Worthwhile Canadian Initiative

The Global Effects of U.S. Fiscal Policy

That's the title of a discussion paper (pdf) by Kimberly Flood at the Bank of Canada. This is from the conclusion:

The results of our U.S. fiscal policy simulations show that the expiration of the tax relief from the AMT and the expiration of the tax cuts enacted in 2001 and 2003 can impose short-run economic costs to the U.S. economy. However, in the long run, aggregate demand in the United States and the rest of the world benefits from the expiration of AMT relief and the 2001 and 2003 tax cuts, owing mainly to a corresponding fall in the world real interest rate. Furthermore, the simulations highlight the potentially important role that U.S. fiscal policy adjustment can play in the unwinding of global current account imbalances. In particular, the increase in taxes associated with the expiration of relief from the AMT relief and the expiration of the 2001 and 2003 tax cuts can result in an improvement in the U.S. current account deficit. Nevertheless, this improvement is small compared with the size of the adjustment required to reverse global current account imbalances: U.S. fiscal policy is only one factor behind such imbalances, and will therefore be only part of a successful adjustment package.

The results of our study suggest that the initial expiration of relief from the AMT will:

• reduce the level of U.S. real GDP by 0.1 per cent, on average, over the first five years following the expiration of AMT relief, and increase real GDP by about 0.5 per cent in the long run
• improve the U.S. current account-to-GDP ratio by about 0.2 percentage points in the long run
• increase the level of Canadian real GDP by about 0.5 per cent in the long run

The results of our study also suggest that the expiration of the 2001 and 2003 tax cuts will:

• reduce the level of U.S. real GDP by an average of 0.2 per cent over the first five years following the shock, and increase real GDP by about 1.5 per cent in the long run
• improve the U.S. current account-to-GDP ratio by 0.7 percentage points in the long run
• increase the level of Canadian real GDP by about 1.5 per cent in the long run

Memo to the US Democratic Party from the rest of the world: Please get your act together and win the election. Thank you.

Comparing central banks' responses to the credit crunch

Here's an interesting graph from the Bank of Canada's Monetary Policy Report:

Yes, yes, I know; it's almost impossible to tell the difference between the UK and Canada in that graph, but if you look at the original document and zoom in to 200% of the original size, you can (just barely) conclude that the UK series is the one that has the second-highest spread as of April 2008. Someone at the graphics department of the BoC deserves a scolding.

Anyway, here is a summary of what the the four central banks in that graph have faced since mid-July, and how they've responded:

• The US: The spread increased by 175-200 bps since July. The Federal funds rate has decreased by 300 bps.
• The euro zone: The spread increased by 125 bps. The ECB hasn't changed its interest rates.
• The UK: The spread increased by 175 bps. The Bank of England reduced interest rates by 75 bps.
• Canada: The spread increased by 125 bps. After increasing its overnight target by 25 bps on July 10, the Bank of Canada has reduced interest rates by 150 bps.

Canada and Argentina in the 20th century

Whenever I teach growth theory, I like to compare the Canadian experience with that of Argentina. Up until the 1930's, the two countries followed very similar paths: foreign investment financing the development of resource-based economies. But then the 1930's happened, and Canada and Argentina parted ways.

This is the best graphical demonstration that starting points are not destiny (the data are from Angus Maddison):

During the 65 years between 1870 and 1935, Argentina kept pace with Canada. Since then, Argentina's income per capita increased by a factor of 3, less than half that of Canada.

It's hard to see how that gap could be explained by anything other than the unhappy choices made by Argentina's political classes over the past four generations. Which makes me think that the answer to Dani Rodrick's question is a despairing 'yes'.

Update: Brad DeLong has just reposted his 1991 piece with Barry Eichengreen on the decisions Argentina took in the 1930s and afterwards.

Oil prices in currencies other than the USD revisited

Time up update my irregular series of graphs of oil price movements in currencies other than the USD:

The story of the first couple of months is pretty straightforward: oil prices fell in January and came back up in February, and there wasn't much in the way of significant exchange rate movements. By the end of February, we were pretty much where we were when the year started.

And then March hit, with important swings in both oil prices and in exchange rates. In the Euro zone, an appreciating currency attenuated much of the rise in oil prices, and oil was slightly cheaper on March 20 than it was on Jan 2. The even stronger appreciation of the yen means that oil prices in Japan are 7% lower than when the year began.

The CAD has been tracking the USD pretty closely over the past few months, but the recent drop in oil prices has been offset by a depreciating CAD. The net result is that CAD oil prices are still more than 5% higher than at the beginning of the year.

As long as forex markets peg the CAD to oil prices, the CAD value of oil exports should hold up.

On the Canada-US decoupling

There has been a certain amount of discussion about the 'decoupling' hypothesis:

Economic train wreck in the U.S. would hit Canada, decoupled or not: After subprime, decoupling just might be the most overused word of the year in economics.

A quick database search yields hundreds of newspaper stories about the decoupling phenomenon in the past three months alone.

Here's the theory: Forget the notion that the global economy closely tracks the fortunes of the mighty United States, that voracious consumer of everything.

The disciples of decoupling would have us believe that a new paradigm has taken root as a housing slump hacks at the foundation of the world's largest economy. This is a made-in-America event, after all, so why would Europe, Asia and emerging markets succumb to the downward drag? Instead, they argue that booming Asia will lift Europe, along with emerging markets from Africa to Eastern Europe...

The decoupling theory has even gained a few fans in Canada, who apparently believe that Alberta's oil will save us all.

BMO Nesbitt Burns economist Douglas Porter argued in a recent report that it's "a myth that every time the U.S. sneezes, Canada catches a cold." He pointed out that four times since the sixties, Canada has stayed in the black while the U.S. sank into recession - 1970, 1974, 1980 and 2001.

"Even if the U.S. economy does succumb to a full-fledged downturn, that does not necessarily mean that Canada will also automatically follow suit," Mr. Porter said.

He pointed to looming tax cuts, the relatively healthy housing sector, less restrictive credit conditions and still-strong commodity prices as evidence Canada can hold back the tide.

This sounds a bit like what I said here a couple of months ago. It's worth exploring a bit more in detail.

Recent oil price movements in currencies other than the USD, updated

Oil prices are now approaching USD100. Maybe it's time to revisit the graph of oil prices in other currencies:

In the last four weeks, the CAD has depreciated against the USD, and the yen has appreciated; the net result is that the CAD-yen exchange rate is pretty much where it was on Labour Day. If I were a currency trader on September 4, and if and someone told me that oil prices would jump 25% in the next 3 months, I would have bet on a sharp appreciation of the currency of the country that is a net exporter of oil against the country that is a net importer.

Good thing I have my day job.

Update: The graph for Jan 2 - March 20

Recent oil price movements in currencies other than the USD

Over the past few weeks, we've seen (among other things)

• A rise in the USD price of oil, and
• A fall in the value of the USD compared to other currencies

To what extent do these two phenomena cancel out? Here's a graph of oil prices in terms of the USD, the yen, the euro and the CAD:

So the run-up in the USD oil price is not entirely a story of USD weakness. But  as far as the euro area and Canada is concerned, exchange rate movements are an attenuating factor.

Update: The graph up to November 20.

Why doesn't the US have a consumption tax?

The obvious answer would be 'because it's unpopular with voters', but that really isn't convincing: no-one likes to pay consumption taxes (the adjective most associated with Canada's GST is 'hated'). Come to think of it, no-one likes paying personal income taxes, either.

But among OECD countries, it is only in the US where the architects of tax policy have not been able to set up a broad-based tax on consumption. I'm not even aware of a serious initiative to implement one - and it's not as though no-one in Washington is aware that consumption taxes have fewer deleterious effects on growth than do taxes on income.

The removal of consumption taxes from the policy mix means that discussions about the effect of tax increases in the US are distorted. After all, if instead of asking "What will happen if we increase taxes?", you ask the question "What will happen if we increase taxes that we already know to be most harmful to economic growth?", you're not going to be greatly surprised if the answer is - as Romer and Romer recently find - that the effect is to significantly reduce economic growth rates.

Canada's exorbitant penalty

Canada's current account surplus decreased by $C 5.3b in 2006Q4, thanks to a $C 4.5b deterioration of the income balance.

The puzzle about the Canadian income balance is exactly the opposite of the one posed by the US balance. We've been running a healthy current account surplus for 6 years now, and the net international investment position has increased to around -7% of GDP. But an investment balance deficit of $C 5b on an annual basis is something like still something like 1.4% of GDP.

In contrast, the US net investment position is a deficit of almost 25% of GDP, and its income balance only went negative a year ago. Even now, the deficit in the US income balance is only one-tenth of one per cent of GDP.

There are any number of reasons why the US investment balance defied gravity for so long: Asian central bankers and rich people in politically volatile areas have been happy to buy US assets even if they didn't generate much in the way of return. But these reasons don't easily explain why the Canadian investment balance is still so low.

The #1 reason to fear a hard landing in the US: There are no cushions

A US recession seems inevitable now. Unfortunately for those of us who would be negatively affected by this development, US policy-makers have, in their wisdom, stripped themselves of the means to attenuate its effects.

Monetary policy: The Fed didn't stop raising interest rates in August because it thought that inflation was under control; it did so because it saw a slowdown on the way. The Fed won't react until the recession is severe enough to bring core inflation below 2%.

Fiscal policy: The government deficit is something like 3% of GDP, and the debt/GDP ratio has been drifting north for a while now. That doesn't leave a lot of room for a counter-cyclical fiscal policy.

Yikes.