...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