...against fictions and other tall tales

Saturday, 31 December 2011

Eliminating Canada's household sector deficit: A sectoral balances view

Earlier this month, the Governor of the Bank of Canada, Mark Carney, pointed out in a speech that it is important for Canada's household sector to eliminate the net financial deficit it has incurred during the past decade as a result of several years of increased indebtedness*. (For a visual depiction of the interaction between sectoral financial balances and debt-related indicators, refer to Chart 1).

Chart 1 (Click on image to expand)

According to Mr Carney, the most effective way to remedy this situation without hindering economic growth would be for Canadian businesses to increase their level of investment in upcoming years. The intended objective of increasing corporate investment is to offset the gap in the economy that is likely to occur as a result of increased household deleveraging during the next few years.

One commentator applauded Mr Carney for being the only government official at the moment to "speak the truth", that is, to tell Canadians the true state of the country's economy and exhort businesses to take this opportunity to improve their productivity and competitiveness by investing in their operations.

Still, there remains one 'truth' that has yet to be mentioned by anyone, including Mr Carney. And that is the fact that the federal government's commitment to balance its budget is highly incompatible with the objective of seeking to eliminate the household sector's net financial deficit.

To be sure, Mr Carney did mention in his speech that one way to reduce the deficit of the household sector is for governments to increase spending. But given that the speech later implies that this option is not sustainable, it is hard to tell whether Mr Carney would actually endorse the view that government deficit reduction at this time is an impediment to reducing the net financial deficit of the household sector.

The notion that government deficits have a positive effect on the financial balance of the household sector may sound like a far-fetched economic theory. But, in the case of Canada, as I have demonstrated previously, it is a well-supported empirical fact that is statistically (and intuitively) significant.

As you can see from Chart 2 below, based on Statistics Canada's sectoral net lending figures dating from 1961 to present, there is a strong relationship between the (consolidated) government deficit and the net financial surplus of the household sector. The reverse is also true, as government surpluses tend to be associated with household sector deficits.

Chart 2

The only important exception to this longstanding economic reality surfaced in 2008 when the net financial position of the government sector fell back into a deficit (after several years of surpluses) as a result of the sharp drop in Canadian exports, a situation that enabled the foreign sector to return to a considerably large surplus position (see Chart 3). And against the backdrop of a massive and persistent corporate sector net financial surplus starting in the year 2000, the current government sector's deficit has not proven sufficiently large to return the household sector to its traditional net financial surplus position (see Chart 3).

Chart 3

So, given the above, what should the federal and provincial governments do to help eliminate the net financial deficit of the household sector?

First of all, although it now appears likely that the federal government may be headed in that direction, the federal and provincial governments should immediately abandon or, at a minimum, postpone their plans to reduce their deficits and/or balance their budgets. At present, as explained above, the government deficit is actually enabling the household sector's net financial deficit from increasing any further.

Second, governments should take immediate steps to cut down on public expenditures that result in an outflow of funds away from the Canadian economy. As the above analysis suggests, large scale spending on foreign goods has the effect of both increasing the surplus of the foreign sector while simultaneously increasing the size of Canada's public sector deficit. In this regard, there is a strong case to be made for the federal government to cancel its planned purchase of American-made fighter jets.

Similarly, provincial and local public transit authorities should aim, as much as possible and in a manner consistent with established principles of economy and efficiency, to purchase equipment produced in Canada. It should be stressed that the cost-efficiency criterion for choosing among different bids for these public works projects should not be cast aside so as to ensure minimal impact on the tax burden imposed on households and businesses.

Third, as recommended in a previous column, the government should encourage firms to undertake productive investment by imposing a small, yet noticeable tax on retained earnings or on the turnover of corporate financial instruments. These measures would create incentives for firms to reinvest their profits in business operations by increasing the cost of undertaking unproductive activities (e.g., speculative investment) with profits.

Finally, the federal government should reconsider the decision taken in 2008 of requiring the Employment Insurance (EI) fund to balance within a given period. As it stands, when the fund goes into a deficit (as it has been since 2008 due to the rise in unemployment), the government must seek to eliminate the deficit in the short- to medium-term by increasing employer and employee contributions. While such a mechanism may help to reduce the size of the government deficit, it should be emphasized that this policy is highly pro-cyclical given that it acts as an impediment to reducing the net financial deficit of the household sector by decreasing the disposable income and purchasing power of households at a time when they most need it.

To conclude, Mr Carney was right in highlighting the urgency of addressing the current net financial deficit of the household sector. However, it is similarly urgent for government officials in Canada to realize that the objective of balancing public sector budgets is self-defeating and will make matters worse for households given that it reduces a source of employment and revenue. Now, it is very likely that officials of the Bank of Canada are aware of this fact but feel it is not their role to make such an observation. The purpose of the above analysis is a modest attempt to get the word out. Such is my hope and recommendation for 2012. So, on that note, I leave the reader with an excerpt of a letter by John Kenneth Galbraith addressed to President John F. Kennedy dated March 1959 summarizing the point of this column quite nicely:
I have always found that the most useful answer to [those who believe the government must balance its budget] is that the Federal Government, by unbalancing its budget, can help the man who needs a job balance his budget. (1998:29)

* A sector's net financial balance is the difference between its quarterly sectoral savings and investment as a share of gross domestic product. The sum of all sectoral balances must add to zero, which explains why the surplus of one sector is always offset by the deficit of at least one other sector.


Eisner, R., How Real is the Federal Budget? (New York: Free Press), 1986

Galbraith, J.K., Letters to Kennedy (ed. James Goodman) (Boston: Harvard University Press), 1998

Godley, W. and A. Izurieta, "The US economy: weaknesses of the strong economy", PSL Quarterly Review, vol. 62, nn. 248-251 (2009), 97-105

Seccareccia, M., "Growing household indebtedness and the plummeting saving rate in Canada: an explanatory note", Economic and Labour Relations Review, Vol. 16, no. 1, July, 2005, pp. 133-51


  1. Circuit,
    Great post and amazing quote from John K. Galbraight!

    The funny thing is that Carney's dream scenario in which the corporate sector ramp up investment (thereby runs a deficit) in order to allow households to run a surplus so that they can pay off debt is an absolute nightmare scenario for the corporate sector itself!

    Let me explain... there are only two channels in which there could be a net cash flow from the corporate sector to the canadian household sector: wage and dividends. Leaving aside dividends for now, Carney may not know it, but when he is arguing in favour of an increase in investment so that household could pay off their debt, he is really arguing in favour of higher transfer in the form of wage from the corporate to the household sector (not necessarily an increase in hourly wage, it could simply be an increase in total wage resulting from higher employment level). Now, what would households do with this increase in wage "transfer"' from the corporate sector? Destroy the money by paying off debt (repaying loans destroy deposits) instead of purchasing the additional goods and services produced by the corporate sector as a result of the increase in their level of investment. Therefore, the corporate sector would be caught with mountains of unsold inventories and mountain of losses in Carney's "dream scenario"...

    All to say that the corporate sector is likely not foolish enough to increase investment unless it is reasonnably sure that an increase in aggregate demand is down the road...

  2. JL, those are good points. Thanks for the comment and explanation. The risk you point out is quite significant. I'm especially glad you brought up the problem of deficient demand, which Governor Carney mentioned in his speech. Indeed, the domestic household sector cannot be relied upon to sustain growth. But, to be fair to Gov. Carney, in his speech he is making the pitch that firms should invest to become more competitive on the global market. Hence, I think he's anticipating that demand *could* come from new/emerging markets. It's possible, but I tend to think it'll be a while before Canada sees a positive current account balance. Seen in this light, I can see the merit of trying to increase business investment. In other words, it's worth a shot, from a policy standpoint.

    Nevertheless, all this still tends to support the view that government spending is necessary in the short and medium term. In my view, the real problem lies in ensuring that any additional government spending gets to the household sector rather than just adding to the accumulated profits of firms. I think that's where the real test lies for the next few years.

  3. Good point with respect to the current account. Running a current account surplus with the dollar at par is no small feat however as you pointed out. Case in point, exports from the Canadian manufacturing sector have been in severe decline for a number of years. It will take more than encouraging words from Mr Carney to reverse this trend.

  4. The BoC could help in that regard. It has the means, and now the rationale, to act. I can't think of a better time to help exports.

  5. Not sure which means you are reffering to... exchange rate targeting by the BoC, or just by decreasing the overnight?

  6. Decreasing the overnight, unless it sees an opportunity to intervene on foreign markets. Total CPI is at the upper range of the inflation control target range at 2.9, which some might see as problematic. But core index is 2.1, well within range.

  7. I am not a strong believer in the "overnight channel" to turn around an economy, so you can imagine that I am not a believer at all in the overnight channel to turn around exports. Therefore, I believe that the Bank of Canada is powerless vis-à-vis the level of exports (unless the BoC engages in exchange rate targeting, this is not in the realm of possibility as I do not think that Canada wants to be part of the so-called club of "currency manipulators").

    Although no channel is a magic bullet to promote exports, I think the best indirect approach remains the fiscal channel (which is obviously not under the purview of the BoC). Targetted infrastructure investments to enhance competitivness and productivity would help as you mentioned.

    Moreover, higher fiscal deficit could weaken the currency through a volume effect(more Canadian debt in circulation means more deposits denominated in Canadian dollars in circulation) if foreigners loose appetite to sit on their Canadian dollar holdings. That is, if foreigners desire to save in Canadian dollars decrease.

  8. Thanks for posting this. Have you considered updating your time series. I would be interested and I am sure others would as well.