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".

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.

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).

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/