Skip the stimulus
There’s an almost symbiotic relationship between financial markets and modern media cycles. Financial markets absorb a continuous flow of new information and incorporate it into asset prices, and the resulting market movements provide raw material for the media. This relationship may work well for both parties, especially since financial markets work at the same high frequencies as the media. But it distracts attention away from other, potentially more important data sources, and offers a distorted background for policy debates. The fact that financial markets dominate the daily news doesn’t mean it’s the only or even the most important source of information about how the economy is doing or what govern- ments should be doing.
The most recent news coming out of financial markets is not good: a depreciating dollar reduces our purchasing power, and falling stock markets represent a reduction in net worth. And as this news gets repeated day after day, the urgent tone mounts — as it must if it is to still be considered news. The most recent addition to the dynamic is a wave of press releases from bank economists calling for immediate fiscal stimulus to address the “crisis.” And since private-sector economists are a pivotal node in the finance-media ecosystem, this advice has been amplified into banner headlines in which Ottawa is said to be “under pressure” to implement fiscal stimulus.
The most remarkable feature of this advice is its lack of sophistication. There are many steps you have to work through before you get to recommending fiscal stimulus, and approximately none of them are addressed in these analyses. The crudest version of this story says that Ottawa should increase spending as a direct response to the fall in oil prices and the resulting depreciation of the Canadian dol- lar. This narrative is almost certainly wrong: there is no mechanism that I know of by which changes in government spending ( a demand response) can offset the effects of changes in oil prices (a supply shock). If Bay Street knows of one, they should let the rest of us in on the secret.
A slightly less crude version goes like this: there is still some residual slack in the economy left over from the recession that ended more than six years ago, so the federal government should move immediately to stimulate demand. This raises an entirely different series of questions, not the least of which is “why now?”
Another is why Ottawa should be resorting to fiscal stimulus, even if there were significant levels of idle capacity. According to the New-Keynesian paradigm that – for better or for worse – is the consensus theoretical framework for Canadian macroeconomic policy analysis, fiscal policy is not of much use unless interest rates are at the effective lower bound ( ELB). We used to think that the effective lower bound was zero, but recent experience in Europe suggests that central banks can actually push interest rates below zero before people stop using banks to hold their money. Since the Bank of Canada’s policy rate is still above zero, we’re still in a situation where monetary policy is still more likely to be effective than fiscal policy.
And of course, it’s not clear that there will be any measurable slack in the economy by the time any stimulus measure – monetary or fiscal – takes hold. The drop in oil prices is likely to close any remaining output gap by reducing the economy’s potential, even if demand stays weak. And it’s probably worth remembering that the unemployment rate in December was still only 7.1 per cent, well below the post- 1976 historical average. Moreover, federal government revenues remain surprisingly robust, and the federal budget balance is running ahead of what last April’s budget projected. Why implement fiscal stimulus if the automatic stabilizers built into the tax system haven’t even kicked in?
It’s not impossible to arrive at the conclusion that t he f ederal government should use fiscal policy to increase aggregate demand: you can mount a strong case to support the stimulus package in the 2009 budget. But instead of meeting and answering the theoretical and evidence- based objections to using fiscal policy, bank economists seem comfortable with proceeding as though these counter- arguments simply don’t exist.
The second-most remarkable feature of the policy recommendations coming out of Bay Street is their lack of diversity: no one seems willing to go public with the claim that immediate fiscal stimulus would be at best a pointless gesture in the short or medium term. In contrast, the academic economists who have picked their way through the theoretical thickets of macroeconomic policy analysis have either rejected the case for fiscal stimulus to boost economic growth in the short or medium term, or have concluded that a convincing case has yet to be made. ( They generally remain open to the idea of using wellthought- out infrastructure projects to promote longterm growth.)
This is a problem, especially when you consider that the price of admission to the private, pre- budget consultations with the Minister of Finance is a forecast for the Canadian economy. For reasons I have discussed earlier, macroeconomic policy analysis and macroeconomic forecasting are very distinct fields: expertise in one does not suggest expertise in the other. By giving a special role to forecasters, these consultations give an additional advantage to Bay Street, beyond its stranglehold on media coverage of the economy.
THE FEDERAL GOVERNMENT CAN’T ‘FIX’ WHAT’S CURRENTLY HURTING THE ECONOMY. BUT THEY’RE BEING URGED TO TRY.