The federal budget: Austerity or stimulus or neither?

This year's federal budget is going to be an interesting one. A two-year stimulus package was introduced in 2009, which meant that the 2010 budget didn't have much to say. But now some decisions will have to be made. Should the government extend the fiscal stimulus? Follow the United Kingdom's example and embark on an austerity program to get rid of the deficit? Do nothing?

Clearly, the direction we want to take depends very much on where we are. GDP growth rates for the last two quarters were disappointingly low, generating alarming stories to the effect that Canada is lagging behind the rest of the G7. But let's put this in perspective a bit. Here's how GDP has evolved:

And here's the graph for employment (both graphs are based on OECD data):

Canada is the only G7 country to have recovered pre-recession levels of output and employment. The story in 2010Q2-2010Q3 isn't one of Canada lagging behind so much as the other G7 countries catching up.

In the early days of 2009, the case for fiscal stimulus was fairly compelling: output and employment were falling sharply, and the Bank of Canada was about to hit the interest rate lower bound. Things are very much different now, and it's hard to see how a convincing case for extended fiscal stimulus could be made using available data.

So should we embark on a round of austerity to deal with the deficit? Well, no: the recovery isn't really complete. Yes, total employment has recovered its pre-recession peak, but important series such as full-time employment, private-sector employment and hours worked have not. (The hours worked series is choppy, so I've plotted the 3-month moving average.):

In this post, I noted that Paul Martin didn't bring down his famous 1995 austerity budget until after private-sector employment had recovered from its pre-recession peak. And in 1995, the Bank of Canada was in a position to offset fiscal austerity by cutting interest rates by 5 percentage points in the subsequent 18 months. Neither of these conditions are currently satisfied. The Bank of Canada may have created enough of a margin to handle small negative shocks, but not enough to counter a contractionary fiscal policy at the same time.

So that leaves neither renewed stimulus nor a program of austerity - at least, not for the 2011-12 fiscal year. Next year, if current trends continue, we'll face a different set of circumstances: the recession will likely be behind us, and the deficit will likely still be with us. It would be nice to see some indication in this year's budget of how the government intends to deal with next year's problems.

Comments

[Guillaume]

I don't know what it's worth, but I heard that Flaherty didn't want to be the "austerity" minister and would leave before it turns to that. In what appears to be an election year, I don't see what kind of political gains there are to be made by enacting an austerity program. That will anger a portion of their base, but I doubt the Liberals will make big gains by promising a Martin 2.0 program.

There will be plenty of posturing about fiscal responsibility, of course, but I don't think the Tories will go ahead with significant cuts (let's not even talk about tax increases). IMO, that will be for 2012.

[Stephen Gordon]

Yeah, the political games are a whole other thing. What you said sounds right to me.

[Determinant]

Recovering to pre-recession employment levels is nice, but we have had population growth in the meantime. I view pre-recession levels + expected population growth as a more meaningful threshold. We need to be back on trend, not just back to the datapoint reached a few years ago.

When it comes to the deficit and elections, there is the problem that no party is headed for a majority. When the Bloc sits on 40+ seats in the House routinely and the rest of Canada has two or three party races in most ridings, a majority is impossible. Quite apart from finances, we haven't had this much electoral deadlock in the history of Confederation. Another minority government will be a record. We've never had four in a row, ever.

Budget votes are confidence matters by constitutional convention. Try doing anything "brave" or "courageous" in the Yes, Minister sense of the word in that environment.

[Nick Rowe]

Good solid post Stephen. My God but the US stands apart. Worst by far on employment, but second best on GDP!! Its relative productivity growth is so surprisingly high.

[RSJ]

Should you be looking at percentage change from peak or deviation from trend?

[Patrick]

On Nick's point re. US: A combination of those who still have jobs really hauling ass/running scared (how long can they keep it up?), and a lot a pre-recession labour that wasn't all that productive?

Shouldn't the deficit fix itself once the gov't tax haul returns to pre-recession levels (well, minus 'starve the beast' shenanigans) and automatic stabilizers wind down ?

[R I]

Great post dealing with, economically, how we should be thinking about the upcoming budget. If we were going to make predictions, however, I think we have to also consider political pressures. With ballooning deficits, I don't think the conservative party is interested in being known as the party that couldn't keep a handle on the budget. Regardless of what we think the country needs at this time, I don't think the government is willing to risk its credibility on the fisc.

[Mike Moffatt]

"When it comes to the deficit and elections, there is the problem that no party is headed for a majority. When the Bloc sits on 40+ seats in the House routinely and the rest of Canada has two or three party races in most ridings, a majority is impossible."

Highly disagree with this (in fact, I have a piece coming out in the Globe soon on this topic). Once the next round of byelections are over, the Conservatives should be at 145 seats - only 10 away from a majority.

There are 4 Liberal incumbents not running again and the Conservatives are already a lock in one of them (Keith Martin's old seat). They should be competitive in the other 3 and could easily pick up 2 of the other 3.

There are a handful of other Liberal seats that look vulnerable, particularly around the 905 - the two Brampton seats being an obvious example. Add those to the seats where the NDP look vulnerable to the Conservatives (Welland, N. Ontario, Edmonton Strathcona), it's not difficult to put together a list of 25-30 seats that the Conservatives have a chance of picking up.

Now a lot of things have to break right for the Conservatives to have a net gain of 10+ seats, but it's far from impossible.

[Nick Rowe]

I think Stephen should do a second post:

Title: "American productivity exceptionalism"

Content: first two graphs from this post. Plus: "WTF is going on with US productivity, compared with all the other G7 countries? How come, for example, US labour productivity has increased (about) 4.5% relative to Canada?".

[Nick Rowe]

It's not just that US productivity increased *relative* to Canada. (I.e. it's not just that US productivity fell less). US productivity actually *increased in absolute terms* (slightly). That is *very* rare for a country in recession. And note that all the other countries had declining productivity, which is what you normally expect, given Okun's Law.

In fact, that fact blows away the standard RBC theory of recessions. The standard RBC story says that a negative productivity shock is what causes a recession. Well, there wasn't one (for the US). The productivity shock was positive (or maybe zero, relative to trend).

In the long run, productivity is (almost) the only thing that matters.

[Nick Rowe]

Patrick: "On Nick's point re. US: A combination of those who still have jobs really hauling ass/running scared (how long can they keep it up?), and a lot a pre-recession labour that wasn't all that productive?"

Yep, all that's plausible. Until you ask: "why wouldn't it be equally plausible in other countries? Why did that story only work in the US?"

[Adam P]

"In fact, that fact blows away the standard RBC theory of recessions. The standard RBC story says that a negative productivity shock is what causes a recession. Well, there wasn't one (for the US). The productivity shock was positive (or maybe zero, relative to trend)."

No, that's just wrong.

A productivity shock in an RBC model is relative to whatever was the equilibrium aggregate expectation productivity growth (which may differ from a filtered estimate of "trend").

In a sort of canonical RBC model, since they all assume ratex, the only way you get the high debt/income ratios of the bubble, not to mention the high asset prices, is if future productivity growth is expected to be way high. Thus, effectively the debt/income ratios don't seem so high because incomes will be higher when the debt comes due.

There is absolutely nothing inconsistent between a recession that maintains a positive growth rate of aggregate productivity and the standard RBC story.

[Bob Smith]

"Shouldn't the deficit fix itself once the gov't tax haul returns to pre-recession levels (well, minus 'starve the beast' shenanigans) and automatic stabilizers wind down ?"

It's already happening to a large degree. The 2009-10, 2010-11 deficit figures are inflated by a lot of one time spending (2009-10 included $5.6 billion for HST harmonization payments to the provinces and another $4.5 billion for the automakers and the stimulus spending, while 20010-11 will still include significant chunks of stimulus spending). Those will all come off the books this year and next resulting in seemingly large drops in the deficit number (with no real political pain). And tax revenue (particularly corporate income tax revenue) has been growing far faster then expected (at least as of October) for 2010-11.

I figure the 2010-11 deficit figure will come in well below the target in the last budget (probably in the high $30 billion range). The one thing that mitigates in favour of the a spring election for the Tories is that they'll be able to boast about how they've reduced the deficit so significantly this year, even though the really haven't done anything.

[Alex Plante]

I know this is off-topic, but isn't anyone worried that Canada is running a current account deficit of 4% of GDP?

[Matthew]

"WTF is going on with US productivity, compared with all the other G7 countries? How come, for example, US labour productivity has increased (about) 4.5% relative to Canada?".

Nick, wouldn't that be because job losses were higher in the US (i.e. fewer workers producing more)?

[Hesam]

With unemployment at 7.6% austerity should be shelved. Ottawa should combine a second round of stimulus with some improvements to the tax code. 'Ideally' something like this:

1. eliminate capital gains tax
2. income tax cuts (new rates: 0-10-15-20-25)
3. eliminate corporate income tax
4. eliminate dividends tax credit
5. raise GST to 10% (with a delay: maybe start Jan. 2012?)

[Stephen Gordon]

Alex Plante: I had an Economy Lab post on the current account deficit a few weeks ago.

[westslope]

If there is going to be more stimulus I want to benefit. Me. Not some other guy.

[westslope]

Do aggregative productivity numbers figure in unemployed workers? I don't believe so.

Would not a complete aggregate productivity number also take into account sidelined, inactive workers?

[westslope]

Stephen,

Thanks for the terrific and most informative graphs! Would love to see similar for other groups of economies, the Jaguar economies (Brazil, Chile, Colombia), the Nordic countries, resource-levered Australia, etc. And then make a whole mess of hasty conclusions about how some economic institutions seem to work better than others judging by criteria deemed important by US governing institutions, for example.

Slow, steady growth is good in this environment, given our leverage to the USA and the punishing impact of the high-flying Canadian dollar.

But why not start scheduling in tax increases? Pre-crash, the Harper Conservatives reduced the federal value-added sales tax (GST) by 2 percentage points. At the height of an out-of-control commodity-driven boom.

It may be a mistake to conclude complete asymmetry of effects. For one, did the GST cuts noticeably affect the already frenetic pace of development? Did the GST cuts help beef up the labour market for a sharper, harder fall from peaks levels in provinces like Alberta? I doubt it.

We could easily detail a list of negative socio-economic impacts from the frenetic pace of development but I doubt the GST cuts contributed that much.

Stephen, you underestimate the strength of the Canadian private sector. Raise taxes and raise them now. (Please avoid raising the taxes on income.) In the process, Canada would signal unequivocally a rock-solid fiscal situation. Put all this talk of structural deficit behind. China runs enormous surpluses and yet grows quickly. Why not Canada? The current commodity-driven boom will carry us perhaps a few more years but will by no means magically eliminate macroeconomic fluctuations.

[Stephen Gordon]

I'd be happy if they announced a 2-point GST increase, effective January 1, 2012.

[Paul Friesen]

I would like to propose that responsibility for deciding an appropriate level of deficit spending be removed from political control, in the same way that central banks have been removed. Give an independent, appointed authority control of some key tax rate, for example the GST. The authority would have a mandate to reduce the debt level over the long term, but might run a deficit if required in the short term. The politicians would control spending and other tax rates, but they would know that if they cut taxes or increased spending when the economy is doing well, the independent authority is going to raise the GST to counter-act the effect on the deficit.

I think such a system could be a good way for countries with debt problems to signal that they are serious about getting them under control. Setting up such a system could be a useful requirement for a bail-out.

[Stephen Gordon]

Notwithstanding some obvious technical, political and constitutional problems of getting such a system set up, I like the thinking behind this idea.