Rethinking Canadian macroeconomic policy

Olivier Blanchard and a couple of colleagues at the IMF have circulated a paper with the title "Rethinking macroeconomic policy". Some of the ideas that are touched upon include

• Increasing inflation targets to 4% instead of the 2% goal that is more popular among central bankers. The idea is that when inflation and interest rates are low, it is easier to bump into the zero lower bound. And if you do get to the lower bound, real interest rates will be -4%.
• Taking fiscal policy more seriously as a countercyclical policy instrument - both in expansions and recessions.
• Paying closer attention to financial market regulation.

What can Canadian policy-makers take away from all this?

Probably the first thing would be the warm fuzzies of smugness. It's pretty hard to make the case that the most recent recession was caused by errors on the part of the Bank of Canada and/or the Department of Finance. And it's only slightly less hard to make the case that the recession was exacerbated by Ottawa's mistakes. But it would be a mistake to be entirely complacent about the recent experience - what lessons should we take from it?

The 2% inflation target: My point of departure is 'If it ain't broke, don't fix it'. And it's not at all clear to me that the 2% target has failed as a policy. One of the more important assets that the Bank of Canada had going into the crisis was its credibility. It had already shown - during the deflation of the early 1990's - that it took its inflation target seriously. This was a painful exercise, and it cost John Crow his second mandate as Governor, but the policy remained. Before the recession hit, inflation had been running at 2% plus or minus a small white noise error for more than a decade. Expectations were firmly anchored there, and - from what I can tell from the Bank's surveys over the past year - they stayed at 2% during the recession.

If the only concern about higher inflation rates were the distortionary effects of the inflation tax, Blanchard is quite right to note that inflation is not the only distortionary tax we have, and is far from being the worst - some Canadian jurisdictions still have capital taxes on the books. We could probably safely trade low and stable inflation against higher and stable inflation as an insurance policy against hitting the lower bound, but it's not clear that this choice is available to us. Higher inflation has in the past been invariably associated with more variable inflation and with greater distortions in relative prices.

What about the dreaded Zero Lower Bound? Well, what about it? The Bank burned up 150 basis points on the financial crisis well before it actually hit the real economy, and the world didn't end. I like David Altig's take:

Among the lessons taken from the financial crisis, I include this: The "zero bound problem" was not all that big of a problem at all.

Did we hit the lower bound, or did we just graze it? The Bank never did see fit to actually implement a policy of quantitative easing, even though it (quite rightly) laid out the groundwork to do so. The 2% target has gone through a fairly stiff stress test, and has not been found to be wanting.

But I think that this experience should give pause to those in and around the Bank who have been floating the idea of moving to price level targeting. It's one thing to say that monetary policy will engineer a return to a given target for the price level, but it's quite another to credibly commit to a path to get there from the depths of a crisis. The theoretical arguments in favour of price-level targeting are sound, but we're going to have to think about a counterfactual of how such a policy might have played out in the past couple of years. The model has to be extended to include things like friction and panic.

Fiscal Policy: We did well to run surpluses and to bring down debt-GDP ratios during the last expansion, and other countries would have done well to do so as well. In the previous two recessions, the automatic fiscal stabilisers went rogue: revenues fell by more than we expected, and expenditures rose by more than we could afford. This time, we could accept these developments with a certain amount of equanimity. And we could even throw in a few percentage points of GDP worth of extra spending for couple of years without upsetting bond markets.

But what did this extra spending buy? In the standard Keynesian one-good framework, it really doesn't matter what you buy; all that matters is pumping up aggregate demand. But as I noted over here, employment losses were largely concentrated in the Ontario manufacturing sector: 5.3% of Canadian workers absorbed more than 36% of total job losses.

I'm sure that it suited the federal government to distribute cheques across the land, but I'm much less sure of the efficacy of spending money in sectors and regions that were untouched by recession. It sent the worst possible signal to the usual gang of well-connected, media-savvy interest groups: "We're giving money away, and we really don't care who gets it!".  The result was a contest in which those with the sharpest elbows and the best PR campaigns won. This is not a competition in which the most marginalised elements of society do well.

My preference would be to refuse to play this game, and to focus on strengthening the social safety net for those who need it most.

Financial market regulation: Paying closer attention to this file means thinking hard about what problems you want to avoid. For example, Ottawa is almost certainly right to dismiss Gordon Brown's proposal for a financial tax, for the simple reason that the tax isn't designed to solve a real economic problem. Yes, there was a crisis. But would that crisis - characterised by a catastrophic disappearance of liquidity in financial markets - have been made less bad by making transactions more costly? I don't see the connection. But I do see the connection between a political need to Do Something and Doing Something Random, Pointless and Counterproductive.

So I guess I really wouldn't call on a major rehaul of Canadian macroeconomic policy, for the simple reason that I don't see where it went awry. But I may be wrong and complacent, and that's what the comments section is for.

Comments

[Nick Rowe]

Before 2009 there seemed to be some movement towards lowering the 2% inflation target, when it next came up for renewal. I think we can now rule that out as being a bad idea.

My views have been shifting on price level path vs inflation targeting. I used to prefer inflation targeting. Now I'm leaning towards PLP targeting. If credible (and I think it could be made credible, given time) it would give us an extra bit of leeway if we ever encountered similar circumstances again.

The Canadian financial system survived. But maybe that was skill, or maybe luck. I would prefer a system I felt were more robust to bad judgment and bad luck. The ABCP crisis was contained, more or less. But it wasn't good, and might have been worse. But yes, I don't see how a transactions tax can be the correct instrument to fix a liquidity crisis, for example. I would prefer something more structural, along the lines of "living wills" that specify in advance exactly what will happen if a financial institution defaults, and makes those things happen immediately, without judges and lawyers.

[Michael Buckley]

I don't understand the objection to a Tobin tax. I take your objection (reduced liquidity) as the goal of the tax. It is supposed to be sand in the gears. The marginal cost of productive activity lost vs eliminating a bunch of speculative froth is supposed to be favourable. The Tobin tax isn't supposed to get us out of trouble -- it is supposed to discourage the exuberance that gets us into trouble. Do I misunderstand this? Or is there some quant work that shows a net loss?

[Jim Rootham]

Shakespeare specified the only solution to removing judges and lawyers from that situation. It's a little drastic.

You could certainly cut their scope for mischief down.

As much as I am disgusted with Martin and Chretien for how and how much they brought the deficit down I have to appreciate Martin's implementation of a sound principles based regulatory system.

The ABCP mess was about customers getting shafted by dodgy selling practises at a level of purchase where it's not completely unreasonable to expect financial competence. It didn't really affect the the soundness of the banks, at least not the major ones.

[Rob]

We did get bailed out by the more unconventional policies pursued in the United States and elsewhere. If not for that we could have found ourselves in real ZLB problems and having to resort to similar measures.

Going forward I would like to see price level targeting, and at a higher rate of 3% to 4%.

[Andy Harless]

Per Dave Altig: "Among the lessons taken from the financial crisis, I include this: The 'zero bound problem' was not all that big of a problem at all."

In the US, anyhow, the reason it was not a huge problem was that there was a lot of help from fiscal policy. Which brings up a couple of issues:

1. Lucky that the US had an election just as all Hell was breaking loose, giving one party (and the more pro-stimulus party at that) just enough control of the government to push through a substantial stimulus bill. With a (more typical) gridlocked US government, 2009 (and 2010) might have looked very different, and the zero bound might have been a tremendous problem for the US. Canada would undoubtedly have been affected too.

2. Why does everyone write as if the fat lady were already singing? I've heard operas with similar plots before (Verdi's "Il gran depressione", Puccini's "Il decennio perso del Giappone"), and they aren't generally quite so short. The US fiscal stimulus is a temporary measure and will begin winding down just as the boost from the inventory cycle is dying out and the preliminary steps of the Fed's exit strategy are having their impact. All this with the US unemployment rate still projected to be above 9%. For the US, anyhow, it's way too early to draw the conclusion that the zero bound was not a big problem. And I would want to be cautious about drawing that conclusion for Canada.

I would also point out that Canada got serial stimuli from the US: first the dollar rally and then, just as that was reversing itself, the spillover effect of the US fiscal stimulus. The zero lower bound would have been more of a problem for Canada without those stimuli. (How much more, I'm not sure, but I think it's enough to be an issue.)

[asp]

What about the CMHC "bailout" of the mortgage market? Without the resulting increase in home sales and prices, we would still be in recession.

Would the BoC's actions look sterile without this outside stimulus?

[Patrick]

I suspect that Canada has fared better mostly because we didn't have a big RE bubble, and our banking system didn't die and come back as a zombie.

Anyone aware of a country that had a big real estate bubble pop, but whose banks didn't blow-up? How did they fare? Unfortunately, Spain fits this description, but they got clobbered by the Euro so we can't compare.

[Angelo Melino]

The ABCP fiasco stands out as the biggest failure of Canadian policymakers during the crisis. The "General Market Disruption" clause was a purely Canadian creation that managed the remarkable achievement of being so sketchy as to get a thumbs down from the big US ratings firms, even though they had no problems rating lots of subprime mortgage junk as AAA. We still have to get to the bottom of what went wrong there and whether or not it was just a "one-off" failure.

By contrast, the IMPP (or what asp calls the CMHC "bailout") was an extremely smart move, and my candidate for the most successful and important distinctly Canadian policy.

[Andrew F]

I liked the Economist's suggestion to require financial institutions have arrangements to raise substantial amounts of capital prepared well in advance of any crisis. This way, existing shareholders won't get nearly as hosed as many did in the US simply because capital markets froze. Government bailouts won't be necessary in most cases, it would likely end up being bondholders. Enough to bring them up to 20% tier 1 capital should the need arise. The cost of doing this in highly leveraged firms would seem to discourage such leverage.

It seems to me that for automatic stabilizers, we need some mechanism to ensure we run surpluses during booms. It is very difficult, politically, to run large surpluses without raising expectations for pro-cyclical spending or tax cuts. I don't know if we need to set up some kind of smoothing fund including overpayments to EI, etc.). My other wish would be that provinces save resource royalties rather than spending them immediately. This would do a lot to smooth out the white hot booms and crushing busts that provinces like Alberta (and increasingly Saskatchewan, Newfoundland, etc.) face as we go through commodity cycles. This is a major omission in our automatic stabilizer program.

[Patrick]

Chile ran huge surpluses during the copper boom (which was politically unpopular), but it meant they could do a big fiscal stimulus when the world collapsed and copper prices went through the floor.

Ah, if only we could be as fiscally prudent as Chile... ;)

[edeast]

Chile's cabinet.

[paine]

"My preference would be to refuse to play this game, and to focus on strengthening the social safety net for those who need it most"

this hardly makes sense if the choice that cuts deepest
is can i keep this job or will i get fired

now an employer attempting to extract maximum output
knows where he stands on this

but for the jobling elements
maybe effective demand
that pre empts job less automatically
exceeds the cuddliness of a soft safety harness

but obviously you'll never cure yourself of deficit fetish eh ???

balancing the maple leaf books
fun stuff for numbers wonks.... if you got tenure

[paine]

merit class winners oughta feel like it was a lottery win despite the false label

but they really don't

and social justice as a system of "fair" rewards and punishments
brings out the emminent victorian in all of you

[paine]

price level targets are indeed an improvement

but in the spirit of we Fishermen
automatic debt adjustment would work better still

of course the free range corporate system
might sublate itself
just as it might
if we had hyper employment macro targets
and a universal mark up cap and trade system

i suspect such "gosplan II" RX's
might cause a rugged bold liberal marketeer of a canadian econ con
to lose some " initiative " though eh ??

like "capital" taxes

which reminds me of an old contre temps i witnessed between
mundell and vickrey
both leafs
both old blue tenure-ites
but
opposite as noon and midnight

[RebelEconomist]

I agree with you Stephen; there is no convincing evidence that there is a problem with the present 2%ish targets. As I wrote on Dave Altig's blog, I am quite cynical about such calls. I do not think that the key point here is a 2% or 4% target, but rather the excuse for going easier now. This will endear Blanchard et al to the establishment, whether intentionally (eg if Blanchard has ambitions to be president of the ECB) or not. For the same reason, I expected Bernanke to become Fed chairman after his November 2002 speech. Since I believe that the financial crisis was largely caused by such expediency - eg the monetary policy responses to LTCM, Y2K, 9/11 etc - I think that it would be a big mistake to go in the direction advocated by Blanchard et al.

[westslope]

If the US had a credible, formal inflation-targeting policy in place before the turn of the century, would there have been a financial crisis of 2008? Under a formal (and credible) policy, would the US federal reserve bank have lowered and kept overnight rates at 1% for so long?

It is amusing to contemplate how economists are socialized to believe in clear signals of relative value and the kind of useful, accurate information transmitted by properly functioning markets, yet here we have a leading macroeconomist arguing that central banks should muddy the waters, and deliberately confuse some agents.

Why? Does he fear an Argentinian style crisis where internal relative price adjustments proved to be inadequate? Will higher inflation rates allow relative price adjustments that wouldn't occur otherwise? Who does Blanchard want to reward? Future bond holders and unsophisticated retirees? Who does Blanchard want to punish?

We could use a theory of economic bull-shit. It might be pedantic and condescending but such a theory of the social benefits of confusing price signals would help enormously.