...against fictions and other tall tales

Thursday, 8 December 2011

BoC: The euro area is experiencing a recession, deleveraging and fiscal austerity are dampening growth in advanced economies

The Bank of Canada (BoC) released today the December edition of its biannual Financial System Review. The report provides an excellent glimpse of the various trends now affecting the Canadian and world economies.

According to the BoC, the risks to the financial system are similar to those identified in the June report. However, the BoC judges that the overall level of risk has "increased markedly" over the past six months.

The main risks identified by the BoC in the report are:
  • the spillovers associated with a further escalation of the European sovereign debt crisis;
  • an economic downturn in advanced economies that could be amplified by remaining weaknesses in the balance sheets of global banks;
  • a disorderly resolution of global current account imbalances;
  • financial stress in the Canadian household sector; and
  • a prolonged period of low interest rates, which may encourage imprudent risk-taking and/or erode the long-term soundness of some financial institutions.
While I don't agree with the entire assessment contained in the report (for instance, I disagree with the report's claim that the public debt-service burden in the US and Japan is a problem, and that global imbalances pose a high risk to the world economy), I found that the report has interesting and well-supported analyses on some of the key trends that policymakers should monitor in the coming months and years.

The section of the report on Canada's increased household indebtedness is particularly noteworthy. As I've previously highlighted, Canada's household debt-to-GDP is currently at a record high. According to the report, the situation could take a turn for the worse in the event of a significant decline in house prices and a sharp deterioration in labour market conditions (p.26). With Canada's unemployment rate increasing, business investment slowing and final domestic demand declining, I view the possibility of these risks materializing as being quite real.

Also, in regard to the situation in Europe, the report mentions that the euro area is now experiencing a recession and correctly points out that a comprehensive policy response is urgently needed to resolve the debt crisis. On this point, the report states:
The European sovereign debt crisis is acute, but it can be resolved if policymakers address the situation in a forceful manner. European authorities must take steps to restore confidence, which will create time to refound their monetary union based on credible fiscal arrangements and enhanced governance.

European authorities are working to strengthen the capital of European banks and provide a more reliable funding backstop for euro-area sovereigns. But, judging from the lingering skepticism of investors, bolder action—including clear decisions and firm implementation—is needed to get ahead of the crisis. (p.14)
Finally, the report indicates that an economic downturn in advanced economies
would have a substantial impact on Canadian businesses, households and financial institutions. While the most obvious channel of transmission would be via the effects of deteriorating credit quality on bank capital bases, these effects could be amplified by significant vulnerabilities in the global economy, including an intensification of funding pressures and of fiscal strains. (p.14) (emphasis added)
According to the BoC, the risk described above is judged to be high and has risen since June, owing primarily to the deterioration in the global economic outlook.

All in all, the picture drawn in the BoC's report is bleak. Therefore, from a macroeconomic policy standpoint, it would be prudent for federal and provincial governments to abandon efforts to cut public expenditures and reduce fiscal deficits. Rather, governments should prepare for the worse and draw up plans to inject additional stimulus into the economy if the need arises in the coming months.


  1. seconds for desserts. excellent write-up, Circuit. gc in another post commented that the euro-area might not hold on. if he says so, it won't.

  2. I saw GC's comment earlier this AM. I responded in the affirmative. I think he's reading it correctly. The tension at all levels must make it hard to find a course. The speed of the market dynamics, the irreconcilable political positions, the ever-present media spotlight: the fog has set. Hopefully, Geithner has brought in the best.

  3. Circuit,

    Thanks for all the statscan links. Now I can use that information for my own devices without having to pay.

    Great post. From an economic perspective, I agree completely. From a political perspective, the federal government will probably wait for a recession to occur before stepping in. I think the government can live with weak growth, but not a recession. What is the point of fixing a crisis before it occurs? The government can't score any political points that way. Moreover, everyone in Alberta and Saskatchewan would hallucinate if the federal government introduced stimulus, given their robust labour markets. In November, the unemployment rate in Alberta and Saskatchewan was 5.0% and 5.1% respectively(http://www40.statcan.ca/l01/cst01/lfss01c-eng.htm).

  4. @jh...'might not hold' seems conditional. gc is literal. It should hold less the UK. Cameron did the right thing.

    @circuit-your takes on EU have been very good and I commend them. Now, the political predicament of markets imposing sovereign values is now tabled. Is politics subservient to monolithic economic criteria that is prescribed, with 'sound and fury' signifying little else than a pricing tag, and respective RoI. This is questionable. Are we challenging the very basis of essential democratic institutions, of national interests and autonomous polity? I think one of your nods (Ken Wheare) would find this nexus problematic. Nice work on the BoC!

    @bumzo: I like your cautions on stimuli, but regional allocations need neither be commensurate nor similar. There are sufficient policy resources to accommodate the diversity of our leads and lags on the diverse economic settings and prescriptions of the country. On the other hand, you are more than insightful when you suggest that the GoC may just wait it out (nod!).

  5. Timing is a matter of timing,lol

    As a sovereign issuer, I do not think that Gov. King and his circle would have approved otherwise-opting out is best. The downside risks for the UK were enormous. What the EU now means will be articulated by the needs of many and the demands of a few. How long will the needs of many tolerate the political and economic contractions and contraptions of so-called 'euro-survival'.

    I assume Joe Stiglitz will respond to Larry Summers recent op-ed on the Washington Post:

    The governance issue is one; the funding is another, and the regulatory format is a third. One should not complicate the setting.

  6. Welcome Bumzo. Good comments. Glad you appreciate the links. I agree with Swells that stimulus plans could be targeted to specific areas. But your political feel seems right on. As a result, we probably won't see much action until the hurt has started. That said, always remember this question: When did Noah build the ark? Answer: Before the storm!

  7. Swells, the solution that's being developed will surely find support under the current emergency situation. Under such circumstances, leaders are usually willing to go ahead with these types of measures as a way to get out of their current predicaments. When things get better (a big if), however, we'll start to see leaders claim that national objectives are being vetoed by foreign interest! Nationalism, resentment and basic 'us against them' mentality will prevail. All these solutions appear equitable to everyone at the moment. But take away the crisis, and these budgetary limiting measures will be perceived as unfair and illegitimate interventions by outside actors. Populist rhetoric will follow. Before we know it, leaders will find currency in such discourse. And then other problems surface.

  8. @gc You beat me to the Summers op-ed. I think Krugman, not Stiglitz will comment.

    On your UK optic, I don't quite understand why 'King and circle' would not have approved otherwise.

    On your EU comment, I presume that the few are Germany and France, and the many are those member states that require financial support.

    I also presume that you are not too confident in the Euro's chance to survive.

  9. Thanks KP for the question. I actually understood 'the many' to mean 'citizens', but I think you're right that GC is referring here to the nations other than DE and FR. As for Summers' piece, I'm with GC on this: Stiglitz absolutely must respond.

  10. @kp: I hope Joe Stiglitz replies to Larry Summers and comments on the IMF.

    Unfortunately, I've been caught up in catch up after the rubbish of the last weeks. Paul Krugman will comment, measured in his tone, although he's probably extremely disillusioned as are the majority of US observers and policymakers. The result, and both Treasury and the Fed know this, is to defer the inevitable shakedown of the Union six months to one year. Then another summit, and then another deferral, and then another summit, and on and on and on..

    Mrs. Merkel and Mr.Sarkozy have isolated the UK. Mr. Cameron will be considered by the continent as a rogue for a while; but the real rogues are on the continent. I am confident that the UK will come out of this better than Germany and France surmise. I suggest it is also best for Osborne and King. Now the UK can start spending responsibly. Mr. Sarkozy may not be re-elected, and that will cause confusion in the realm (lol, nod CI). Mr. Cameron can now abandon austerity with political expediency. One should recall that King and circle are 'all economic pragmatists' exposed to the ideas of the giant Godley. It was easy for Messrs Cameron and Osborne to see the opportunity of making a U-turn. Watch the ride towards spending. Would that Wynne Godley be in Treasury, at this moment; it would have been a cruise!

    One piece of rubbish that is circulating in the 'London markets' is that responsible for the euro's demise are excessive spendings. Young gilt-traders are quite articulate about Godley perspectives. All praise 'responsible spending'. Responsible spending generates growth and well-being! Wasteful spending (both in the EA and UK) creates irreparable damage to an economy. Only wasteful spending, that is, non-productive spending generates havoc. Markets are badgering 'euro-spending' on 'rubbish'.

    As a result we are entering into a late phase of what i consider 'subsistence financing' which precedes 'palliative financing' and that will be the 'swan song' of Rome-Maastricht.

    What I disagree with is the markets' growing sense of 'power and identity' as a supranational entity. The seeming assumption of a political dimension beyond its restricted role as a financial intermediate.

    In passing, the rise in US equity markets was more a reaction to good news on the US economic front than the the news coming out of the 'euro-summit' I assume the markets disregarded the decrease in US households' and NPO net worth of $2.4 trillion:


    You can surmise the split.

    I am not confident that the Euro will survive. As I said: timing is a matter of timing! It will fall, the question is when and that depends on the timing and logistics of certain decisions.

    @circuit: I hope FRB's Messrs Harper and Carney are looking at austerity's 'failed experiment'.

    National budgets are a contextual economic effort, privy to a people and subject to the moral and social values of a community. Setting broad transnational economic parameters for deficit management and budget control is, first and foremost, an aberration of the role of economics and its related disciplines (law, business, political geography). Suffice to recall the whole of economic thought, and the history of modern economic policy, including German economic policy between 1919-1958.

    My concern is that the level of social indignation in the EU will rise in the ensuing months. The ones who will suffer are entitlements (pensioners who will see their privileges reduced), young people who have difficulty finding employment, young families, single-parent families, labor and NGO's, municipalities, health and education) Growth will be greatly restricted in those afflicted economies. The IMF's additional access to funds is a temporary balm supported by the very few.

    Europe is become a circus of bad planners and decision-makers.

  11. @gc I thoroughly enjoyed your comment (mod!). I just have two points. The first point refers to your note that US equity markets rose as a result of good news from the home front rather than from the European accord. I have a caution on your observation. I find it too one-sided. It's surprising that the market would not have reacted to the Fed's stats on household (nod to you for pointing it out). The second is a nod for your Stiglitz referral.

    @ circuit, After reading gc and his reference to Stiglitz, I browsed the web and read an older (Dec 5/11) article by Joe Stiglitz:


    where he notes the causes of many recessions:

    "There is, interestingly, a common thread running through all of these cases, as well as the 2008 crisis: financial sectors behaved badly and failed to assess creditworthiness and manage risk as they were supposed to do."

    The observation reminded me of a very similar conclusion that you had come up with a posting ago dated much earlier than the Stiglitz Dec 5, 2011 article. I wanted to nod your insight!!!

  12. Thanks for these comments. GC, I'm hoping that UK policymakers see this as an opportunity to move towards spending. I'm glad to hear there is a chance for economic pragmatists to convince their political masters of changing course at this juncture. I have to say that I'm quite impressed by the output coming out of the BofE. It seems to me that, if anybody can help steer the discussion towards more useful ends, the officials of the Bank are the right people. Also, I have no doubts that the Treasury houses some good, sensible minds as well. That said, I am a bit skeptical as to whether political staffers are ready to re-write the script and change strategies. I wonder if they will act on the opportunity that last week's developments have opened to them. The split might be the perfect time for a new strategy. No doubt, the British media will play along.

    Also, excellent comments regarding the necessity of national budgets to be molded and adapted to the values and requirements of a community. I think the restrictions being imposed won't achieve anything. They will just accelerate the inevitable. And they won't work - yields will continue to climb as contraction is further imposed.

    As for Godley, I agree entirely. And I'm sure many folks on the Continent and UK alike are re-discovering his genius. Here is one for the history books (from 1992!):


    One last thing, I'm interested by these notions of subsistence financing and palliative financing. I see what you mean. Are these concepts formally tied to criteria in literature? If not, that's fine too; I know of examples where the terms could be applied appropriately.

    @Swells: I've been thinking about what KC Wheare would say. I can only say that he would be appalled by what is happening. He won't not approve of the way the federal principle is used without regard for the existing norms of democratic governance. And for the benefit of the market, to boot! I've always felt the EU Council of Ministers lacked legitimacy given the extent to which it has influence over the lives of ordinary citizens. In the nineties, lots was written about this. An executive council that deliberates without regard for proper rules of openness and transparency is not what Wheare would have envisaged, even for quasi-federations. To make it legitimate enough for me (as a minimum), the Council would have to be presided by someone who's elected by the EU citizens. I'm pleased to say that Charles Goodhart has recently revived the idea. He is right: new political institutions are needed to maintain the Union.(h/t Ramanan).

    @KP: Stiglitz is one of the good guys. And he's right. Excessive risk-taking caused the crisis. To say that public deficits or excessive savings caused the crisis is simply wrong. Thanks for the nod to my previous article. But to be fair to JS, he's been saying that since the onset. He's a great spokesperson for economic pragmatism.

  13. @Circuit. juxtaposing the BoC and the euro-area/euro-union was an excellent idea. the economics of unaverted risk, unrestrained expectations and stunted growth are now global. they affect GoC as much as they do the USG. i concur, as many others i know, with your position that what is structurally deficient in the eu and the ea are institutional structures that enable accountability and enforcement to be effective.

    @GC...been a while. i nod your depiction of the political travesty that is sweeping through europe. i find insidious merkel/sarkozy proposing a new accord with parameters to which the UK had already voiced its opposition. the de-democratization of european polity is unbelievable, and in such a short time. to Mr. Cameron, whose rhetoric and politics i have been radically opposed, i commend his courage. laying traps for the diplomat backfires when national interest triggers the statesman to come forward. i agree that the moment is opportune for the turn to keynesian policy. it may become the Cameron Moment for the UK and Mr. Cameron. not the last summit; ecb is still not a backstop and the imf is a poor intermediary without certain support. well done GC!!!

    @bumzo! i agree that GoC will wait it out. on the other hand, the Cameron move may be influential.

  14. @gc & circuit. Quite a rip on the continent. But I agree; there is little that will last. This is the fifth 'summit' in less than 2 yrs. The joke is actually on Sarkozy who wanted the UK out of a position of influence. Unfortunately, he will be the victim of an ousting, and Merkel will find little comfort on the progressive slowdown of the German economy. I presume the US needs time to patch up its banks' exposure, ascertain the downside's timing and write-up a phase-out for the distressed-five, and oncoming France. Sarkozy is now endorsing austerity: the timing is a matter of timing as you say.

    My concern is the corporate world's reaction to Mr. Cameron's move, which veto, in passing I commend and concur. I can't understand his economics at all with everything from production to orders faltering. I have an intuition that he will turn on policy and configure a public-X program that will smooth and stabilize both the currency and the economy.
    MI may well be overly creative these days, mitigating City with the mainland.