not a *major* one, since we still had a surplus and the debt/GDP was low"
    No it wasn't. In fact it probably meant the recession was more mild as compared to them not doing that.
    The *private* debt/GDP ratio - household debt has been increasing to crazy levels.
    Take a look at this BillyBlog graph:
    http://bilbo.economicoutlook.net/blog/?p=31985
    "The next graph shows the contributions to real GDP growth of the major expenditure components since the March-quarter 2013. The graph is a classic depiction of the boom-bust cycle that resource exporting nations face.
    The Government was able to cut spending in 2013 and 2014 without seriously undermining growth because net exports were so strong as was the accompanying business investment. Support also came from the fairly robust household consumption contribution (more on this later).
    With the resources boom over, the only thing that is driving growth now is household consumption."
    http://bilbo.economicoutlook.net/blog/wp-content/uploads/2015/10/Canada_Contributions_June_2015.jpg

    ReplyDelete
    Replies
    1. "The Government was able to cut spending in 2013 and 2014 without seriously undermining growth because net exports were so strong as was the accompanying business investment."

      This reminds me if an earlier situation.

      'As Smallwood points out, the Treasury and Bank drew the wrong conclusion from the apparent success of the combination of fiscal contraction and monetary expansion in the 1980s and 1990s. "In both cases, the contractionary impact of tax rises and spending cuts was counterbalanced by substantial falls in interest rates, and of the sterling exchange rate at a time when our export markets were growing," he writes. Exports and investment took up the slack left by budgetary cuts.'

      http://keegan94.rssing.com/chan-14842860/all_p1.html

      Delete
  6. "fiscal policy can run out of ammo,"
    Then New Keynesians are wrong. It can't run out of ammo.
    "(New) Keynesians recognise that fiscal policy can run out of ammo, and it makes sense when above the ZLB to (slowly) bring the debt/GDP ratio down again to what it was before the recession, to replenish your "fiscal space"/ammo box ready for the next emergency. "
    Fiscal space is the real resources in the country.
    Deficits do nothing of the sort.
    It allows people who want a big number in their account to have one. It is unlikely to cause a problem by them having a big number, but it makes them feel nice. Which means they'll continue spending.
    That's the same with all of us. And no matter what the interest rate is set to.

    ReplyDelete
  7. At least we're getting 'moral' and 'political' arguments thrown around now.

    If Nick Rowe wants to be 'moral' then he needs to identify whose savings he's going to steal, or who he is going to put deeper into debt. Because that's what he has to do. Identify them and find a way of doing it that doesn't stop them spending.

    "though we are maybe running out of somewheres to build bridges to, given all the preponed investment in 2010"
    Really? You don't say.
    Right, Canada has been doing "investment" since the recession. Spending needs to engage all resources, regardless of if some accountant arbitrarily decides it to be investment or not.
    A similar problem occurs with the "balance the current budget" idea:
    http://www.3spoken.co.uk/2015/09/corbynomics-and-current-budget-balance.html?m=1

    ReplyDelete
  8. "replenish your "fiscal space"/ammo box ready for the next emergency."

    Misleading analogy.

    By restricting output and raising household debt now you have *less* ammo and private sector resilience.
    Totally stupid to have your ammo manufacturers at half capacity and lots of unemployed soldiers who have lost their will to fight and will need to be retrained.

    The real issue is effectiveness, that is, achieving desirable outcomes. It's about ends. Efficiency is about means, essentially getting the most from resources without compromising other vital factor like effectiveness and resilience. Militaries know this, for example. Efficiency is not tops on their list. Being resilient enough to handle contingencies and winning conflicts is way ahead of efficiency.

    Militaries are there to protect society. So is the economy, which is a society's life-support system. It's there to support life not make some individuals and families wealthy as the rich presume.

    If World War 3 broke out would politicians care about "debt to GDP ratios." They would engage all resources. Would they rely on volunteer soldiers? Nope. Deliberately not use resources "to control inflation"? Nada.

    The correct analogy is that deficits build up a nongovernment sector tin shed.

    If we can have full employment bombing Germans, we can have it in peacetime. And we did for a while. People demanded it. They should again.

    ReplyDelete
  9. My problem, in terms of assigning credit for optimal Canadian fiscal policy, when I look at who incurred the net deficits, from 2006 to 2015, is that only 60% of the net deficit volume belongs to the federal government. 40% belongs to the 10 provinces, mostly run by Liberal governments. Total accumulated (net) deficits were $201 billion, of which $119.8 were federal, and $81.2 provincial. The volume attributable to the federal government occurred from 08-09 to 13-14, in the following percentages: 134,67,61,59,53, and 26%. In 14-15, the feds ran a small surplus ($2 billion) while the provinces were still running $11.5 billion in deficits.

    In the meantime, total government debt rose from 71% of GDP to 87.5% of GDP, an increase of 16.5%. During the same period, GDP per capita increased by 6.3%.

    So who deserves the credit for what is being considered a very successful economic policy?

    ReplyDelete
  10. Undoubtedly beside the point, but apart from the parlous state of Canada's railway track and a rather large number of bridges needing immediate attention, the country's housing stock currently requires in the neighbourhood of five times as much energy to heat than it ought to, sprawling suburbs are crying out to be knocked down and rebuilt as denser urban infill, and Aboriginal communities are facing severe crowding and indoor air quality. Practically all Canadian hospitals are obsolete, and public transit is vastly underfunded. My own city recently cancelled plans to build a modern waste recovery and processing facility in favour of good old-fashioned dumping, as well as plans for an LRT system. I don't think we're short of options for building infrastructure, despite a brief dose of spending (and lots of tax cuts) brought in by the minority Conservative government in 2009.

    ReplyDelete
  11. There is a direct UK connection to Canada's fiscal response: Mark Carney and his one-size-fits-all approach to economics. The approach: pumping residential real estate markets to trigger a housing boom and most importantly wealth effect AND home building jobs (and all the favourable domestic multipliers attached to home building).

    In Canada, he plunged rates and the government pumped up home mortgage guarantees to the point where our national debt is now roughly equal to the home mortgage guarantee debt of the CMHC (Canadian Mortgage Housing Corporation - our version of Fannie/Freddie). Both are now about C$600B. All mortgages over 80% LTV must be guaranteed. We've binged with high ratio.....it's as if no one here caught CNN and the housing crash in 2008.

    It was the domestic housing BOOM that bailed out our economy and create fantastic employment figures. Our housing prices are now the highest on the planet (except for Hong Kong - a different universe) when measured on price-to-income.

    But the employment and multipliers from residential development are wonderful. And the mortgage debt is at least partially covered by the home owner. It'll be fine, until it isn't.

    BTW, through all of this Carney continued to TALK about how risky real estate was, how he might increase rates etc. etc. for years. Just as he is doing now in the UK. One trick pony. But the trick works....until the housing bubble bursts.

    The fiscal stimulus in Canada was dwarfed by the housing bonanza. The scary part is how our industrial base has been eroded beyond recognition and replaced by brick layers, real estate agents and "home stagers".

    I'm a Keynesian at heart, but I don't think Keynes recommends a housing bubble to solve demand problems. Although this is better than digging holes then refilling I suppose.

    -Gary M
    Vancouver, BC |(the epicenter of the bubble)

    ReplyDelete
  12. Alberta's new budget seems to also be heavily influenced by Keynes - http://www.cbc.ca/news/business/alberta-deficit-economy-1.3291097

    ReplyDelete

Unfortunately because of spam with embedded links (which then flag up warnings about the whole site on some browsers), I have to personally moderate all comments. As a result, your comment may not appear for some time.