The macroeconomics of Robert Solow: A partial view

During a hearing before a Congressional Committee on Science and Technology, Robert Solow (MIT) described himself as a "generally quite traditional, mainstream economist".

In my view, either Prof. Solow is unaware of who qualifies as a "traditional, mainstream economist" these days or the definitions of the words "traditional" and "mainstream" need to be completely changed!

Consider, for instance, his views on the notion of "expansionary fiscal consolidation":

[H]ow does a human race with limited intelligence...deal with situations in which the short run need for policy are quite different from the long run need for policy? The feeble-minded, it seems to me, attempt to solve this problem [by asserting] that fiscal consolidation is really expansionary in the short run. I have never been able to understand the mental processes that underlie that statement. But I will take it seriously only -- only -- when its protagonists faced with a situation of clear excess demand propose fiscal expansion. Because if fiscal consolidation is expansionary then fiscal expansion must be contractionary. I don't believe that would happen. So I don't take that argument seriously at all. I think it's cooked up to make a real difficulty go away. (The Feasibility of European Monetary and Fiscal Policies: Rethinking Policy from a Transatlantic Perspective)

...on the supposed lack of microfoundations in Keynesian economics:

You know, there is something a little ludicrous in the belief that microfoundations for macroeconomics were invented some time in the 1970s. If you read Keynes's General Theory or Pigou's Employment and Equilibrium (or many lesser works) you will see that they are full of informal microfoundations. Every author tries to make his behavioral assumptions plausible by talking about the way that groups or ordinary economic agents might be expected to act...But you can recall Keynes's argument that the marginal propensity to consume should be between zero and one, or his discussion about whether the marginal efficiency of investment should be sensitive to current output or should depend primarily on "the state of long-term expectations". Those are microfoundations. (2004, p. 659)

...on the claim there is a connection between the money supply and price level:

[T]he financial press sometimes writes as though there is some special direct connection between the money supply and price level. So far as fundamentals are concerned, monetary policy works through its effects on aggregate nominal demand, just like fiscal policy, in the long run, too. The only direct connection I can think of is itself the creation of pop economics. If business people and others become convinced that there is some causal immaculate connection from the money supply to the price level, completely bypassing the real economy, then the news of a monetary-policy action will generate inflationary or disinflationary expectations and induce the sorts of actions that will tend to bring about the expected outcome and thus confirm the expectations and strengthen the underlying beliefs. (1998:4)

...on the problem with Milton Friedman's reliance on correlations between and M and other variables to infer policy conclusions and the assumption of an exogenous money supply (with John Kareken):

The unreliability of this line of argument is suggested by the following reducto ad absurdum. Imagine an economy buffeted by all kinds of cyclical forces, endogenous and exogenous. Suppose that by heroic, and perhaps even cyclical variation in the money stock and its rate of change, the Federal Reserve manages deftly to counter all disturbing impulses and to stabilize the level of economic activity absolutely. Then an observer following the Friedman method would see peaks and troughs in monetary changes accompanied by a steady level of economic activity. He would presumably conclude that monetary policy has no effects at all, which would be precisely the opposite of the truth. (Karaken and Solow, 1963, p. 16)

...on choosing the right model in macroeconomics:

[I] believe rather strongly that the "right" model for an occasion depends on the context --  the institutional context, of course -- but also on the current mix of beliefs, attitudes, norms, and "theories" that inhabits the minds of businessmen, bankers, consumers, and savers. (2004, p.xi)

...on the problems with the DSGE model:

I do not think that the currently popular DSGE models pass the smell test. They take it for granted that the whole economy can be thought about as if it were a single, consistent person or dynasty carrying out a rationally designed, long-term plan, occasionally disturbed by unexpected shocks, but adapting to them in a rational, consistent way. I do not think that this picture passes the smell test. The protagonists of this idea make a claim to respectability by asserting that it is founded on what we know about microeconomic behavior, but I think that this claim is generally phony. The advocates no doubt believe what they say, but they seem to have stopped sniffing or to have lost their sense of smell altogether. (For more, see here and here)

...on the difference between budgetary and real resources costs:

The trouble is that the great world -- including a large part of the intellectual world -- has lost sight of the fundamental difference between budgetary costs and real resource costs. An unemployed worker and an underutilized or idle plant is not something we're saving up for the future. Today's labor can't be used next year or the year after. And the machine time in a plant that's down can't be redone two years from now or three years from now. Three years from now we hope that the plant will be running for current uses. So there's that important sense in which idle resources are almost - and maybe literally - free to the economy. The problem is to get them used in a reasonable way. (see 22:00 here):

...on the importance of fiscal policy for stabilization purposes:

I start from the belief that non-trivial imbalances of aggregate supply and demand do occur in modern industrial capitalist economies, and last long enough that public policy should not ignore them...When such imbalances occur, fiscal policy is a useful tool. The single instrument of monetary policy can not do justice to the multiplicity of policy objectives; and the Ricardian equivalence claim is in practice not nearly enough to convince a realist of the ineffectiveness of fiscal policy. The real obstacles to the rational conduct of fiscal policy are the uncertainties about the proper target for real output and employment, and the tendency for stabilization goals to become inextricably tangled in and distracted by distributional and allocational controversy. (Is fiscal policy possible? Is it desirable?, p. 23)

...on the long run potency of deficit spending financed by bonds vs. deficits financed by money creation, and on the contractionary nature of open market purchases of government bonds (with Alan Blinder):

[N]ot only is deficit spending financed by bonds expansionary in the long run, it is even more expansionary than the same spending financed by the creation of money. [Foonote: An interesting corollary of this is that an open-market purchase, i.e. a swap of B for M by the government with G unchanged, will be contractionary!] (Blinder and Solow: Does Fiscal Policy Matter? 1973)

...on how statements by a central bank can influence how the public translates relative price changes into expectations about the consumer price index:

There are various interest groups in the economy: bankers, investors, savers, lenders, borrowers, buyers and sellers and what not. There is no reason for them to react in the same way. How does one aggregate expectations?

...on the use of "expectations" to explain macro policy outcomes:

[T]o rest the whole argument on expectations -- that all-purpose unobservable -- just stops rational discussion in its tracks. I agree that the expectations, beliefs, theories, and prejudices of market participants are all important determinants of what happens. The trouble is that there is no outcome or behavior pattern that cannot be explained by one or another drama starring expectations. Since none of us can measure expectations (whose?) we have a lot of freedom to write the scenario we happen to like today. Should I respond...by writing a different play, starring somewhat different expectations? No thanks, I'd rather look at data. (1998:93)

...on the claim of self-correcting markets and the role of aggregate demand in causing output fluctuations:

Capitalist economies do not behave like well-oiled equilibrium machines. For all sorts of reasons they can stray above or below potential output for meaningful periods of time, though apparently they are sightly more likely to stray below than above. Even apart from considerations of growth, macro policy should lean in the general direction that will nudge aggregate demand toward potential, whenever a noticeable gap occurs. The relevant point is that this strategy is also growth-promoting. Whatever the level of real interest rates, excessively weak aggregate demand -- and the prospect of weak and fluctuating aggregate demand -- works against investment. Few things are as bad for expected return on investment as weak and uncertain future sales...Successful stabilization contributes to growth too. (Role of macroeconomic policy, p. 301)

...on the need for public policy to address the unemployment of unskilled labor:

It needs to be insisted that the root of the problem lies in the enormous range of earning capacities generated by the interaction of modern technology (and other influences on the demand for unskilled labor) with the demographic and educational outcomes on the supply side of the labor market. There is no really good way for a market economy to deal humanely with that spread. (Too Optimistic)

...on the fallacy of self-correcting markets and the limits of monetary policy during deep recessions:

One important lesson that I hope we have learned from the crisis and the deep recession still going on is that economies like ours can experience uncomfortably long intervals of general excess supply or excess demand. Of course, we -- economists and interested civilians -- used to know that. But it was widely forgotten during the Great Moderation and the accompanying optimism among economists and civilians about smoothly self-correcting markets. The general belief than was that monetary policy was an adequate tool for taking care of any minor blip. During long and deep recessions, however, it has become evident that monetary policy may reach its limits without being able to generate enough aggregate demand to close the excess supply gap. (IMF Talk: Macro and Growth Policies)

...on the problems with Ricardian equivalence:

What might interfere with [the claim that it is optimal for households to save a tax reduction]? Any number of things: if households had been unable to consume as much as their optimal plan required because they lacked liquid assets and could not borrow freely, then the added liquidity provided by the tax reduction would enable them to consumer more now. If the Treasury were a more efficient, less risky, borrower than many households, then the appearance of some new public debt would also affect real behavior. And, of course, if consumers do not look ahead very far or very carefully, if they give little weight to the interests of descendants, or if they tend to ignore or underestimate the future implications of current budgetary actions, then Ricardian equivalence will fail, and tax reduction financed by borrowing will indeed be expansionary. All those "if" clauses strike me as very likely to be real and quantitatively important, and that suggests that Ricardian equivalence is not a practically significant limitation on fiscal policy. (Is fiscal policy possible? Is it desirable?, p. 12)

...on the problem with the natural rate of unemployment hypothesis:

Let me try to explain what nags at me in all this...We are left here with a theory whose two central concepts, the natural rate of unemployment or output and the expected rate of inflation have three suspicious characteristics in common. They are not directly observable. They are not very well defined. And, so far as we can tell, they move around too much for comfort -- they are not stable. I suspect this is an intrinsic difficulty. I have no wish to minimize the importance of, say, inflationary expectations. But we are faced with a real problem: here is a concept that seems in our minds to play an important role in macro behavior, and yet it's very difficult to deal with because it escapes observation and it even escapes clear definition. 

On the natural rate of unemployment, I think the behavior of the profession exhibits problems. In order to make sensible use of this kind of theory, you want the natural rate of unemployment to be a fairly stable quantity. It won't do its job if it jumps around violently from one year to the next. But that's what seems to happen. We, the profession, are driven to explaining events by inventing movements of the natural rate, which we have not observed and have not very well defined. The issue came up first in the passage of the big European economies from 2 percent unemployment, on average, to 8 or 9 percent unemployment, on average, within a few years. The only way to explain that within the standard model is to say that the natural rate of unemployment must have increased from something like 2 percent to something like 8 or 9 percent. The actual facts that could account for any such dynamics never seemed to me or to any critical person to be capable of explaining so big a change. So we are left with inventing changes in the natural rate of unemployment to explain the facts, and it is all done in our heads, not in any tested model. I regret to say that you often find this kind of reasoning: the inflation rate is increasing because the unemployment rate is below the natural rate. How do you know that the unemployment rate is below the natural rate? Because the inflation rate is increasing. I think we are all good enough logicians to realize that this is exactly equivalent to saying that the rate of inflation is increasing, and nothing more. 

It seems to me that we ought to be thinking much more about the determinants of whatever you choose to call it. I hate to use the phrase "natural rate" but of course I do. It was a masterpiece of persuasive definition by Milton. Who could ever want an unnatural rate of unemployment? (Fifty years of the Phillips Curve: A Dialogue on what we have learned, p.84)

...and more on the natural rate of unemployment:

There is nothing like an adjustable, unobservable parameter to keep a theory afloat in rough seas...I think the doctrine [of the natural rate of unemployment] to be theoretically and empirically as soft as a grape. To say that in the long run the unemployment rate tends to return to the natural rate of unemployment is to say almost nothing. In the long run the unemployment rate goes where it goes. You can call where it goes the natural rate; but unless you have a more convincing story than I have seen about the length of the long run and the location of the natural rate, you are only giving a tendentious name to a vague concept (1998, pp. 9, 91)

Impact of the US Payroll tax cut...and tax hike

This is a very informative (and short) piece by economists at the NY Fed on the effect of the 2011 US payroll tax cut and its recent expiration.

Here's a good summary:

Overall, our analysis suggests that the payroll tax cut during 2011-12 led to a substantial increase in consumer spending and facilitated the consumer deleveraging process. Based on consumers’ responses to our recent survey, expiration of the tax cuts is likely to lead to a substantial reduction in spending as well as contribute to a slowdown or possibly a reversal in the paydown of consumer debt. These effects are also likely to be heterogeneous, with groups that are more credit and liquidity constrained more likely to be adversely affected. Such nuances may be lost in the aggregate macroeconomic statistics, but they’re important for policymakers to consider as they debate fiscal policy.

Reference

Zafar, B., van der Klaauw, W., My Two (Per)cents: How are American Workers dealing with the Payroll Tax Hike, Federal Bank of New Work, Liberty Street Blog.

A kind word for Paul

Paul Krugman's recent posts on the abuse use by politicians of economic studies as a way to support ideologically-driven fiscal austerity have been right on. Here's from his latest:

...the important story isn’t about the sins of the economists; it’s about our warped economic discourse, in which important people seize on academic work that fits their preconceptions. Even if you don’t think Reinhart-Rogoff made much difference to actual policy, the meteoric rise and catastrophic fall of their reputation speaks volumes about why this slump goes on and on.

I made a similar point in an earlier column when I wrote that austerity was a

...prepackaged "solution to a problem" that fits with today's dominant policy-making ideology, which holds that governments have little or no purpose other than catering to financial interests and leaving the path clear for free-market actors to find solutions to every problem facing society.

...[F]iscal austerity is simply another example of a "solution looking for a problem", an empty and empirically ineffectual idea with no clear rationale other than giving the appearance that "something is being done".

This is why I continue to think that the ones who are really responsible for austerity are the politicians who support this view. Economic studies were used to provide cover for these leaders' preferred set of policy choices.

Anyway, there's no matching Prof. Krugman's performance these last few months. Not only have his forecasts been right on, but his retrospective look at why things unfolded the way they did has been downright flawless.

Moving past the 90 percent threshold: Focusing on growth

Now that the proposition of a 90 percent threshold (of public debt-to-GDP above which countries' economic growth would significantly slow) associated with the work of Carmen Reinhart and Ken Rogoff has been refuted, it's important that the debate now turn to the critical issue of how best to achieve growth moving forward.

On this point, one important aspect to keep in mind is that the uses toward which public debt is directed and the composition of public debt tend to have a significant impact on a country's economic growth.

A recent study by the IMF entitled "Public Debt and Growth" appears to support this view. The study, which examined the public debt dynamics in over 30 countries, found that, although the elasticity of growth with respect to public debt is -0.02, the elasticity of other variables that positively impacts growth offsets this number. For instance, as Iyanatul Islam has noted, the study shows that the elasticity of growth to initial years of schooling is above 2.0.

In other words, it's quite likely that public debt directed toward productive uses has the effect of supporting growth by cancelling out some of the negative effects associated with high public debt that impede growth.

These are the sort of issues policymakers should be discussing moving forward. I think it would go a long way to help us get out of the economic doldrums we're facing today.

Reference

Manmohan and Jaejoon, Public Debt and Growth, IMF, July 2010

Fiscal austerity: A solution looking for a problem

Since the release earlier this month of the paper by IMF economists Olivier Blanchard and Daniel Leigh, I've noticed a lot of comments on blogs and news websites suggesting that the IMF economists and their inability to properly measure the size of the fiscal multiplier earlier are to blame for making political leaders believe that fiscal austerity could be expansionary and for misleading them into enacting austerity measures within their respective nations.

That's nonsense.  As if the decision to go down the road of austerity depended on a technical detail such as the potency of the fiscal multiplier.  Such a statement is as implausible as suggesting that some of the ill-advised military interventions in the Middle East during the last decade would have been prevented had those leaders who decided to enter those wars had been provided better intelligence.

Those looking to blame someone for the current disaster created by fiscal austerity should instead turn to the real culprits, the politicians themselves, as well as their horde of political aides who recommended a course of action that flies in the face of both common sense and empirical evidence.

As I discussed in an earlier post, the case against expansionary austerity was well established even before nations decided to enact austerity measures.  And amazingly, the empirical evidence against expansionary fiscal austerity stems from one of the most highly circulated economics papers of 2009, which, ironically, was branded as supporting the case for expansionary fiscal austerity.

This paper is the study by Alberto Alesina and Sylvia Ardagna, which found that the combination of austerity and growth occurred in 25 percent of the relevant episodes recorded by the OECD between 1970 and 2007 (2009, Data Appendix:Table A2).

In other words, the study demonstrated that the odds of successfully reducing public debt levels and achieving increased growth through austerity were 1 in 4.  As far as empirical support in favor of expansionary fiscal austerity goes, that's pretty weak.  With such information available, going ahead with austerity was tantamount to someone deciding to intentionally leave their umbrella at home knowing that there is a 75 percent chance of rain that day.  So much for the theory of the rational decision-maker!

And now economists are to blame?

The bottom line is that the disaster of austerity is not about economists getting it wrong.  Rather, it is a typical example of a policy-making failure: policymakers making decisions without regard for the facts.  But, more importantly, fiscal austerity was a prepackaged "solution to a problem" that fits with today's dominant policy-making ideology, which holds that governments have little or no purpose other than catering to financial interests and leaving the path clear for free-market actors to find solutions to every problem facing society.

To conclude, fiscal austerity is simply another example of a "solution looking for a problem", an empty and empirically ineffectual idea with no clear rationale other than giving the appearance that "something is being done".  In this sense, fiscal austerity joins the list of other well-known solutions looking for problems that have been tried and failed in the last thirty years such as deregulation, privatization, supply-side economics and so on.

References

Alesina, A and Ardagna, S., "Large Changes in Fiscal Policy: Taxes vs Spending", NBER Working Paper No. 15438, October 2009

Blanchard, O. and D. Leigh, "Growth Forecast Errors and Fiscal Multiplier", IMF Working Paper WP/13/1, January 2013

Evsey Domar's "On Deficits and Debt": A survival guide for making sense of today's economic challenges

As I look back to 2012, I'm reminded about how relevant the work of economist Evsey Domar, the late Professor of Economics at MIT and previously a Federal Reserve staff economist, is for making sense of the predicament facing the US and the world economies today.  Three news stories during the last year provided a good backdrop for presenting Domar’s views on public debt, budget deficits and economic growth.

First, there was the surprising about face during the summer months when European leaders switched from advocating austerity to voicing their support for actions that promote growth.  Professor Domar would have most likely approved of this change of heart by Europe’s ruling elite given that, many decades ago, Domar authored “The Burden of the Debt and National Income” (1944), a paper which argues that “the problem of the burden of the debt is a problem of achieving a growing national income” rather than one associated with the size of the budget deficit or national debt.

E. Domar

Specifically, in his paper, Domar demonstrated that, in the long run, the ratio of debt to GDP will gradually approach the ratio of the fraction of GDP borrowed each year to the rate of growth of GDP.  So, for instance, the US federal government borrowed approximately 7 percent of GDP in 2012.  If the borrowing continued at the same rate and the GDP (in money terms) grows at 2 percent per year, the ratio of debt to GDP will approach 3.5; with a 3 percent growth, it will be 2.3.

Thus, Domar showed that "less attention should be devoted to the problem of the debt and more to finding ways of achieving a growing national income" (1945:415)

According to Domar, attempting to reduce the public debt by cutting government expenditures (thus removing a significant source of income and growth from the economy) is largely self-defeating and exactly the wrong course of action if undertaken when the economy is struggling.

Then, in the fall, there was the debate among economists and bloggers about the intergenerational burden of the public debt.  Had he been around, Professor Domar would have probably been disappointed to learn that issues addressed (and, for many, put to rest) decades ago are still being debated.

And now we're facing the so-called ‘fiscal cliff’, a metaphor depicting the slowdown facing the US economy as a result of the expiry of tax breaks enacted at a time when the US federal fiscal budget situation was in better shape.  In the face of such a situation, Domar would have understood that the last thing policymakers should do when the economy is weak is to increase taxes which take away purchasing power from the economy.

As we enter a New Year, it is worth remembering Domar’s views on these and other related issues.  And nowhere are these matters best addressed than in his short, three-page article “On Deficits and Debt” published in 1993.  In this article, Domar challenges many of the widely held beliefs about debt and deficits. 

First, the article begins by taking on the popular view that considers the US federal government debt as analogous to household debt:

Our old puritanical injunctions against running into debt remain valid when applied to a private person. He or she can disregard them only at his or her peril.  A large corporation has more leeway: it can borrow by issuing bonds, and replace them with new ones when they fall due. If many large corporations simultaneously decided to pay off their debts, our economy would collapse: it is based on credit, the inverse of debt. Still any corporation, however large can go bankrupt...But, the Federal government is in a class by itself: so long as its debt is expressed in dollars (which fortunately is the case), it can always print as many dollars as it needs to pay the interest, though nowadays it would issue bonds, sell them in the market and, if necessary, have the Federal Reserve repurchase them. The Federal government, the creator of the Federal Reserve System, is its own banker.

Then, Domar describes the merits of a budget deficit:

By definition, a budget deficit means that the government spends more money then it receives, or, in other words, that it creates more purchasing power by its expenditures than it destroys through taxes.  Is this good or bad? It depends. If the economy is working to capacity, the creation of extra purchasing power will do little good and much harm: it will cause an inflation, which is easy to start and hard to stop. But when the economy has plenty of unused resources, the additional purchasing power is welcome. At such a time, we should rebuild our physical infrastructure, improve our education, health, and environment, and intensify our scientific and industrial research efforts, without raising taxes and without reducing or eliminating other needed services, always keeping a watchful eye on economic barometers to make sure that we do not overdo it.

All this sounds nice and easy, perhaps too easy to avoid suspicion. Are we to get something for nothing, as the old saying goes? Is there such a thing as a free lunch, after all? The offer of a free lunch is strictly temporary; it lasts only so long as unused resources, and particularly unemployed labor, are available, because they can be put to use with little, if any, social cost. But one they are gone government expenditures, however, desirable, must be matched with revenue.

Later in the article, Domar explains that the true burden of the national debt is distributional in that it involves a transfer of resources from one group to another group within the economy:

Some early proponents of fiscal policy argued that the size of the debt and of interest payments on it are not important because “ we owe it to ourselves”...There is some truth in this argument, but it should not be exaggerated. Even if all the Federal bonds were owned by Americans and all interest on the debt received by them, problems created by the existence of a large debt and by the need to transfer [billions of dollars] from the taxpayers to the bondholders would remain...

On the other hand, this does not mean that the...interest paid on the debt represents a net loss to the country...[T]hat interest go to other Americans, directly or not and that much of it is subject to Federal income taxes. President Eisenhower, who disliked deficits and debts, is reported to have said, shortly before he left the White House, that every American baby born at the time carried on its neck a tag indicating its share of the Federal debt. Perhaps it did; but it must have also borne a second tag showing its share of the value of the Federal bonds.

The article then presents some interesting views about whether the country’s ratio of debt to GDP is an appropriate indicator of the state of the economy:

Does the ratio of the debt to GNP matter? Yes, it does. Other things being equal, I would prefer a smaller rather than larger ratio...Other things are not equal. There are times and conditions calling for a deficit. Without it, unemployment may rise and the GNP may fall, thus raising, rather than lowering the debt burden.

The article concludes with a comment on how to best address the “debt problem”:

The proper solution of the debt problem lies not in tying ourselves into a financial straight-jacket, but in achieving faster growth of the GNP, a result which is, of course, desirable by itself. To the Republican and other politicians who are hell-bent on reducing the deficit and even repaying the debt, I would like to address a very short and simple question: Why? Are we suffering from an excess of purchasing power now?

As we head into the New Year and get ready to face many of the same concerns as in 2012, I think it would be a good idea to keep in mind these points.

On that note, I wish all readers of this blog a very Happy New Year!

UPDATE: The third paragraph was revised on January 12, 2013.  It originally indicated that Domar demonstrated in his 1944 paper that the ratio of deficit to GDP would equal the ratio of the fraction of GDP borrowed each year to the rate of growth of the economy.  Rather, Domar focused on the ratio of debt to GDP.  I also added a subsequent paragraph (after paragraph 3) which includes a reference to Domar's article "The Burden of the Debt: A Rejoinder" (1945).

References

Domar, E., "The Burden of the Debt and the National Income", American Economic Review, 34(4), December 1944

Domar, E., "The Burden of the Debt: A Rejoinder", American Economic Review, 35(3), June 1945, pp. 414-418.

Domar, E., "On Deficits and Debt", American Journal of Economics and Sociology, 52(4), October 1993, 475-478.

Behind the deficit: high interest rates and recessions

As a follow-up to my previous article, I thought I would post this chart:

Primary government balance, Source: Statistics Canada

It shows Canada's consolidated government financial balance with and without interest on the debt.  The government's primary budget balance (i.e., current revenue less spending excluding interest on debt) is a good indicator of the magnitude of fiscal policy, declining during downturns and rising when real GDP increases. (Refer to this Statistics Canada table to view the relevant data)

The chart shows a few things.  First, it shows that interest on the debt (and the Bank of Canada's high interest rate policy in the 1980s) was an important contributing factor to the size of the deficit in the 1980s and early 1990s.  Notice how the gap between the two series shrinks as we move towards the 1990s.

Second, it drives home the point that recessions have a significant impact on the size of the government budget deficit by increasing the use of automatic stabilizers (i.e., unemployment benefits and other expenditures) and reducing government tax revenues.  Note that the primary government balance reached a surplus during the late 1980s as a result of the deficit reduction efforts of the federal Tories under Mulroney and of the provinces (see arrow).  The primary government balance only declined again as a result of the recession of the early 1990s.  The end of the recession restored the primary surplus.

Third, it makes it clear (given the above) that the series of government surpluses that Canada witnessed starting in the mid- to late-90s had their roots in the fiscal policy measures of the 1980s (e.g., tax increases and spending cuts) rather than solely in the cutbacks of the 1990s under the federal Liberals and of the provinces.  This is a point that very few commentators in Canada appreciate.

But the main lesson to take away from the above is that the large budget deficit of the early 1990s was caused by the recession. It was not a consequence of 'out of control' government spending, as most are led to believe.

Austerity in Canada: Then and Now

Canada's economic accounts for the third quarter of 2012 were released last week.  They show a very weak quarter.  Real gross domestic product barely stayed positive, growing by a mere 0.1 percent (see chart 1).  The details can be found here, courtesy of Statistics Canada (click on charts to expand).

Chart 1 Real GDP growth, quarterly % change

Many reasons have been given to explain the economy's weak performance, including the slowdown in China, the fiscal and financial situation in Europe, as well as tepid growth in the US during the summer months.

Of course, as usual, no one is pointing to the fact that Canada is currently undergoing its second most important (i.e., longest and sharpest) bout of public sector austerity in half a century.  One would think that commentators would highlight this reality in their analyses.

As you can see from the chart below, real (consolidated) government expenditure (excluding transfers) has been in decline since the fourth quarter of 2010.  Historically, such a decline in real government spending has only occurred once: during the period of fiscal restraint of the mid-1990s.

Chart 2: Real government expenditures, Source: Statistics Canada and author's calculations

The reason why commentators don't think of austerity as the potential cause of the current weak performance is that Canadians live under the illusion that government spending cuts have little or no impact on the economy.  This stems from the fact that the fiscal austerity put forth during the 1990s gave Canadians (and especially their political leaders) the false impression that cuts in government spending generally help to boost the economy.

Visually, this is how most commentators interpret Canada's experience with austerity in the 1990s (note: I'm not seeking to show a correlation between the two series. I'm simply overlapping both sets of data on a common timeline):

Chart 3: The vanishing deficit and the road to surpluses, Source: Statistics Canada

The standard view holds that fiscal austerity during the 1990s helped to shrink the deficit, thus enabling Canada to run a series of budgetary surpluses throughout the early- to mid- 2000s.  Also, this view holds that fiscal austerity played a crucial role in helping Canada recover from the recession of the early 1990s and contributed to Canada's strong economic performance during the period from the mid-1990s until the financial crisis. 

The problem with this interpretation is that it completely disregards the fact that the Canadian economy during the mid-1990s was impacted by a massive increase in demand stemming from the domestic household and external sectors.  Consider the following charts showing that, as fiscal austerity was undertaken, net borrowing by both the household and external sector exploded in Canada during that period:

Chart 3: Household sector falls into net financial deficit, Source: Statistics Canada and author's calculations

Chart 4: Increased foreign demand to the rescue, Source: Statistics Canada and author's calculations

Net borrowing is the difference between a sector's total spending and income.  It is a key indicator of the demand generated by any sector of the economy. 

Supported by a much easier monetary policy and falling exchanging rate (a consequence of US President Clinton's desire to "have a strong dollar"), the increased net borrowing generated by these two sectors was effective in offsetting the decline in net borrowing of the government sector caused by fiscal austerity.

The increase in net borrowing by the household sector between the mid-1990s and the mid-2000s was unprecedented.  Between 1995 and 2007, net borrowing by the household sector increased by close to 10 percent of GDP (see arrow going down).  As for net borrowing of the foreign sector, it increased by approximately five percent of GDP.  Combined, this additional demand was more than sufficient to offset the decline in demand caused by fiscal austerity.

Today, unlike in the 1990s, the household sector is seeking to reduce its level of borrowing.  And the foreign sector, due to the strength of the Canadian dollar and the weakness of the world economy as a result of global austerity, cannot be a significant source of demand at this time.*

As a result, any attempt by Canada's policymakers to balance the budget in such a context is self-defeating and actually exacerbating the problem given that it is taking away purchasing power from households and firms.  And, as we are witnessing now, it is taking its toll and slowing GDP growth as a consequence.

Economist James Tobin said it best several years ago:

Deficit reduction is not an end in itself. It's rationale is to improve productivity, real wages and living standards of our children and their children. If the measures to cut deficits actually diminish GDP raise unemployment, and reduce future-oriented activities of government, business and households, they do not achieve the goals that are their raison-d'être; rather, they retard them. This perverse result is likely if deficit reduction measures are introduced while the economy is as weak and as constrained by effective demand as it is now.

It's time to think more clearly about these issues.  What "worked" in the past need not be the appropriate course of action today.  The Canadian economy now is not like the one that existed back then.  It's time to move forward.  Trying to relive the "success" of the 1990s will only make matters worse. 

Update:

Chart 2 should be entitled "Real consolidated government expenditures (all levels of government) (millions of chained 2002 dollars)". The title and headings in charts 3, 4 and 5 are accurate.  All data comprises expenditures on goods and services, as well as on capital formation. They exclude transfers.


*  The critical point to remember is that, as I've explained before, the government deficit cannot be reduced in isolation from the other sectors of the economy.  Public sector deficits are from an accounting standpoint the equivalent of surpluses in the private sector, plus additional net imports.  The reason for this is that government deficit spending adds to the net accumulation of private holdings of households and businesses (and/or the foreign sector, where applicable).

In other words, any reduction in government spending or tax increase has a direct impact on the financial position of the private sector.  To believe otherwise is wishful thinking.  If external demand and/or increased demand from another domestic sector (households or businesses) are not high enough to offset the demand shortfall created by reduced government expenditures, continued attempts at fiscal austerity will impose additional deflationary pressure on the economy.

Reference

Tobin, J., "Thinking straight about fiscal stimulus and deficit reduction", Challenge, March 1, 1993