Worthwhile Canadian Initiative

Why the GST is a good idea

It occurs to me that although most of the media coverage on the cuts to the Goods and Services Tax - and the various proposals to reverse those cuts to the GST - makes note of of the fact that there is a broad consensus among economists about the merits of consumption taxes, I haven't yet seen a good explanation for why they are so popular with economists. This is a problem: it makes it too easy for dim-witted politicians - which is to say the Conservatives, the Liberals and the NDP - to dismiss the merits of the GST without being called on it.

So below the fold, I'll try to explain the logic behind the GST.

In which sentient Canadians can only goggle in slack-jawed horror at the people who govern us

This is simply frightening:

Ian Brodie, Prime Minister Stephen Harper’s former chief of staff, delivered an astonishingly frank explanation today for why the Conservative government cut the Goods and Services Tax, and why he’s glad they did, even though just about every economist and tax expert said it was a terrible bit of public policy.

“Despite economic evidence to the contrary, in my view the GST cut worked,” Brodie said in Montreal at the annual conference of the McGill Institute for the Study of Canada. “It worked in the sense that by the end of the ’05-’06 campaign, voters identified the Conservative party as the party of lower taxes. It worked in the sense that it helped us to win.”

Words fail me. More precisely, words that would keep this blog's family-friendly rating fail me.

Update: It occurs to me that I'm unfairly singling out the Conservatives here. After all, The Liberal won the 1993 election on a promise to eliminate the GST. Nor has the NDP ever had a kind word for the GST. The point is that none of our rulers or of our would-be rulers have refused to play this game.

US road trip!

This will be my last post for a couple of weeks. I'm off on a US road trip!

My last big US road trip was Summer 1976. Berkeley to New York, by a very circuitous route. This one will be shorter, down the Atlantic coast, across to the Gulf of Mexico and back up along the Mississippi (unless we change our minds). I am really curious to see how the country has changed in 33 years.

The timing is good: gas is relatively cheap; motels relatively empty (according to Calculated Risk, though he didn't have stats for campsites); and the loonie is at 80 cents (it was at par 33 years ago). And I'm on sabbatical :-).

Why failed bond auctions are good news

Suppose an increased supply of government bonds to finance deficit spending were met with an increased demand for government bonds from the private sector, so that interest rates stayed the same, and the bond issue were fully subscribed. That is exactly what would happen for a bond-financed tax cut under full Ricardian Equivalence, for example. I would interpret that "very successful" bond auction as very bad news for fiscal policy. It means fiscal policy won't work.

A failed bond auction however is good news.

Let's take an extreme example (because it's simpler): the "nightmare scenario". Suppose people are willing to hold the existing stock of government bonds, but refuse point blank to buy any more, at any interest rate. What would that mean, for fiscal policy, and for aggregate demand?

"Failed" government bond sales?

The UK government "failed" to sell all the bonds it wanted to sell to finance its deficit spending. The story is here. And here.

There are many aspects of this story I find puzzling.

Two questions; no answers.

Are we seeing the first signs of recovery, or just a temporary bear-market rally?

What caused it? Fiscal policy? Monetary Policy? Financial policy? Or did it just happen by itself?

As I said, I don't have the answers, but while the rest of the economics blogosphere seems to be concentrating on AIG bonuses and the Treasury Plan, I thought I would at least raise these questions. I do so hoping that your comments might help us at least recognise more of the symptoms, and help provide the evidence for a diagnosis. Let's pretend I'm Gregory House. (Well, at least I look a bit like him.)

Liquidity and risk: liquidity as the value of an option to sell at the market price

Is this a risk crisis or a liquidity crisis? What's the difference?

We can define "risk" and "liquidity" any way we like, but some definitions are more useful than others. A useful definition would explain why "risky" assets need high yields to make people willing to hold them, and why "illiquid" assets need high yields to make people willing to hold them. And useful definitions of "risk" and "liquidity" would allowed us to distinguish the two.

Here's my distinction between risk and liquidity:

The value of an asset can be decomposed into two parts: the value of the stream of dividends (where redemption counts as a final dividend) to the owner of the asset; and the value of the right (or option) to sell the asset at any time at the market price. We should use "risk" to talk about the effect of uncertainly on the value of the stream of dividends; and use "liquidity" to talk about the value of the right to sell the asset. The value of liquidity is the value of an option to sell at the market price whenever I choose to exercise that option.

The Quebec provincial budget: Live-blogging on tape delay

I'm off to the media lockup for today's budget; I'll be helping out with the CBC radio (English) budget special. You can listen here; it starts at 4:00 pm, EDT.

I won't have internet access, but I'll take notes and post them when I do.

6:27: I'm free! Free! The day's events are documented below the fold.

Why does liquidity matter so much?

This question has been bugging me for the last few months. I see the financial crisis as largely a liquidity crisis. People only want to hold the most liquid assets, and shun the illiquid. So liquid assets have high prices and low yields; and illiquid assets have low prices and high yields.

But if we think of liquidity in terms of transactions costs, it is hard to see why people would pay so much to avoid holding illiquid assets. The transactions costs don't seem big enough to justify the yield spreads. A 1% extra transactions cost would only justify a 1% yield spread if you expected to hold the asset for one year. So you would need really big differences in transactions costs, or really short expected holding periods, to explain any significant yield spread between liquid and illiquid assets. Neither seems plausible.

Perhaps it's not transactions costs, or not just transactions costs, that determine differences in liquidity. Perhaps it's the fear that my need to sell the asset to raise cash may be correlated with other people's need to sell the asset to raise cash. If our needs to raise cash are correlated, the market price will fall at exactly the wrong time. A 10% fall in the market price if I ever needed to sell the asset would have the same effect on liquidity as a 10% transactions cost.

Economic Impact Assessments, and fiscal policy: the fallacy of decomposition

Some extra money from the last Federal budget went to fund new projects at universities. As part of its application for funds, each university must say how it plans to spend the money, and also do an "Economic Impact Assessment". I have been called in to help. I know little about EIA. I remember a bright, cynical, graduate student once say "Add up all the money you spend, multiply by 2, and tell a story".

So I spent a little time on the internet reading about EIA, and a bit longer thinking about EIA. I just wanted to share some of my naive thoughts about the relation between EIA and the way macroeconomists normally think about fiscal policy.

The US may need a financial hegemon. But the US is not the world.

Canadians are federalists by instinct, so my reaction to Dani Rodrik's recommendation to resist the imposition of a global financial regulator with a Procrustean mandate is to nod my head in approval. In the current context, the proper Canadian reaction to such a proposal would be to wonder why on earth ceding authority to a US-dominated - does anyone believe that it would be anything else? - financial regulator would be a good idea.

Brad DeLong may be quite right to think that a global authority might have a better chance of keeping the US in check. But for the rest of us, it looks like a way for the US to drag everyone else down with them.

Unless the US is willing to truly abandon its sovereignty in this matter - and there is nothing in its history to suggest that it would - then this project is doomed to failure.

The unit-root zombie: Dead, but still wreaking havoc

If there's one thing that is guaranteed to drive the still-too-small community of Bayesian macroeconometricians up the wall, it's the debate about whether or not GDP - or any other variable - has a unit root. If you don't know what a unit root is or why it has anything to do with GDP, then you might want to give the rest of this post a miss: the stuff after the fold is pretty darn wonkish.

Is quantitative easing trying to raise or lower interest rates?

The Bank of England has switched to quantitative easing. It is buying long bonds (gilts). What would count as a signal of success? We could argue that falling yields would signal success, because it is trying to reduce long interest rates to stimulate investment. But we could equally argue that rising yields would signal success, because higher expected growth in real output and inflation would increase long interest rates.

What does that ambiguity imply about thinking of interest rates as the monetary policy instrument or indicator? What does it imply about the likely success of that form of quantitative easing?

The Globe and Mail's subprime envy

Today's G&M has what purports to be an exposé on subprime mortgages in Canada:

Canada's dirty subprime secret: Since the subprime mortgage meltdown in the United States, Canadian leaders have assured the public that a similar tidal wave of foreclosures can't hit here. They have cited the prudence and market dominance of Canada's five most prominent banks, the conservatism of Canadian consumers and the tiny, 7-per-cent market share of subprime lenders, which is much lower than their 22-per-cent market share in the United States. Just four days ago in a speech, Prime Minister Harper said: “We have avoided the extreme of the unregulated, or barely regulated, financial and mortgage industries that has caused such grief around the world.”

However, The Globe's investigation shows that while Canada's real estate sector hasn't suffered as much as its counterpart in the United States, the Prime Minister and others have grossly underestimated the impact of that small portion of subprime lenders.

Huh? I've read through the piece several times now, and it shows no such thing.

Canada is no longer a net debtor country

Given our history of wringing our hands about Foreigners Owning Canadian Assets, I'm a bit surprised that this story hasn't yet been picked up on the news sites I watch:

Canada's net international investment position: Following a trend to reduced net foreign debt since the mid-1990s, Canada recorded a net asset position of $13.5 billion in the fourth quarter of 2008 — the first net asset position in this time series which dates back to 1926.

This isn't actually a surprise after a long string of current account surpluses followed a sudden depreciation. And it may be revised away, as this episode was. But I would have thought that it was newsworthy, nonetheless.

The Parliamentary Budget Office is asking for public support. It should get it

This is bad news (h/t to Shock Minus Control):

Budget watchdog pleads for help: The watchdog created by the Harper government to scrutinize the state of Canada's finances has just issued a public plea for help, asking the Prime Minister and opposition parties to rescue his office as it confronts a funding crunch and pressures to curb its independence.

Parliamentary budget officer Kevin Page, who is facing the prospect of dismissing staff if Ottawa doesn't deliver on its full funding pledge for the new office, has written Prime Minister Stephen Harper and opposition leaders to straighten out confusion over what he's supposed to be doing for Canadians.

He strongly hints in the March 11 letter that he's not being given enough freedom to do the job as originally designed – or the promised level of funding.

One of the reasons why I started this blog is that there simply isn't enough informed commentary on economic issues in Canada. In its short and underfunded history, the PBO has tried to correct this state of affairs, and the work it has been able to produce is - given the constraints - very promising indeed. It should be given the resources and the freedom to do what it is supposed to be doing.

Temporary vs. permanent quantitative easing

A permanent increase in the money supply (or one that is expected to be permanent) will have a different, and bigger, effect today than a temporary increase in the money supply (or one that is expected to be temporary). To say the same thing a different way, an increase in the expected future money supply has an effect today. I am not saying anything novel or unorthodox; just reminding us of something we already knew. Yet this distinction between temporary vs. permanent increases in the money supply seems not to occupy our attention much in discussions of quantitative easing.

GDP, GDI, terms of trade and why Canada is in a recession: It's all about the beer and pizza

The Parliamentary Budget Office has released a report (pdf - h/t to Kady O'Malley) that makes note of the distinction between Gross Domestic Product (GDP) and Gross Domestic Income (GDI), and shows that by the latter measure, the fourth quarter of 2008 was even more dreadful than the GDP numbers that made all the headlines.

As a public service, I'm going to explain what the difference is between GDP and GDI and how it relates to the current recession. It starts below the fold, and yes, there will be beer and pizza.

Liquidity and aggregate demand

Money is perfectly liquid. Other assets are not as liquid as money, but some are more liquid than others. One of the main features of the financial crisis is that some assets became less liquid than they had previously been. I want to look at the channels through which a fall in the liquidity of those assets could reduce aggregate demand.

Altruistic individual responses to the financial crisis

We don't rely solely on government to alleviate poverty. We don't rely solely on government to provide public goods. Altruistic individual responses can help too. Perhaps we shouldn't rely solely on government policies to help solve the financial crisis either.

At the very least, asking what individuals could do to help alleviate the problem might help us better understand the nature of the problem. In what ways does individuals' acting in their own rational self-interest cause an undesirable outcome? What sorts of changes in individuals' behaviour could improve things?

Here are my recommendations. They reflect my own understanding of the nature of the problem.