...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

Sunday, 18 December 2011

ECB staff: Interest rate hikes decrease output, increase unemployment and widen public deficits

From a new working paper by the European Central Bank:
The impact of an interest rate tightening in our model is consistent with existing evidence for the euro area and with widely accepted theoretical prior: (i) output and prices decrease (the latter more persistently); (ii) consistent with a liquidity effect, money falls below the baseline; (iii) unemployment grows and labour productivity falls, resulting in a pro-cyclical response of the latter.
...The public deficit widens significantly after the restrictive monetary policy shock, in line with the expected budget worsening due to lower tax receipts following the slowdown in economic activity induced by the interest rate hike and with the outlays related to the automatic stabilizers at work. (Bonci, 2011:5-6) (emphasis added)
It wouldn't surprise me if Mario Draghi was given an advanced copy of this paper to read on his first day as head of the ECB. If so, it might explain why he was so decisive in lowering interest rates upon his appointment. In many respects, the findings in the paper appear to support the view that the decisions of Mr. Draghi's predecessor to raise interest rates earlier this year were ill-advised.

Indeed, while it does not explicitly aim to do so, the study provides evidence as to why Jean-Claude Trichet's final actions as ECB President may have had the effect of worsening the economic situation in Europe by increasing both unemployment and reliance on automatic stabilizers, and thus enlarging public sector deficits in a pro-cyclical manner. As far as I know, this is the first study examining the impact of interest rate policy on the different sectors of the economy within the euro area as a whole.

Bonci, Riccardo, "Monetary Policy and the Flow of Funds in the Euro Area", ECB Working Papers Series, No. 1402, December 2011

Wednesday, 14 December 2011

Music break: Protester edition

So 'the protester' made it as Time's person of the year. Only one track came to mind. The music is courtesy of Anti Social Workers and the Mad man himself.

I like to think, as CUNY's Peter Hitchcock once wrote, that if Marx had been around in our lifetime he would have formulated his eleventh thesis to state that the role of the philosopher is not interpret the world but to dub it.

Monday, 12 December 2011

BoC Governor Mark Carney: Growth in exports, government spending or business investment needed to eliminate the household net financial deficit

A quick post. The Governor of the Bank of Canada, Mark Carney, gave a speech today on the risks facing Canada and the world economies. While the speech contained many of the same themes covered in the December edition of the Bank's Financial Stability Report released last week (see here), a noticeable emphasis was placed on the issue of Canada's household indebtedness. This is not surprising given that Canada's 2011Q3 National Balance Sheet figures are expected to be released tomorrow.

From a Canadian standpoint, the most important part of the speech was when M. Carney's discussed the different ways in which the net financial deficit of Canada's household sector can be eliminated. According to M. Carney, the deficit of the household sector could be eliminated through a combination of export growth, government spending and business investment.

But it is clear from the speech that M. Carney would prefer that Canada's business sector, which is currently running a significant net financial surplus, take a leading role in helping to stimulate the economy while households are seeking to reduce their level of debt. This approach may sound familiar to regular readers of this website. Here is the relevant excerpt of the speech:
To eliminate the household sector’s net financial deficit would leave a noticeable gap in the economy. Canadian households would need to reduce their net financing needs by about $37 billion per year, in aggregate. To compensate for such a reduction over two years could require an additional 3 percentage points of export growth, 4 percentage points of government spending growth or 7 percentage points of business investment growth.

Any of these, in isolation, would be a tall order. Export markets will remain challenging. Government cannot be expected to fill the gap on a sustained basis.

But Canadian companies, with their balance sheets in historically rude health, have the means to act—and the incentives. Canadian firms should recognize four realities: they are not as productive as they could be; they are under-exposed to fast-growing emerging markets; those in the commodity sector can expect relatively elevated prices for some time; and they can all benefit from one of the most resilient financial systems in the world. In a world where deleveraging holds back demand in our traditional foreign markets, the imperative is for Canadian companies to invest in improving their productivity and to access fast-growing emerging markets. (emphasis added)

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.

Wednesday, 7 December 2011

Functional finance, public capital budgeting and the productivity-enhancing role of public investment

I really enjoy the interviews that the folks at the Institute for New Economic Thinking (INET) have been producing recently. They provide a quick and easy way of learning about new and different approaches to economics.

One interview that I think is particularly interesting from a policy standpoint is the one with economist Mario Seccareccia of the University of Ottawa. The topics discussed during the interview include the pre- and post-crisis approaches to fiscal and monetary policy, functional finance, the financial flows view of macromanagement, public capital budgeting and the productivity-enhancing role of public investment.

Needless to say, I believe the issues discussed in this interview are of fundamental importance to the modern practice of economic policymaking. The part of the interview that I found most interesting is when M. Seccareccia explains the importance of public investment, and the critical role it plays on enhancing productivity.

For those who are interested in knowing more about public capital budgeting, I recommend this excellent short paper by the late economist Richard Musgrave, a pillar in the area of public finance. R. Musgrave's ideas are discussed during the interview.


Musgrave, R., "Budget Balance and Sound Finance"

Saturday, 3 December 2011

Canada's 2011Q3 Economic Accounts: federal deficit increases, saving rate drops, growth in real PDI flat

This is a quick post to go over this week's release of Canada's 2011Q3 Economic Accounts and November's Employment report. The title above says it all but here is some added insight.

The increase in the federal government's deficit will no doubt disappoint the federal Minister of Finance, Jim Flaherty. While a growing deficit is a positive development for the economy, as it provides for additional purchasing power, it is very likely that the Minister will attempt to deal with the enlarged deficit by augmenting the level of expenditure cuts he is planning for the upcoming year. Budget plans for next fiscal year are currently being drawn up in Ottawa. Increasing cuts to public expenditures would only worsen the situation and come at a bad time for the economy.

The drop in the saving rate from 4.1 to 3.5 percent will discourage the Governor of the Bank of Canada, Mark Carney. Since early in the recovery, M. Carney has been trying to persuade Canadians to ramp up savings and pay down debt. I doubt that M. Carney still believes this is possible for the near-term: real disposable income has slowed considerably since mid-2010 and Canada's labour market is not faring well at present. And add to the mix the contractionary effects of fiscal measures aimed at reducing the deficit and it is likely that the saving rate will remain low throughout the next year.

Click on image to enlarge

Finally, the unemployment rate increased for the second month in a row. It now stands at 7.4 percent, only 0.2 percent lower than in November 2010. With government spending about to decline, business investment down in the third quarter and final domestic demand flat, it is hard to be optimistic about the job market moving forward.

Unemployment rate, Source: Statistics Canada


Click on image to enlarge

Saturday, 26 November 2011

Deficit myths (Part 3): The effect of budget deficits on business profits

Martin Wolf is right in saying that government fiscal tightening will hurt business profits. As Wolf correctly points out: "In order to reduce huge government deficits, surpluses must fall elsewhere".

For the UK, this means that the only way the government can succeed in balancing its budget is if the reduction in the government deficit is offset by a reduction of equivalent magnitude in the surplus of at least one other sector of the economy (i.e. household, corporate or foreign sector). And according to Wolf, the surplus sector that is most likely to be affected by the government's plan to reduce the deficit is the corporate sector because, at the moment, the household sector is not willing to incur additional debt (and fall back into deficit) and UK exporters are unlikely to reverse the flow of wealth currently exiting the UK economy (thereby reducing the surplus of foreigners).*

In a way, Wolf could just easily have argued that, in the UK right now, it is the government deficit that is enabling the corporate sector to run a surplus. And when households are deleveraging and exports are declining, business profits can only be realized if the government runs a deficit. Thus, by cutting the deficit, the government is in effect reducing an important source of business profits.

Proof of this direct, positive relationship between government deficits and business profits is best demonstrated by manipulating the basic national income accounting identity in a manner consistent with the approach of economists John Maynard Keynes and Michal Kalecki. The following arithmetic demonstrates that government deficits have a positive effect on business profits.

Let Y=Total Output; C=Consumption; I=Investment; G=Government Expenditures; X=Exports; M=Imports; T=Taxes; R=Retained Earnings by Firms; Hs=Household Net Savings

Let the combination of the above (X - M) = Current Account Balance or Net Exports; (G - T) = Government Deficit; (Hs + R) = (Y - T - C) = Total Net Private Savings

To start off, here is the basic national income identity, as taught in all macroeconomic textbooks:
Y = C + I + G + (X - M)

Subtract taxes (from both sides of the equation) to achieve an equation "net" of taxes:
Y - T = C + I + G + (X - M) - T

Rearrange the equation to isolate total net private savings on the left side and to subtract taxes from government expenditures:
Y - T - C = I + (G - T) + (X - M)

Since (Y - T - C) can be broken down into household net savings (Hs) and retained earnings by firms (R), the equation can be stated as follows (see Krugman, 1994:313):
(Hs + R) = I + (G + T) + (X - M) 

...and can be rearranged as such:
R = (I - Hs) + (G - T) + (X - M)

In plain English, this translates into:
Firms' Retained Earnings = Investment - Household Savings + Government Deficits + Net Exports

The above equation clearly demonstrates that business profits are positively impacted by government deficits, net exports and private sector investment.* Household net savings, on the other hand, have the effect of reducing firms' retained earnings. Similarly, balanced budgets and government surpluses have either no impact on profits or have the effect of reducing them.

One objection to this line of reasoning often invoked by economists is that government deficits increase the level of private sector savings (as households and businesses reduce consumption in anticipation of future tax increases). This claim is known as the Ricardian Equivalence proposition. However, there is little empirical evidence that this claim holds true and that the impact of government deficits gets neutralized (or offset) by a corresponding increase in private sector savings. As Douglas Bernheim argued in his seminal work on the topic:
...the case for long-run neutrality is extremely weak, in that it depends upon improbable assumptions that are either directly or indirectly falsified through empirical observation...[B]ehavioral evidence weighs heavily against the Ricardian view (1987:213)
To conclude, it should be emphasized that the purpose of economic policy is not to enable firms to realize profits, but to maximize employment and ensure that the product of industry is beneficial to the overall economy. Business profits, by creating an incentive for firms to invest and employ available resources, can help to promote these objectives. In the above analysis, my aim is to show that government deficits cannot be looked at in isolation from the financial positions of other sectors of the economy. Whether it is to stabilize aggregate demand or to provide for much needed public goods, deficits serve an important purpose. Attempting to reduce government deficits without considering its impact on the overall economy is not a sound basis for policy.

* Paul McCulley provided a similar analysis (2010).
** A different, yet equally effective approach to examining the relationship between profits and government deficits is found in Levy et al. (2008:16).


Bernheim, D., "Ricardian Equivalence: An Evaluation of Theory and Evidence", NBER Macroeconomics Annual 1987, S. Fischer, ed., Vol. 2, pp. 263-316, (Mass: MIT Press), 1987

Krugman, P., International Economics: Theory and Policy 3rd Ed., (New York:Harper-Collins), 1994

Levy, D., et al., Where Profits come from? Answering the Critical Question that Few Ever Ask, The Jerome Levy Forecasting Center, LLC, 2008

McCulley, P., Facts on the ground, Policy Note, Levy Institute of Bard College, 2010

Monday, 21 November 2011

Crescenzi watch: Public investments boost our standard of living

In a previous post, I criticized Tony Crescenzi, author of PIMCO's Global Central Bank Focus column, for depicting Keynesian-inspired policy remedies as wasteful and ineffective. So I was surprised to discover that the November edition of Crescenzi's column contains one of the most spirited pleas in favor of increased public investment that I have read in recent weeks.

Here is an excerpt from Crescenzi's column,
The vigor and verve with which Franklin Delano fought the Depression today is sorely lacking in Washington, which through its self-aggrandizing and ignorance spits with contempt at fires that rage across the U.S. economic landscape, leading Americans to feel anxious and helpless. This anxiety is present throughout the world, which perceives U.S. leadership to be adrift and intensely polarized. The same goes for European leaders. [...]

U.S. policymakers made one of their first serious blunders in this crisis in 2009 when they crafted an economic stimulus plan targeting consumption rather than investment. The benefits of the stimulus therefore faded rather quickly, which is to say the stimulus had a low or negative fiscal multiplier. The money would have been better spent on investments, which tend to have longer-lasting benefits that boost the national standard of living

Consider this example. When Uncle Sam divvies out stimulus checks to consumers it leads to increased purchases of pants, socks, shoes, a hamburger, a garden hose, you name it, but the purchase of these and other everyday essentials do nothing for America’s long-run growth potential. Investments, on the other hand, have longer-lasting benefits. Consider the benefit of investing in a highway, or an energy grid – it lasts years. In other words, an investment of this sort has a relatively high fiscal multiplier – it is the gift that keeps on giving. (emphasis added)
I agree entirely with this view of public investment. In fact, the papers by economists David Aschauer and Alicia Munnell linked to my previous post support the claim that public investment results in a net benefit to society in the long-run.

That said, I am a somewhat puzzled by Crescenzi's contention that the recent US federal stimulus did not significantly enhance the level of public investment. As you can see from the charts below, whether you look at total (federal, state and local) nondefense public investment as a percentage of gross domestic product (Chart 1) or public investment as a percentage of private nonresidential investment (Chart 2), the US federal stimulus initiated at the onset of the last recession resulted in a very large increase in public investment.

Chart 1: Public investment as a percentage of GDP, Source: St. Louis Fed

Chart 2: Public investment as a percent of private investment, Source: St. Louis Fed

Finally, in regard to Crescenzi's point about public investment being more effective than measures that boost private consumption, one could argue that government intervention aimed at increasing private consumption is not necessarily detrimental if it is accompanied by a decline in household indebtedness (see Chart 3). As the great economist and disciple of Keynes, Lorie Tarshis, once wrote in relation to remedies for recession (or Depression):
The general objective is clear: to increase employment, we must either increase the propensity to consume or increase investment. And, as a matter of fact, there is no reason why we should not try to increase both. (1947:570) (emphasis added)
But, on the whole, I am willing to agree with Crescenzi that, given the current state of US public infrastructure, increasing public investment would be more beneficial than measures aimed at increasing consumption.

Chart 3: Financial Obligations and Debt service to income, Source: St. Louis Fed


Tarshis, L., The Elements of Economics (Riverside Press: Cambridge), 1947

Wednesday, 16 November 2011

Inflation-targeting: Still the BoC's top priority

It's a shame this sort of discussion didn't occur during the last federal election. A debate on the renewal of the Bank of Canada's inflation-control target would have added much substance to what I thought was a particularly lame election. But what is even more regretful is that this discussion, it now turns out, got to take place only after the renewal of the five-year agreement became a fait accompli

That said, yesterday's session of the House of Commons Standing Committee on Finance aimed at discussing the merits of the renewal of the BoC's inflation target contained some good exchanges. The economists who were invited to present their views included Mario Seccareccia of the University of Ottawa, Scott Sumner of Bentley University, Jim Stanford of the Canadian Auto Workers Union, Chris Ragan of McGill University and Craig Alexander of TD Bank.

I was particularly pleased by the fact that the discussions were not limited to the renewal of the inflation target. Topics also touched upon included the role of fiscal policy, the current slowdown in the global economy, the actions of the Bank of Canada in recent years, as well as the state of Canada's manufacturing sector.

My views on the BoC's inflation target can be found here and here. Given that this type of conversation only occurs once every five years, I thought it might be appropriate to post it here (click on Play to hear the session) Enjoy.

Friday, 11 November 2011

Deficit myths (Part 2): The effect of deficits on macroeconomic stability

Paul Krugman is right in saying that the crisis in Europe has absolutely nothing to do with Europeans' preference for an extensive welfare state. As Krugman demonstrates, there is simply no reason to believe that the deterioration in the public finances of European nations now affected by the debt crisis was caused by the financial cost of welfare policies in those nations.

Indeed, I would add that the claim that welfare policies are somehow responsible for the current debt crisis in Europe is particularly implausible in the case of the Spanish government, which, prior to the financial crisis and ensuing recession, was actually running sizeable fiscal surpluses (see Chart 1). This fact alone should be sufficient to dispel the myth that the current European crisis was the result of uncontrolled and unsustainable government spending. (See Addendum below for data on Ireland and Iceland)

Chart 1: Cash Surplus/Deficit for Spain, Source: St. Louis Fed

In fact, in regard to the causes of macroeconomic instability, there is very little empirical evidence to support the view that public sector debt and deficits cause debt crises or have any significant impact on macroeconomic stability. This was demonstrated recently by the research staff of the International Monetary Fund (IMF) in the May 2010 edition of the IMF Fiscal Monitor (2010:67).

As you can see from the chart contained in the Fiscal Monitor (see below), the relationship between government debt as a percentage of GDP and macroeconomic volatility is extremely weak.* The reason for this is that financial crises can afflict nations with either small or large debt burdens. Examples of nations with relatively small debt burdens that were impacted by a financial crisis include those nations affected by the East Asian crisis in the late 90s.

Chart 2: Macroeconomic volatility and debt level, Source: IMF

* The purpose of the red horizontal line in the chart is to show that the level of volatility is more or less the same at any ratio of debt.


IMF, Fiscal Monitor: Navigating the fiscal challenges ahead, World Economic and Financial Surveys, May 2010

See here to read Part 1 of this series on deficit myths: The effect of deficits on interest rates

Addendum (added on November 11, 2011)

Central government debt: Ireland, Spain, Iceland, Source: St. Louis Fed

Central government surplus: Ireland, Spain, Iceland, Source: St. Louis Fed

Thursday, 10 November 2011

Bank reserves and credit creation

I agree with Joseph Laliberté, a French-speaking blogger out of Canada dedicated to MMT: there isn't much difference between Treasury bonds and commercial banks' reserves with the central bank. Other than the fact that one can be used as collateral, both share similar properties.

Also, more importantly, Laliberté makes a good observation when arguing that bank reserves aren't inherently inflationary. The reason for this is simple: in a modern banking system, contrary to what most students are taught in economics courses, the level of reserves held at commercial banks does not have a significant influence on the level of credit creation. This point was well described recently by economists Claudio Borio and Piti Disnyatat:
The amount of credit outstanding is determined by banks’ willingness to supply loans, based on perceived risk-return trade-offs, and by the demand for those loans. The aggregate availability of bank reserves does not constrain the expansion directly. The reason is simple...in order to avoid extreme volatility in the interest rate, central banks supply reserves as demanded by the system. From this perspective, a reserve requirement, depending on its remuneration, affects the cost of intermediation and that of loans, but does not constrain credit expansion quantitatively. [...]
By the same token...an expansion of reserves in excess of any requirement does not give banks more resources to expand lending. It only changes the composition of liquid assets of the banking system. Given the very high substitutability between bank reserves and other government assets held for liquidity purposes, the impact can be marginal at best. (2009:19) (original emphasis)
The point here is that lending decisions by banks are not based on the amount of reserves. Rather, bank lending depends in large part on whether banks can find a creditworthy borrower.


Borio, C and P. Disnyatat (2009): “Unconventional monetary policies: an appraisal” Bank for International Settlements Working Papers, No. 292.

Sunday, 6 November 2011

Canada needs a National Industrial Policy

The unemployment figures released by Statistics Canada this week are a huge disappointment. With employment in Canada declining by 54,000, all in full-time, and the national unemployment rate climbing by 0.2 percent to 7.3%, it is now clear that Canada was not able to avoid the current slowdown affecting the global economy.

But the most alarming part of October's Labour Force Survey are the figures relating to changes in employment in Ontario, one of Canada's most important industrial regions.

To put it bluntly, the figures are simply devastating. The loss of over 75,000 full-time jobs in Ontario, approximately half the amount of full-time jobs created during the last year in the province, represents a massive blow to Canada's economy. As a matter of comparison, even during the worst of the 2008-2009 downturn, full-time employment in Ontario did not once decline by this much within a single month. And the fact that part-time employment increased by 36,000 jobs in the province does nothing to attenuate the significance of October's decline in full-time positions.

There are two reasons why this turn of events should be of concern to Canadian policymakers. The first is that a rise in part-time jobs without at least some growth in full-time employment does little to improve the economy during a recovery. This is the case because part-time work is often temporary and usually not as high-paying as full-time work.

Another reason to be concerned about the sharp drop in full-time employment in Ontario is because of what it means for the province's manufacturing sector. Given that most of the losses in full-time work originated in the manufacturing sector, it is possible that the job losses are indicative of an acceleration in the decline of Canada's manufacturing sector. While the decline in manufacturing is nothing new (note: Canadian manufacturing has been losing jobs for six years straight, leaving its total employment for the last decade down 22 percent), there are reasons to believe that this trend has accelerated in recent years due to the strength of the Canadian dollar, which makes other nations' exports more competitive, and the drop in demand for Canadian manufactured goods such as automobiles, machinery and equipment. (Cross, 2011)

From a public policy standpoint, the decline in manufacturing has an important downside given that a nation's economy and productivity depends in large part on its manufacturing capacity. However, many policymakers erroneously believe that economies can thrive solely on their services sector. According to economist Ha-Joon Chang, this view is wrong because it disregards the link that exists between a nation's manufacturing capacity and productivity growth. Chang sums up the problem succinctly in the following excerpt of his most recent book:
...the shrinkage of the relative weight of the manufacturing sector has a negative impact on productivity growth. As the economy becomes dominated by the service sector, where productivity growth is slower, productivity growth for the whole economy will slow down. Unless we believe (as some do) that the countries experiencing de-industrialization are now rich enough not to need more productivity growth, productivity slowdown is something that countries should get worried about - or at least reconcile themselves to. (2010:97)
Given that productivity growth plays a critical part in improving our standard of living and quality of life, it would be wise for Canadian policymakers to view seriously any possible acceleration in manufacturing's decline.

One way to address this possibility and help counter any acceleration in the decline of Canada's manufacturing sector would be to put forth a national industrial policy. While some readers may recall that the federal government implemented a policy called Advantage Canada in 2007 to help promote Canadian industry, it should be mentioned that this strategy was abandoned when the federal government put forth the Canada Economic Action Plan, the stimulus package aimed at boosting the economy during the last recession.

To be sure, a national industrial policy should not aim at replacing the current Economic Action Plan. On the contrary, it would be appropriate for the policy to build on the combined success of the federal and provincial governments' stimulus measures, all of which made Canada's response to the recession one of the most effective countercyclical economic policies implemented by a major nation during the last recession. As shown in the chart below, as a result of these stimulus measures, Canada's ratio of fixed public investment as a percentage of gross domestic product now stands at the highest level in over three decades. The fact that Canadian unemployment did not rise too sharply during the last downturn is in good part a consequence of the significant increase in fixed public investment.

Therefore, instead of winding up the current Economic Action Plan, as the federal government appears to be doing as part of its strategy to reduce the deficit, the government should rather be shifting the focus from investing in public infrastructure to implementing measures that will enhance the competitiveness of Canadian industry and, more specifically, its manufacturing sector. Such a measure would be consistent with the approach taken by Canadian governments in recent years and an appropriate transitional policy at this stage in the recovery.


Chang, H-J., "23 things you didn't know about capitalism", (Bloomsbury Press, London), 2010

Cross, P.,  "2010 in review", Statistics Canada, Section 3, Canadian Economic Observer, April 2011

Wednesday, 26 October 2011

Deficit myths (Part 1): The effect of budget deficits on interest rates

Economist Greg Mankiw is suggesting that the US government is nearing an endpoint when it comes to the effectiveness of deficit spending. According to his latest article in the New York Times, any further fiscal expansion will likely lead to rising interest rates and have other negative consequences.

Mankiw is not alone in advancing this point. The idea that governments are reaching the limits of fiscal policy is a common theme these days among economists and financial commentators. This view has also taken hold in Canada where, for instance, a recent TD Bank report suggests that Canadian federal policymakers have less "wiggle room" on the fiscal front now that the outstanding (consolidated) government debt in Canada has surpassed 60 percent of GDP.

The notion that large deficits are detrimental to the economy is central to the mainstream view of fiscal policymaking. This view of fiscal policy holds that governments should stay clear of large deficits because, it is claimed, they increase interest rates, crowd out private investment, heighten macroeconomic instability and lead to larger trade deficits, higher taxes, lower profits and higher inflation.

This is a most pessimistic view of deficit spending. Fortunately, the reality is quite different. In this post, I wish to make the case that, for nations that are sovereign issuers of currency such as the US and Canada, fears of large increases in interest rates caused by additional fiscal stimulus are overblown. The other negative consequences listed above will be examined in later posts.

First off, with respect to interest rates, it should be mentioned that the effect produced by deficits is nothing like what the mainstream analysis suggests. In fact, if it were not for the active involvement of the monetary authorities, government deficits would actually have the effect of lowering the benchmark rate (e.g., overnight rate in Canada; Fed funds rate in the US). The reason for this is explained in the following excerpt from a paper examining the interaction between fiscal policy and monetary policy published by the independent research staff of Canada's Library of Parliament:
...a fiscal deficit results in an influx of cash into the private economy since the government injects more money through its spending than it collects in taxes. This added liquidity – in the absence of any intervention by the Bank of Canada or the Government of Canada – would create an imbalance in the form of surplus liquidity in the private economy that would drive the overnight rate lower. It is the Bank’s role to neutralize, on a daily basis, this injection of liquidity with a corresponding withdrawal of cash from the private economy. [...]
It is worth mentioning that the principle of balancing liquidity in the private economy in order to achieve a target interest rate would be similar for any country with its own floating currency that is non-convertible to commodities. (original emphasis) (2010:5-6)
And, it should be pointed out, central bankers are aware of this fact. For instance, the former Governor of the Reserve Bank of Australia, Ian Macfarlane, provided a similar explanation in an insightful speech in 2001:
Any government deficit not financed by an exactly coincident issue of debt to the public, for example, would mean a rise in cash and a fall in interest rates. Similarly, a surplus not exactly matched by debt retirement would lead to a shrinkage of the amount of cash and an escalation of interest rates. (emphasis added) (2001:15)
Now, one could argue that, despite the above, the impact of budget deficits on existing economic conditions could lead to monetary tightening and increased interest rates. While this is possible, however, there is very little evidence to support the view that budget deficits play a significant role in increasing interest rates. As economist Stephen Slivinski of the Federal Reserve Bank of Richmond recently concluded when examining the case of the US, the link between government debt and interest rates is tenuous:
During the past 25 years, many studies have arrived at the conclusion that there doesn't seem to be much connection between interest rate movement and debt in the long-term. (2010:14)
Finally, it should be emphasized that the American and Canadian economies now face, from a historical standpoint, extremely slack economic conditions. Therefore, both economies could easily absorb the increased demand created by additional fiscal stimulus. And, more importantly, it is doubtful that the level of activity spurred by additional fiscal policy measures would be significant enough to propel the monetary authority in either country to increase interest rates significantly as a result.


Canada (Library of Parliament), "Fiscal Surplus and Fiscal Deficit: Everything is quiet on the monetary front", Background paper, June 2010

Macfarlane, I., "The movement of interest rates", Reserve Bank of Australia, RBA Bulletin, October 2001

Slivinski, S., "Do deficits matter? And, if so, how?", Federal Reserve Bank of Richmond, Region Focus, Second quarter, 2010

TD Economics, "Canada's economy - A fortress or a sand castle?", August 22, 2011

Tuesday, 25 October 2011

Bank of Canada: 2013 is the year normal growth returns

The Bank of Canada doesn't see much improvement in the Canadian economy during the next year or so. As such, the Bank has decided to maintain the overnight rate to 1 percent. A wise decision, indeed.

From today's press release:
The outlook for the Canadian economy has weakened since July, with the significantly less favourable external environment affecting Canada through financial, confidence and trade channels.  Although Canadian growth rebounded in the third quarter with the unwinding of temporary factors, underlying economic momentum has slowed and is expected to remain modest through the middle of next year.
Domestic demand is expected to remain the principal driver of growth over the projection horizon, though at a more subdued pace than previously anticipated.  Household expenditures are now projected to grow relatively modestly as lower commodity prices and heightened volatility in financial markets weigh on the incomes, wealth and confidence of Canadian households. Business fixed investment is still expected to grow solidly in response to very stimulative financial conditions and heightened competitive pressures, although it will be dampened by the weaker and more uncertain global economic environment.  Net exports are expected to remain a source of weakness, owing to sluggish foreign demand and ongoing competitiveness challenges, including the persistent strength of the Canadian dollar.
Overall, the Bank expects that growth in Canada will be slow through mid-2012 before picking up as the global economic environment improves, uncertainty dissipates and confidence increases.  The Bank projects that the economy will expand by 2.1 per cent in 2011, 1.9 per cent in 2012, and 2.9 per cent in 2013.
The weaker economic outlook implies greater and more persistent economic slack than previously anticipated, with the Canadian economy now expected to return to full capacity by the end of 2013. (emphasis original)
For those of you scratching your head and wondering why it'll take so long for full capacity to return, you should know that Canada's current capacity utilization rates are near the lowest non-recessionary levels they've been in two decades.

Also, it's significant that the Bank's statement highlights the fact that fiscal austerity in Europe and elsewhere is contributing to restrain growth across the advanced economies.

Saturday, 22 October 2011

The downside of paying down the national debt

Tom Hickey (via Mike Norman Economics) points us to a NPR article in which we learn of a report outlining some of the reservations of Washington officials during the Clinton years about paying down the US federal debt.

The NPR story reminds me of Alan Greenspan's testimony before the Budget Committee of the House of Representatives on March 2, 2001.  During that testimony, the Chairman of the Fed stunned Congress when he explained that the objective of zero debt might come at a cost.  According to Greenspan,
...continuing to run surpluses beyond the point at which we reach zero or near-zero federal debt brings to center stage the critical longer-term fiscal policy issue of whether the federal government should accumulate large quantities of private (more technically, nonfederal) assets. 
At zero debt, the continuing unified budget surpluses now projected under current law imply a major accumulation of private assets by the federal government. Such an accumulation would make the federal government a significant factor in our nation's capital markets...
In other words, what Greenspan was trying to hint at is that an "accumulated surplus" (i.e., negative debt) would either result in a reduction in the money supply, which would be deflationary, or force the US government to acquire private financial assets, which would be tantamount to the nationalization of US industry.  I remember like it was yesterday the look of disbelief on the faces of Committee members upon hearing Greenspan's testimony.

Of course, there are other problems with paying off public debt.  As I've discussed in a previous column, in the case of Canadian provinces, years of public debt and deficit reduction have led to the increased financial vulnerability of the household sector in those provinces.  Policymakers beware.

Federal Reserve Board, Current Fiscal Issues, "Testimony of Chairman Alan Greenspan Before the Committee on the Budget", US House of Representatives, March 2, 2001

h/t: Tom Hickey

Sunday, 16 October 2011

On austerity in the UK

From the Opinion Pages of the NYT:
Drastic public spending cuts were the wrong deficit-reduction strategy for the weakened British economy a year ago. And they are the wrong strategy for the faltering American economy today. Britain’s unhappy experience is further evidence that radical reductions in federal spending will do little but stifle economic recovery.

A few years of robust growth would go far toward making swollen federal deficits more manageable. But slashing government spending in an already stalled economy weakens anemic demand, leading to lost output and lost tax revenues. As revenues fall, deficit reduction requires longer, deeper spending cuts. Cut too far, too fast, and the result is not a balanced budget but a lost decade of no growth. That could now happen in Britain. And if the Republicans have their way, it could also happen here.

Austerity is a political ideology masquerading as an economic policy. It rests on a myth, impervious to facts, that portrays all government spending as wasteful and harmful, and unnecessary to the recovery. The real world is a lot more complicated. America has no need to repeat Mr. Cameron’s failed experiment.
I couldn't agree more. The only thing missing from this article is a discussion on the high level of indebtedness of the household sector in the UK. For such an analysis, see this first-rate piece of research by economists Richard Barwell and Oliver Burrows of the Bank of England (2011:17).

Barwell, R. and O. Burrows, "Growing Fragilities? Balance sheets in the Great Moderation", Bank of England, Financial Stability Working Paper, No. 10, April 2011.

Sunday, 2 October 2011

Stephen Harper, David Cameron and the illusive dream of austerity

Last week, Canada's Prime Minister, Stephen Harper, and his British counterpart, David Cameron, joined forces to urge world leaders, especially those of European nations, to embrace austerity as a way to avoid tipping the world economy into recession.

According to Harper and Cameron, cutting government expenditures is the only way to fix the national economies of Europe and the United States, and restore confidence in the market. Excessive debt, they say, are to blame for the current problems now affecting several European countries. And the best way to remedy these problems, they conclude, is for nations to deliver on their promises to impose austerity measures and implement budget cutbacks on government expenditures.

In my view, there are a number of problems associated with this course of action. Firstly, from a historical standpoint, it should be emphasized that austerity has been found to be associated with positive economic performance in only a minority of cases where it has been attempted. For instance, an IMF study authored by C.J. McDermott and Robert Wescott concluded that fiscal retrenchment was accompanied by improved economic conditions in only 19 percent of the relevant episodes occurring between 1970 and 1995 (1996).

Also, more recently, a study by Alberto Alesina and Sylvia Ardagna 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, both studies demonstrate that the odds of successfully reducing public debt levels and achieving increased growth through austerity are not very good.

Secondly, austerity rarely leads to improved economic conditions solely as a result of fiscal retrenchment by government. Most often, successful public sector austerity campaigns are the outcome of the combined effects of monetary policy and exchange rate policy, as well as the positive impacts of external economic conditions.

For instance, Canada's experience with austerity in the mid-1990s could be viewed as positive largely because of the change in US exchange rate policy announced in April 1995. As I explained in a previous column, this change in US exchange rate policy
...resulted in the rise in the value of the US dollar against other currencies. The ensuing depreciation of the Canadian dollar provided a huge boost to Canada's exports, and helped Canada achieve several years of consecutive current account surpluses.
In the case of many European countries today, austerity cannot benefit from changes in monetary and exchange rate policies given that the European Central Bank has no mandate to assist members of the European Monetary Union (EMU) in this regard. Also, given the weak global economic conditions at the moment, European nations cannot look to improvements in trade as a way to achieve growth.

Finally, there is something inherently odd about hearing the Canadian and British Prime Ministers scold Europeans with calls to stem the growth in public debt. As the subprime crisis and the ensuing recession have taught us, it is excessive household debt that ought to be the main preoccupation of governments right now. And when it comes to excessive household debt, Canada and the UK are countries with two of the highest household debt to GDP ratios in the world.

To be sure, it is true that public sector debt is currently a problem in many European countries. However, the problem is primarily the result of structural deficiencies in the EMU, not the result of excessive fiscal spending. These structural deficiencies have been known to many economists since before the EMU was even established. Thus, budgetary austerity in the Eurozone will do nothing to remedy the public sector debt crisis now affecting Europe. If anything, further austerity will likely worsen the existing situation (see Forstater, 1999).

On the issue of excessive household debt, the Bank for International Settlements (BIS) has recently estimated that a household debt to GDP ratio above 85 percent has damaging effects on growth (Cechetti et al., 2011). With ratios now at over 94 percent and 100 percent, respectively, Canada and the UK are well above the "safe" limit set by the BIS. Canadian and British policymakers should take note of this fact. (For more on ratio figures, see Tang and Upper, 2010:27)

Also, it would be appropriate to remind policymakers of the "counterpart principle" in government transactions put forth by economist Kenneth Boulding and others several decades ago (1958:169). According to this principle, all activities of government have opposite counterparts in the private economy. Thus, any decision by government to cut expenditures or increase taxation will have an impact on private sector income and savings.

In other words, for every dollar, pound or euro not spent by government, one less dollar, pound or euro gets added to private sector bank accounts. Similarly, for every additional dollar, pound or euro levied in taxes to reduce public sector deficits and debt, there is one less dollar, pound or euro available for the private sector to spend, add to savings or use to pay down private debt.

In a context of excessive household debt and weak global economic conditions, government austerity will most likely have serious deleterious effects on the balance sheets of households. Under such circumstances, austerity is not to be recommended.

To conclude, I strongly urge Messrs. Harper and Cameron to consider the above before continuing to praise the merits of public sector austerity.

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

Boulding, K., Principles of Economic Policy, (Englewood Cliffs: Prentice Hall), 1958

Cecchetti et al., "The real effects of debt", BIS Working Paper No. 352, 2011

Forstater, M., "Introduction", Eastern Economics Journal, Vol. 25, No. 1, 1999

McDermott, C.J and Wescott, S., "Fiscal Reforms that Work", Economic Issues, No. 4, November, IMF, 1996

Tang, G and Upper, C., "Debt reduction after crises", BIS Quarterly Review, September, 2010

Wednesday, 28 September 2011

Economists to Parliament: fiscal policy must remain flexible, government cuts can't go too far, caution is the key word

Yesterday, economists of various persuasions and professional background sat before Canada's Parliamentary Standing Committee on Finance to give their views on the current economic context and the upcoming challenges facing the Canadian and world economies.

It is important to emphasize that not one of these economists advised Canada's federal government to accelerate its objective of reducing and cutting public expenditures.

The first economist to share his views was post-Keynesian economist Marc Lavoie, professor of Economics at the University of Ottawa. According to Lavoie, there is no doubt that the world is heading for another recession or, at the very least, several years of zero growth. Here are a few excerpts from Prof. Lavoie's submission:
"We are witnessing the Japanization of western economies...The Eurozone has structural deficiencies that make it impossible to avoid a crisis...There will be an earthquake in Europe, and North-America will be hit like a tsunami...Canada will not be able to magically escape from this economic crisis...The Canadian government must not introduce spending cuts. The government must implement a new recovery plan for infrastructure and renounce its objective of trying to achieve budgetary balance."
If you tend to agree with the above prognosis, Prof. Lavoie's submission is a must see (His submission begins at 1:55 and ends at 8:00 minutes). See here:


Thursday, 22 September 2011

A truth for our times: without improvements in employment there is no true recovery

From Classic Indeed:
Boehner, Cantor & Associates' understanding of basic economic realities is unreliable and incomprehensible for that level of leadership. They should simply acknowledge that without employment there is no spending and there are no sources of Treasury revenue; and without revenue sources, there is no deficit reduction. If they persist on professing that deficit myth: that deficits matter for the US economy, they will make matters worse. They should recognize their own shortage of viable solutions, and grasp the moment to support fiscal spending programs. As for Rating Agency downgrades, they don't matter at this moment. Recently, they have been shrugged off by all sovereign levels.

Unless the US economy is activated, and this won't happen as a result of Federal Reserve monetary policy, the global economy will remain in a state of stagnation for a long time. It is obvious that any solution must come out of Washington. (my emphasis)
I agree entirely. I would also add that what the GOP needs to understand is that if the US federal government tries to sharply reduce spending to reduce its fiscal deficit, it will most likely run massive deficits anyway. In other words, the GOP's plan to cut spending is just self-defeating.

Now, it's obvious that this is bad economics. However, I would argue that this is also very bad politics. How can the GOP believe that its strategy will prove politically beneficial? Surely, at some point the American public will start to realize that the GOP's preferred approach to the economy will have been completely ineffectual. With employment levels poised to stay the same for several more years, the GOP should see that there is little, if any, currency in continuing to propagate such ideas.

Tuesday, 13 September 2011

Canadian household debt-to-GDP reaches record high

Canada's National Balance Sheet Accounts for 2011 Q2 were released today. Here is a good summary, courtesy of Statistics Canada.

For my part, the most important piece of information that I retain from these accounts is that Canada's personal debt-to-GDP has reached a new record high of 94.08 percent.

Another interesting development is that real estate as a percentage of personal disposable income has jumped to 296.37 percent, the second highest level on record. For those who see trouble ahead in Canada's economy and, more specifically, its real estate market, such figures are not encouraging.

One thing is for sure, there's nothing in these accounts to reassure federal policymakers who, since the fall of 2010, have been raising concerns about Canada's increasing household indebtedness levels.

Sunday, 11 September 2011

The proposed American Infrastructure Financing Authority: Not the way to go

I've been critical of the idea of an American Infrastructure Financial Authority (AIFA) since before President Obama included it in his jobs plan last week. Here is an excerpt of a post I wrote in March on the proposed AIFA and, more specifically, its objective of seeking to direct private capital toward the funding of publicly-oriented infrastructure projects that are both commercially viable and socially beneficial:
In one way, the idea would be a good one if the US economy was riding somewhere mid-point along the business cycle. But the economy is nowhere near such a point. Rather, with real long-term interest rates (i.e. interest rates on inflation-protected bonds) as low as they are today, the US should simply be borrowing massively and investing the amounts on growth-inducing projects, such as building or improving infrastructure, as well as in areas such as education and energy-efficient technologies.

Also, I want to add a word on this notion that the funds be limited to "commercially viable" projects. Let's not forget that the private sector is rarely compelled to invest in projects resulting in positive externalities (i.e. benefits that everyone can enjoy). Governments, however, are much better positioned to do so given that governments can count as profits these types of widely-shared, collective benefits associated with large, public infrastructure projects.
Since Obama gave his jobs speech last Thursday, I've read several commentaries expressing doubt about the necessity and merits of the proposed infrastructure bank. But none are as forceful as this excellent article from the author of the Reuters MuniLand column. Here are some excerpts from the article describing the problems associated with the proposal to establish the AIFA and the role it might play in accelerating the pace of privatization of US public assets:
Currently almost all American infrastructure is funded either through municipal bonds or federal funding. Even as federal funding has been constrained, municipal bond issuance has been very low this year, running at about half of last year’s rate. There is plenty of capacity to fund infrastructure with municipal bonds. From a funding standpoint it’s not clear why we need an infrastructure bank, especially a paygo infrastructure bank. [...]

There is no question that private money is interested in being used for loans to infrastructure projects and guaranteed by the federal government and taxpayers. It’s almost identical to senior bondholders who loaned money to too-big-to-fail banks. It’s the best setup for private money because there is no loss. [...]

[I]t’s a pity that a project dressed as job creator will really be a vehicle to create privatized public assets. Our nation was founded and grew strong on the basis of our shared public infrastructure. It’s a shame that the American Infrastructure Financing Authority will be the agency in which ownership of public assets becomes private. (emphasis added)
I agree that it's a shame. Actually, if the public interest is truly the goal driving such an initiative, US policymakers should stick with a plan that involves borrowing massively and investing into employment-enhancing and growth-inducing public infrastructure projects. Now is exactly the right time to be undertaking such initiatives. As you can see from the chart below, the cost of borrowing for the US government is currently at record lows.*

10-year Treasury Inflation-Indexed Security, Constant Maturity (Source: Federal Reserve)

* Rates on inflation-protected bonds rates are a good measure of the private cost of borrowing to start new businesses or expand existing ones

Wednesday, 31 August 2011

Canada's real GDP declines

Canada's second quarter economic accounts were released today. Real GDP declined 0.1%, largely due to the 2.1% drop in exports (see Charts 1 & 2). Also, business inventories have increased, income growth has slowed and goods production has decreased.

Chart 1 (Source: Statistics Canada)

Chart 2 (Source: Statistics Canada)

Honestly, there isn't much in these accounts to be optimistic about. That said, I still hold a glimmer of hope that business investment might be able to sustain economic activity for the next few quarters. Here are a few excerpts from the summary prepared by Statistics Canada:
Business investment in plant and equipment continued its upward trend, rising 3.7% in the second quarter, a sixth consecutive quarterly increase. Machinery and equipment has contributed the most to growth in overall investment in plant and equipment in four out of six quarters[....]
Government expenditures on goods and services grew 0.4%, after remaining unchanged in the first quarter. All levels of government increased spending on goods and services this quarter[...]

Consumer spending on goods and services rose 0.4% in the second quarter. Consumers increased their purchases of durable goods (+0.4%), as well as services (+0.8%). Purchases of non-durable goods edged down 0.1%, while purchases of semi-durable goods declined 0.8%.
Other than for the positive trend in business investment, it's clear that the second quarter of 2011 was a disappointment. This is definitely not the time to be cutting government expenditures. Instead, federal and provincial policymakers should be drawing up plans to inject additional stimulus into productive, job creating initiatives.

As for Canada's exports, let's face it, there is little hope that these will increase significantly. The strength of the Canadian dollar combined with the weak economy of Canada's main trading partner, the United States, make that goal close to impossible to achieve. A repeat of Canada's export boom in the mid-1990s is highly unlikely (see here). Also, it's simply not a sensible approach right now to expect consumers to be the source of economic growth. As I've explained in previous posts (here and here), the household sector in Canada is currently in the process of accumulating less debt. And that is a good thing given that household and personal indebtedness are currently at worrisome levels.

Therefore, the best bet for policymakers right now would be to abandon plans to cut public expenditures and ensure that business investment continues to expand.

For more on how to achieve the goal of increasing business investment, please refer to my previous post entitled "The right way to balance the budget: target the corporate surplus, not the government deficit".

Saturday, 27 August 2011

Crescenzi watch: Inconsistent messages out of Pimco?

Tony Crescenzi of Pimco is at it again. For the second time since being given the privilege of replacing the now-retired Paul McCulley as the lead author of Pimco's Central Bank Focus (CBF) column, Crescenzi has written a piece that has the effect of undermining the current position of Pimco's two chief investment officers, Bill Gross and Mohamed El-Erian, both of whom have recently been calling upon the US federal government to do more to create jobs, update public infrastructure and invest in education. 

Entitled "Saying no to Keynes and Fiscal Folly", Crescenzi's August edition of CBF is half-filled with the usual nonsense equating Keynesian-inspired policy remedies with costly and wasteful government spending.

The problem with Crescenzi's contention that the application of Keynesian economics and its focus on stimulating aggregate demand through government expenditures result in a net cost to society is that it completely disregards the productivity-enhancing nature of public investment. As economists David Aschauer (1989) and Alicia Munnell (1990) have shown, public sector investment results in productive assets that tend to enhance private sector productivity in the long-run.

In other words, Crescenzi really needs to be more careful. As I mentioned in a previous post, Crescenzi's anti-Keynesian message is exactly the type of commentary that opponents of government intervention would use to attack the very proposals now being recommended by Gross and El-Erian to help prop up the US economy and mitigate against the possibility of another economic downturn.

So, all that being said, what really is the true legacy of Keynesian economics? I like to think that Michael Stewart captured it best when he designed the cover image for his classic text on Keynes, Keynes and After (London: Pelican, 1967): nothing less than three consecutive decades of persistently low unemployment.

Aschauer, D., 1989, "Is Public Expenditure Productive", Journal of Monetary Economics, Vol. 23, pp. 177-200.

Munnell, A., 1990, "Why has productivity declined? Productivity and Public Investment" New England Economic Review, Federal Reserve Bank of Boston, January/February issue, pp. 3-22.

Thursday, 18 August 2011

Consumer credit and spending continues to slow

The August edition of the Canadian Economic Observer is out. For many months now, my eye has been fixed on the declining growth in consumer credit and household expenditures. This is a clear sign that households are accumulating less debt.

Growth in business investment is also slowing, but its current level is from a historical standpoint still very high. No doubt the strength of the Canadian dollar is helping firms update their machinery and equipment.

On the bright side, government expenditures have turned up a tad after several months of decline. Also, capacity utilization rates are continuing their upward trend.

Finally, no sign that Canada's current account balance will improve any time soon (see here for more on export potential and Canada's sectoral balances).

Monday, 15 August 2011

Modern Monetary Theory and its Critics

Paul Krugman published today another of his critiques of Modern Monetary Theory (MMT) (aka neochartalism, for those who've known about this macroeconomic paradigm since the 90s and beyond). For an excellent introduction to MMT, I recommend the following article by economist Pavlina Tcherneva. Prof. Tcherneva's take on MMT is by far the most comprehensive (and relatively brief) description of neochartalism available.*

In his post, Prof. Krugman argues that adherents to MMT are wrong in (1) believing that modern, economically sovereign governments (i.e. governments that have the ability to issue fiat money) do not face financial constraints and in (2) thinking that deficits financed by money issue are no more inflationary than deficits financed by bond issue.

In regard to the first objection, I could keep it short and simply quote the great economist Michal Kalecki, who argued that the only constraint facing a monetarily sovereign government consists of the inflationary impact associated with spending and investment initiatives undertaken by the private and public sectors. As Kalecki wrote in his article "The problem of financing economic development", there are:
...no financial limits, in the formal sense, to the volume of investment. The real problem is whether this financing of investment does, or does not, create inflationary pressures. (1955: 25)
However, it might be best if Kalecki's statement were echoed by the words of someone with Prof. Krugman's credentials, that is, another Bank of Sweden Nobel laureate. For this reason, I wish to highlight the following quote from the late economist Bill Vickrey, who claimed that:
"...in the absence of a norm such as a gold clause, there can be no question of the ability of the government to make payments when due, albeit possibly in a currency devalued by inflation." (2000: 13) (my emphasis)
Having now attempted to give credence to MMT's claim regarding the financeability of government spending, and having determined that the sole constraint affecting the public finances of economically sovereign governments is essentially one of inflation, let me now turn to Prof. Krugman's contention that deficits financed by money issue are more inflationary than a deficit financed by bond issue. Here, I believe a quote by one of the leading figures associated with the "circulation approach" to monetary economics would suffice. According to Augusto Graziani,
The technique of financing a deficit does have an effect on prices, but only in an indirect way, and the effect produced is opposite to what the dominant analysis indicates. In fact a deficit financed by issuing government bonds increases the amount of interest payments and therefore the money incomes of savers; the consequence is that money prices are pushed upwards more than if the same deficit were financed by money creation. (2003: 140) (my emphasis)
One of the best explanations I've encountered for why financing government expenditures using money creation need not be inflationary is contained in "Optimal growth using fiscal and monetary policies", a paper authored by Hassan Bougrine and Teppo Rakkolainen and published by the International Economic Policy Institute. According to Bougrine and Rakkolainen, fears of inflation resulting from the government creating too much money in a context of unemployment are unwarranted given that:
...there is no such possibility for an excess supply of money since all the money that is created has been demanded. When workers seek jobs, they are demanding money. When contractors are hired to build a needed school, a hospital or a bridge, they are demanding money for compensation. Therefore the supply of money is always equal to the demand for money. The supply of money cannot exceed the demand for it and inflation is not a monetary phenomenon. In fact, when the government permits unemployment to exist by refusing to hire workers and neglects the infrastructure by not building the needed schools, roads, and so on, it is voluntarily choosing to suppress the demand for money and keep it arbitrarily low. Understanding money is essential because it effectively liberates the government from being subject to an imaginary budget constraint and allows it to actively intervene to fill the gap of under-utilised capacity of society as a whole, i.e., to strive to achieve full employment and high economic growth and development. (2009, p. 16) (my emphasis)
Before concluding, I should probably also address two points made by Prof. Krugman in a previous critique of MMT. The first point has to do with the role of taxation (note: Prof. Krugman disagrees with MMT that the purpose of taxation is to regulate purchasing power) and the second has to do with Prof. Krugman's belief that increases in the amount of base money is inflationary.

In regard to the role of taxation, Prof. Krugman should understand that it isn't only MMT supporters who believe that the most important function of taxation is to regulate purchasing power. Even some economists steeped in the neoclassical tradition believe this is the case. For instance, economist Robert Eisner in The Misunderstood Economy argued that:
[t]axes serve a number of purposes. The most important is to reduce the purchasing power of taxpayers. Resources are then freed from production of the goods and services that they would otherwise buy. It is in this sense, in real terms, that taxes pay for government expenditures. (1994: 196) (my emphasis)
As for Prof. Krugman's claim that expansions in the monetary base (i.e. reserves plus currency) are inherently inflationary, I wish to point out that leading economists at the Bank for International Settlement have been arguing for quite some time now that the growth in excess reserves need not result in additional credit creation, thus eliminating the possibility that inflation will ensue as a result. Take for instance, this quote from a recent paper by economists Claudio Borio and Piti Disyatat discussing how the amount of base money has no impact on bank lending:
Contrary to what is often believed, [banks’ reserves with the central bank] do not constrain the amount of inside credit creation. Indeed, in a number of banking systems under normal conditions they are effectively zero, regardless of the level of the interest rate. Critically, the existence of a demand for banks’ reserves, arising from the need to settle transactions, is essential for the central bank to be able to set interest rates, by exploiting its monopoly over their supply. But that is where their role ends. The ultimate constraint on credit creation is the short-term rate set by the central bank and the reaction function that describes how this institution decides to set policy rates in response to economic developments. (Borio and Disyatat, 2011: 30) (original emphasis)
To know more on this last point and, more specifically, on why increases in the amount of base money need not be inflationary, please refer to my previous posts here, here and here. In these posts, I discuss the inapplicability of the traditional money multiplier model taught in most macro textbooks and go over some of the implications associated with the Fed's new policy of paying interest on reserves.

* This sentence was updated to include a link to P. Tcherneva's website on 17/08/2011.

Borio, C. and P. Disyatat (2011), "Global imbalances and the financial crisis: Link or no link", Bank for International Settlement Working papers No. 346, May 2011.

Bougrine, H. and T. Rakkolainen (2009), "Optimal growth using fiscal and monetary policies",
Working Paper 2009-11, IEPI, 2009.

Disyatat, P. (2010), "The bank lending channel revisited", Bank for International Settlement Working papers No. 297, February 2010.

Eisner, R. (1994) The Misunderstood Economy: What counts and how to count it (Boston: HBSP)

Graziani, A. (2003), The Monetary Theory of Production (Cambridge: Cambridge University Press).

Kalecki, M. (1955), "The Problem of Financing Economic Development", Indian Economic Review; reprinted in Essays on Developing Economies (Brighton: Harvester Press), 1972.

Tcherneva, P. (2006), "Chartalism and the tax-driven approach to money", in P. Arestis and M. Sawyer (eds), Handbook of Alternative Monetary Economics, (Northampton, MA: Edward Elgar), pp. 69-86.

Vickrey, B. (2000), "Fifteen fatal fallacies of financial fundamentalism: A disquisition on demand side economics", Working Paper No.1, January 2000. A copy of the paper is available on the website of the Center for Full Employment and Price Stability, http://www.cfeps.org/pubs/