What if increased government spending is contractionary?

Suppose that Canada does go into recession, either this month or in the months to come. What policy instruments are in the arsenal?

• The automatic stabilisers: Taxes will fall with revenues, and expenditures will rise as unemployed workers start drawing on employment insurance benefits. (There are of course other mechanisms at work here.)
• Monetary policy: The Bank of Canada has cut its interest rate have by 250 bps since the credit crunch started last summer, and there is still space for further cuts.

Which brings us to discretionary government spending. There is of course a strong case that can be made for increasing discretionary spending in a recession, and the case is even stronger for a country that has been running surpluses for more than a decade. But that's only if you think the fiscal multiplier is positive.

Readers of a certain age who happened to be paying close attention to Ontario politics at the time [Oh come on, there must be someone out there who remembers this - ed.]  may recall Floyd Laughren's line about choosing to 'fight the recession, and not the deficit' in one of his budget speeches during the 1991-92 recession. The problem was of course that Ontario is far from being a closed economy, and whatever fiscal stimulus that the Ontario government could generate would leak outside its borders, with essentially no effect on the Ontario economy. The only thing Bob Rae's NDP government got out of the exercise was a scary deficit. (I should mention here that I don't want to be too hard on Rae or Laughren: they were dealing with a very tough situation, and both acknowledged that they had made a mistake ex post.)

Which brings us to this graphical representation of some of the results from Roberto Perotti's paper 'Estimating the effect of fiscal policy in OECD countries' (the graph comes from the IMF):

It would appear the the import leakage story for government expenditures carries over to Canada as a whole over the past 30 years: if anything, the cumulative effect on GDP of increasing government spending was negative. Curiously, the effect of tax increases has the opposite sign.

I'm not keen on tax cuts as a countercyclical move for two reasons:

1. They're hard to cancel when the need for them goes away.
2. Since low-income households don't pay much in taxes, tax cuts are rarely progressive.

(Yes, I'm aware of the point of how people may simply save the tax cut and not spend it; I'm not entirely sure why I should view that as a bad thing.)

But the case for spending doesn't look much stronger: the only people who would benefit are likely to be the best-connected special-interest groups. If a MP really wanted to help the people of her riding, she should resign and force a by-election -  government money would rain down on her constituents like so much confetti.

Here's what I'd like to see:

• No mention whatsoever of increasing government spending as a counter-cyclical measure - that sort of exercise is pretty much futile.
• Broadening and strengthening the safety net. For example, there are many workers who would not be eligible for benefits if they lose their jobs. If these measures result in a deficit, so be it.

I don't see any point in Canadian governments trying to fight a global recession. They should adopt a defensive position and do their best to protect Canadians from the worst of its effects.

Comments

[Adam]

"They're hard to cancel when the need for them goes away."

Geez, you mean people might actually get to keep their own money even after they don't "need" it? Well that's the end of civilization right there.

[Kyle Dionne-Clark]

Interesting that the results of "Keynesian" expansions bring such different results on a country by country basis.

Also, I must say I am a huge fan of your data representation skills.

[commonsense]

Stephen:

Looking at the most recent data for Canada (1980-2001), we see that every 1% decrease in taxes results, 3 years later, in an economy that is about 2% bigger than if nothing is done, and more than 4% bigger than if spending is increased by 1%. So tell me again why this doesn’t prove that decreasing taxes is the best possible antidote to recession...

[chromo]

Add to that the fact the old saw that correlation isn't causation. The devil is in the details. What other factors are at play? I would think there could be any number of reasons to see that trend.

Also, at some point tax relief is counter productive. Haven't we seen the general political abuse of the Laffer Curve to wrongly "prove" that decreased taxes always result in increased growth, which will always result in increased tax revenues? This is true at high rates of taxation, but the returns diminish as tax rates decrease, then become negative. Taken to an extreme, I doubt not funding government at all would be helpful to the economy.

[Phillip Huggan]

There is a selection effect here. You lower taxes in "good" economic times (when the fed masses don't protest). You raise programme spending for a variety of reasons. Another minor adjustment is debt isn't costed by GDP. Mulroney gets brownie points for doubling federal debt while Chretein gets penalized (economic growth under GWB is negative if costing debt).
I look at it as two competing ROIs. Giving money to corporations vs programme spending. You can't really compare different years as programmes and corporations change. We have big oil and banks making much of the profits now, and the opposition parties had efficient programmes (daycare, GHG costing, affordable housing, Kelowna Accord), so I'm left wing now. In the past when telecoms were a bigger slice and gun registry was a prospective programme, maybe right wing was better.

Conservative/Liberal corporate tax cuts are scheduled to peak right around 2012, when boomers will start to need last year of life palliative care. Crank up those corporate rates, drop some income taxes, or get bed sores. The future is left wing.

[reason]

The comparison between Australia and Canada (superficially very similar places - urban medium sized economies which export mostly agricultural products and raw materials) is wierd! Any comments on why the response profiles seem so erratic?

[Nick Rowe]

I'm trying to think of theoretical reasons why fiscal policy multipliers might be (or might seem to be) negative:

1. because the Bank of Canada raises interest rates in response to the loosened fiscal policy, in order to keep inflation on target, and mistakenly raises interest rates too much.

2. because households fear that the increased deficits and debt will cause future taxes to increase, overestimate those future tax increases, and mistakenly increase savings by even more than they need to pay those future tax increases.

3. because investment falls since those future tax increases reduce the after tax return on investment.

Explanations 1 and 2 assume consistent mistakes by the bank of canada or households. Explanation 3 relies on a high elasticity of investment. Or maybe fiscal policy just appears not to work.

Like Phillip Huggan, I doubt the ability of VAR techniques (as used in the paper) to 'hold other things constant'. Generalising his point, if monetary/fiscal authorities set monetary/fiscal policy to target constant inflation/output growth at an H-month horizon, and have rational expectations, then (it can be proven) inflation/output growth will be uncorrelated/unforecastable with any measure of monetary/fiscal policy (or any public information) with a lag of H months or longer. All econometric estimates of monetary/fiscal multipliers will fail. This point was (sort of) understood 30/40 years ago, but has been (largely) forgotten. At horizons of less than H months, we are more likely to be estimating the response of monetary/fiscal policy to inflation/output growth than vice versa, so the negative estimated multipliers are not a surprise. Anticipating falling inflation/output, they loosen monetary/fiscal policy.

I am old enough to remember the days of "Pink" Floyd Laughren and the Ontario NDP attempt to use fiscal policy to fight a recession. What we forget however is that this was just the last gasp of how fiscal policy was done for many decades; it used to be conventional wisdom that fiscal policy (at least at the national level) should always be presented and formulated to attempt to stabilise real output. And only economically illiterate people thought that the national debt was a problem, because the economically literate knew that "we owed it to ourselves". (Read Abba Lerner on "Functional Finance" to recapture the flavour of those days.)

Back to the present, Nick....