The federal budget: it's (probably) time for a (mild) fiscal contraction

It is widely believed that the March 29 federal budget will make cuts in program spending, and the Conservative government seems to have done a very good job of preparing public opinion for them. I've written a few Economy Lab posts ([1], [2], [3]) on the topic without actually coming down on any side of the should-they-or-shouldn't-they question, but I guess it's time to get off the fence.

Last year, I was of the opinion that the 2011-12 budget was not the occasion to deal with the deficit: it was still too early in the recovery. But one year later, things are different. Last year at this time, private sector employment was still 1% below the pre-recession peak, and that gap has now closed:

That graph should also make it clear that Canada is in a different situation than the UK and the US. The UK started cutting well before employment had recovered, and the US is still nowhere near that point. But we shouldn't be drawing general lessons about how contractionary fiscal policy is always and everywhere a terrible idea.

Of course, a severe contraction on the order of magnitude of the Chrétien/Martin years would be a very bad idea: the Bank of Canada has very few bullets in reserve, and we can't count on strong US growth to compensate for a severe fiscal contraction (although developments on that front are more promising than they have been for years). But that's not going to happen, because there's no need for it. The PBO's estimate for the structural deficit for 2012-13 is $14b, less than one per cent of GDP.

The Conservatives aren't going to raise taxes to reduce the deficit. Neither did the Chrétien Liberals - the last Prime Minister who raised taxes in an attempt to balance the budget was Brian Mulroney. I don't have anything against cutting programs per se - there are doubtlessly some programs that wouldn't pass a cost-benefit analysis and should be cut. And it would be a good idea to prune back some of those tax expenditures.

But I don't like Procrustean budget cuts: chopping programs simply to reach a spending target. Too often, programs that are cut for budget reasons end up being reinstated anyway, and laid-off public servants being re-hired as consultants at a higher cost. But that's what we're going to get.

I keep referring to Table 5.9 of last year's budget, because it's the only available indicator of where the government want to go, and past experience suggests that when this government says it will do something, it generally does it - for good or for ill.

So here is Table 5.9: 

The strategy is to hold direct program spending constant - which means a reduction in terms of share of GDP - and letting transfer programs grow with GDP. Revenue growth - personal income tax revenue growth in particular - is supposed to close the gap between spending and revenues (Table 5.8 of the budget).

I have my doubts about whether that plan will last four years: that's a long time to sustain a regime of continual program erosion ("cuts" doesn't seem to be the right word). Stuff happens.

But if the plan is implemented, I have a hard time seeing how it could be all that big of a deal as far business cycle analysis goes. Spending cuts on the order of $4b-$8b are just under half of a per cent of GDP, roughly equivalent to a one percentage point increase in the GST. That's not going to put us back into recession on its own.

I suppose I have to pause here and comment on this report, in which the Canadian Association of Professional Employees (CAPE) claims that budget cuts of $8b would produce job losses of some 116,000, of which 61,000 would be in the private sector. This didn't pass my smell test (there's no way an equivalent tax increase could produce a mini-recession), so I decided to take a closer look. Here is the press release, which in turn links to explanatory notes here and here. It turns out that the analysis is based on passing the budget cuts through StatsCan's input-output tables and adding up all the changes.

As macroeconometric policy analyses go, this is a remarkably amateurish attempt: using the input-output table coefficients to predict behavioural responses to a change in fiscal policy is simply wrong. It's a static model with no markets, no prices, no budget constraints, only y = A∙x → ∆y = A∙∆x. The CAPE analysis adopts the same methodology as all those dumb "economic impact" studies that promoters use to show how a government subsidy for their pet project will generate enormous spillovers, and deserves the same weight we give those exercises. That is to say, none at all.

Last year, the arguments for delaying a fiscal contraction were that the recovery was still not sufficiently advanced, and there was the risk of something bad happening in the US and/or Europe. This year, the recovery is one year older, the US is finally showing signs of a sustained recovery, but there's still the risk of something bad happening in Europe.

We already know that waiting until the moment is exactly right before dealing with the deficit is in itself a risky strategy: there is always going to be a risk that something will go wrong. If things do go pear-shaped in the next few months, the policy stance can be adjusted accordingly.

Although I disagree with the way that the Conservatives have chosen to bring it about (my preference would be an increase in the GST), I think a mild fiscal contraction is the right choice for this year's budget.

 

Comments

[Determinant]

Well, a couple of points. First, I believe the government has been catastrophizing so that the actual cuts are not as bad as advertised. Second, the Main Estimates were tables yesterday, that is the Government's spending plan and it gets translated into Appropriation Acts. It is a very important part of the budget process and actually more important than the Budget itself, which is concerned with raising money and with broad policy. The Estimates are about spending money and programs. But the Main Estimates tabled this year do not contain cuts; those will be detailed during the Budget and implemented with Supplemental Estimates. This is unusual and indicates the Government had a hard time coming to a final decision.

Second, layoffs in the Public Service are conducted according to specific rules which may be found here: http://www.tbs-sct.gc.ca/lrco-rtor/wfa-rde/faq-eng.asp

Key points: Indeterminate, full-time employees get one of the following:

1) A guarantee of a reasonable job offer; or
2) No guarantee of a reasonable job offer and one of the following transition measures:
- Option A – 12 month paid surplus period; or
- Option B – a lump sum payment called a transition support measure; or
- Option C – a transition support measure plus up to $11,000 for tuition and other related fees.

Further, laid-off employees in the second category get a 12 month priority in internal and external hiring to help them find another position, this priority ranks above all other priorities. This means that relatively few people are actually going to be involuntarily and permanently separated from the Public Service. What will happen is that external hiring will slow.

Third, and this is an important and subtle point, the Government does not behave like a private employer when it comes to money. The Public Service cannot reduce spending or hiring right now based on present Estimates, it has to wait until new Estimates are tabled that actually implement cuts before anything can be done. The Public Service cannot take anticipatory action like a private employer can. It is extremely process and rules oriented. The Estimates give the Public Service the authority and mandate to spend money, it cannot willingly spend less and cannot spend more either without authorization, both are thwarting the will of the Government and of Parliament.

This was explained to me by a senior Public Servant who is a friend of mine. Legally and policy-wise the Estimates are a more important document than the Budget, though the Budget has a higher political priority.

Last point, Stephen in my opinion that graph is conceptually flawed and misleading. It would be much better to plot Employment Rate against time to show the change in the Employment rate. The Employment Rate takes into account population change, your graph does not. The pool of people seeking employment today is not the same as in 2008, we have had people exit the pool through retirement and enter the pool through graduation and seeking a full-time job.

Your graph assumes a static labour pool when in fact it is dynamic.

[Declan.]

Stephen, please don't compound the Globe's error by lending credence to the nonsense Nanos poll you reference in your opening line.

Here's the question from the poll: "Do you agree, somewhat agree, somewhat disagree, or disagree with the Government of Canada’s objective of generating at least $4 billion in ongoing annual savings by 2014?"

Who doesn't like generating savings, really? Find a poll where people are in favour of actual specific, named, cuts and then let's talk.

As for fiscal contraction, with household debt well into (past) the danger zone, it's putting a lot of faith in the private sector to take on enough debt to offset the savings of both the household and government sectors. Sure, they have the capacity to make investments but why would they with government and households retrenching and the dollar too high for most exports to be competitive. More oil, I guess.

[slantendicular]

Quote: "The Conservatives aren't going to raise taxes to reduce the deficit. Neither did the Chrétien Liberals - the last Prime Minister who raised taxes in an attempt to balance the budget was Brian Mulroney."

Didn't the Liberals introduce two 'surtaxes' of 3% and 5% (high-income surtax) in the mid-90s in order to balance the budget?

[Kevin Milligan]

Hi Slanted. The surtaxes were first introduced in 1985. They went up through 1991. They started to come down in 1992/93. They were constant from 1993 to 1999. They were removed after 2000.

[Sina]

what's the rush?

[MBO]

And a Federal deficit is bad because we could become Japan where the currency is greatly depreciated, interest rates are high, unemployment is high and the manufacturing sector is in tatters.

[Jacques René Giguère]

Stephen: I'll believe it's time for a mild fiscal contraction when the unemployment rate is 2% with a particpation rate of 70%. I'll believe in mild fiscal contraction when we'll have a monetary policy that insure same. I'll believe in a mild fiscal contraction when we won't cut GST to 5%. I'll believe in a mild fiscal contraction when we don't shut Arctic research station on global warming while buying jet fighters to battle the ??? ( who dispute cdn sovereignty in the Arctic except the U.S?). I'll believe in mild fiscal contraction if it means not building prisons ( oups, we'll need them for all those Ministers and MPs soon to be in for election fraud...)

[Nick Rowe]

I agree with Stephen. The only AD case for fiscal policy is if you believe that monetary policy is powerless at the ZLB (and that belief is debatable). Canada is not at the ZLB. The BoC has set AD where it wants it to be, taking fiscal policy into account, so fiscal policy can have no effect.

(Oh dear, using the StatsCan IO model to calculate a fiscal multiplier!! Why didn't they just multliply by 2, just like all the other rubbish "Economic Impact Assessment" studies. Quite apart from all the problems Stephen lists, it ignores money.)

But, I'm less concerned about the federal deficit than I am about some provincial deficits.

[Nick Rowe]

Jacques Rene: "I'll believe it's time for a mild fiscal contraction when the unemployment rate is 2%..."

Why not 0%? How would you know if 2%, or 0%, or whatever, was too low to be sustainable with AD policy alone?

[W. Peden]

Nick Rowe,

If unemployment is above 2% and inflation is rising rapidly, we can just introduce a wages and prices policy to cut costs which are the cause of inflation when the economy isn't at full employment. Since prices are determined by bargaining power, there won't be any negative consequences from messing with the so-called price system (which is really the class system at the level of exchange). As John Stuart Mill put it: the laws of production come from nature, the laws of distribution are ours to create and change.

[Stephen Gordon]

Oh dear.

[J.V. Dubois]

While I agree with Nick that it makes no sense to use fiscal policy for AD boosting, however are there not any micro-economic arguments against fiscal contraction? Why to contract if bond yields are just around 1%? Are there really no government programs that could have better returns, or that could be moved from future to present, so they can be financed so cheaply be eager private sector?

[Bob Smith]

"The Conservatives aren't going to raise taxes to reduce the deficit. Neither did the Chrétien Liberals - the last Prime Minister who raised taxes in an attempt to balance the budget was Brian Mulroney."

That's technically true, although my recollection is that, throughout the 1990's the tax system was de-indexed (at least where inflation was less than 3%, as it was for much of the 1990's), so there were hidden income tax increases throughout the Chretien/Martin years, as inflation pushed Canadians into higher tax brackets. It's a fair point that Chretien didn't implement that hidden tax increase (Mulroney did, in 1985), but it really didn't bite until the relatively low-inflation period of the 1990s, under Chretien's watch. He didn't implement that legislation, but he wasn't in a rush to reverse it (although, to his credit, indexation was finally restored in 2000).

[Nick Rowe]

W. Peden: economic theory has moved on since J S Mill wrote that (for example, the whole marginal revolution of 1871).

I can build a macroeconomic model with monopolistic firms and unions, in which price and wage controls plus loose monetary/fiscal would be good macroeconomic policy, would increase employment and income and make everyone better off. But I don't believe that model. It would be easy to make that policy work right, if all firms were identical, and nothing ever changed, like in my simple model. But having lived through periods of wage and price controls (the UK, Canada and the US tried them in the 1970's), I know that the world is a lot more complicated. There's a reason they were abandoned, and nobody talks about them nowadays. They didn't work very well.

JV: Hmmm. Fair point. I think a lot of such investment projects have already been preponed over the last 3 years. But if there are any left over that would meet the Cost Benefit test at current low interest rates, it would make sense to still do them. Pity we don't measure the deficit/debt with assets in there too.

[Sina Motamedi]

Nick: "The only AD case for fiscal policy is if you believe that monetary policy is powerless at the ZLB (and that belief is debatable). Canada is not at the ZLB. The BoC has set AD where it wants it to be, taking fiscal policy into account, so fiscal policy can have no effect."

But the BoC is still operating at near-zero rates. It does have room for monetary policy, but not much. So why rush with the fiscal contraction? Especially since the BoC will need that room in case Europe implodes.

I would rather stay the course fiscally until the BoC is able to raise its rates some more and be farther away from the ZLB.

[Min]

"That graph should also make it clear that Canada is in a different situation than the UK and the US."

Question (OT for here, perhaps, but how about another thread?): Why is Canada doing better than the US? (Or is it just that the nuts roll south? ;)))

[Paul Friesen]

I'm not sure if it's time for the federal government to start cutting back. The situation is still fragile. At the provincial level in Ontario, there is a definite need to reduce deficits now.

I do think, though, that the U.S. situation could start to change very fast soon. This is due to the extremely high level of reserves in the U.S. banking system from quantitative easing. Look at this chart. Blows my mind. This is money that the banks could be lending out if they saw good lending opportunities. But they don't want to lend it to home buyers without jobs or companies without sales.

This creates an unstable situation. If things start to turn around, things will look better to the banks, leading to some of those reserves being lent and getting into the real economy, stimulating it and creating a situation where more loans look viable. This could create a positive feedback loop ending the recession with a bang and even possibly creating inflation if the FED does not act quickly.

I think this might be coming soon. The housing market seems to be turning the corner, which is what could trigger this.

So here in Canada, we might not need more stimulus. But the timing of this is not very predictable.

[W. Peden]

Nick Rowe,

I wonder if it's impossible to advocate any position in macroeconomics that is so ridiculous that it is obviously sardonic...

[richard]

"Although I disagree with the way that the Conservatives have chosen to bring it about (my preference would be an increase in the GST), I think a mild fiscal contraction is the right choice for this year's budget."

I assume you mean that a GST hike is a better way to reduce the deficit than spending reductions. Or perhaps you mean that both would cause contraction, but the GST hike is preferable for other reasons.

If we had a better idea of exactly what was being cut, we could better judge the value of those cuts and the relative value in reducing the deficit. We are largely in the dark about that, although bits and pieces of information show that a number of science programs are being gutted. Meanwhile we are still getting Economic Action Plan ads on TV - a higher priority? - I guess the deficit cannot be that bad.

Given that several provinces are also trying to cut expenditures, and that the US recovery is fragile, there is still a good likelihood of economic contraction this year or next. Should that occur, some regions of the country will suffer more than others; I wonder how much that plays into the politics of expenditure cuts at the federal level?

[richard]

From today's Globe and Mail:

"Canadian economic growth slowed to an annualized 1.8 per cent in the fourth quarter of 2011 from a sharply upwardly revised 4.2 per cent in the third, as positive temporary factors faded and as government stimulus continued to wind down."

In that light, are further significant federal govt spending cuts a good thing, or a bad thing?

[Stephen Gordon]

I don't think it weakens the case. I just posted this on E-Lab.