Canada is in recession. It's central bank chief Steven Poloz made it official on July 15th, with his comments follwing this year's second rate cut. Blame it on the price of oil. That's Prime Minister Harper's line as he pursues fiscal austerity despite a weak economy. Unfortunately, its the same tired, false equivalency between household and government finances, coupled with the myth that fiscal austerity will magically lead to prosperity. In a demcracy, the people get the government they deserve, and old ideas die hard. Canada's upcoming election is an opportunity for Canadians to reject the long dead idea that austerity is good for growth or that governments face the same kind of fiscal constraints as the private sector. It's high time that government budgets are formulated with sound economics, not dysfunctional politics.
Canadian Surpluses:
Government surpluses in Canada have been frequent occureneces over the past 50 years. Politicians in Canada like to take credit, extolling the virtues of "balancing the books." However, these surpluses are merely the result of the larger commodity cycle. For example, when oil prices soared in 1974 as a result of the Arab embargo, the Canadian achieved a massive budget surplus of 8 percent of GDP. When oil prices normalized in mid eighties and 90s, Canada ran mostly deficits. The has repeated a few other times. By 1997, commodity prices were rising again, and would do so until the financial crisis. For nearly all these years, Canada ran budget surpluses which again became huge deficits once oil prices crashed in late 2008.
It is also important to realize that the stance of Canada's fiscal policy is by definition tied to its external balance with the rest of the world. Recall that:
Y = G + I + C + (X-M)
can be rewritten as
(S-I) = (G-T) + (X-M)
The above equations are well know macro economic accounting identities. The term (S-I), or savings minus investment, can be thought of as the private sector's budget balance.
(G-T), or government spending minus taxes, is the state's fiscal balance. And finally, (X-M), or exports minus imports, is the external balance with the rest of the world.
Thus, the private sector can only achieve a surplus if the government is in deficit or if the country has a positive trade balance. Intuitively, this makes sense because private sector financial wealth is frequently cancelled out by private sector financial debt. Each time a credit card is swiped, new debt is created which on net cancels out the increased financial balances of those receiving credit card payments. However, most private sector agents desire to increase their net financial wealth over time. But again, this is impossible in aggregate without a government deficit or a trade surplus since one man's spending is another man's income.
In 2015, the Canadian economy is receiving twin shocks. Prices for its exports have fallen, which has resulted in a current account deficit. At the same time, the Government is mindlessly insisting on balancing the Federal budget. This only further squeezes the private sector's balance sheet. In other words, since the Government is running a nearly balanced budget, and the current account deficit is about three percent of GDP, the Canadian private sector by definition must be in deficit. And finally, the natural reaction to drop in income is to reduce spending. Both the Canadian household and corporate sector are rolling back their spending plans, further depressing economic activity.
Bank of Canada:
With fiscal policy makers hard at work to slow the economy, despite a renaissance south of the border, the Bank of Canada has come under enormous pressure to cut interest rates to keep the economy chugging along. Furthermore, divergence in the respective monetary policies of the Bank of Canada vis-a-vi the Federal Reserve has contributed to a large depreciation of the Canadian Dollar. In recent months, the Loonie has even performed worse than the Euro and Japanese Yen, whose respective central banks are in the midsts of implementing unprecedented easing programs.
The BoC has clearly indicated in its communications that it hopes a weaker CAD will boost manufacturing exports and help close Canada's trade gap. That would shore up the Canadian prviate sector's balance sheet as aggregate earnings from abroad came into balance with money spent on imports. However, a weak dollar policy is a rather crude mechanism for fixing the private sector's balance sheet problem. With oil prices falling faster than the CAD, it would take substantially more weakness in the Loonie to actually close Canada's trade gap.
Other dynamics are also at play, such as the price elasticity of demand for Canada's non-oil exports (since a weaker CAD makes Canadian exports cheaper abroad). In any event, it is uncertain if a weaker CAD can by itself rebalance the Canadian economy. And even if it could, the process could lasts years.
The primary mechanism by which monetary stimulates the economy is via reducing the cost of credit. However, Canada's problem is not a lack of private sector borrowing, but too much of it. Canada has one of the most indebted household sector's in the developed world. History shows that it is large secular increases in private sector leverage, not public debt, which portend crisis. In both the 1920s and 2000s, the rate of credit growth accelerated to unprecedented levels. Furthermore, 1929 and 2008 both saw all time highs in private debt as a percentage of GDP. Those years also share something else in common, namely, specutarly declines in asset prices and financial crisis. A similar phenomenon occurred in Japan in the early 90s, and Sweden in 1992. A massive build up of private sector debt led to the bursting of the credit bubble and then to financial sector and household insolvency.
Fiscal Policy:
The response of the US corporate and household sectors to massive reductions in borrowing costs in the wake of the financial crisis was largely predictable. Rather than take on new debts in the face of a deep recession, most people preferred to shed excessive debts and repair their balance sheets. Despite record low interest rates, credit growth in the US was basically flat until 2014, a full five years after the official end of the Great Recession.
A key lesson from the financial crisis, and the Japanese malaise, is that interest rate reductions are not the answer private sector indebtedness. Government deficit are. When the government spends more than it taxes, the net income it provides to the private sector allows households and firms to earn their way back to solvency, allowing for private investment and consumption to return to prerecession levels. Today, Canada is using the wrong tool solve its problems.
Harper's Gambit:
The hallmark of Stephen Harper's reelection pitch has been achieving a balanced budget. This rather folksy, austere message is meant to appeal to misguided voters who believe government budgets are like household budgets. This idea is a dangerous myth. Governments can print money and tax. Countries like Canada which issue debt in their own currencies also control the interest rate at which they borrow via their own central banks. There can be no issue of debt sustainability or state solvency. While it is indisputable that excessive money creation via deficit spending can be inflationary, that is unlikely to occur during recessions when large output gaps exist. Big deficits in the US and the UK, accompanied by full blow QE, failed to produce meaningful inflation in either nation precisely because so much excess capacity existed in the wake of the crisis. There wasn't the classic case of "too much money chasing after too few goods." Rather, firms responded to what little new spending there was by ramping up capacity, not raising prices.
Nobody disputes that it is a good idea for households to save money. However, the aggregate household sector cannot save without a trade surplus or a government deficit. At a time when Canadians are desperately trying to reduce their debts and increase their savings after years of heavy borrowing, and when the trade deficit will widen because of low oil prices, it is madness for the Government to pursue contractionary fiscal policies.
Harper demeans potential stimulus as short-sighted and irresponsible. History and facts about government spending under sovereign currencies refute this assertion. There is nothing responsible about keeping people out of work or reducing economic output with restrictive fiscal policy.
Sadly, Harper's gambit may pay off. Should commodity prices rebound and he somehow pulls out a relection win, he will no doubt brag that fiscal austerity works. But something as important as jobs and the vitality of the economy ought not be the purview of politics, or of politicians trying to appeal to far-right constituencies. Canadians (and Americans) would do well to remember this as the head to the polls this October.
Conclusion:
Meanwhile, the United States continues to outperform the other advanced economies, and that its includes its northern neighbor, the nation of Canada. Given the integration of the US and Canadian economies, the consensus from a few years ago was that US would pull up all of North America. To be sure, most of that thinking was developed before the crash in oil prices. Nonetheless, Canada's pro-cyclical fiscal policy, in contrast to the flexible and counter-cyclical fiscal policy of the United States, largely explains much of the two nations' divergence in economic performance. Excessive fiscal tightening, and the over reliance on monetary policy is worsening Canada's downturn. Canada would do well to learn from the lessons of history and recent experience. Austerity didn't work in 1930, it didn't work in Europe in 2011. And it won't work in Canada.
