Fiscal Policy, the Eurozone, and Ontario under Bob Rae

This post is mostly questions, not answers. I am hoping the commenters will write this post for me. Because I don't have a comparative advantage at this sort of thing.

[BTW, JP Koning has an excellent post, much better than this, drawing a parallel between Greece's proposed and Alberta's 1936 parallel currency.]

The strongest argument against fiscal policy is the monetary offset argument. An increased fiscal deficit will not cause an increase in Aggregate Demand, because the central bank would offset if it caused AD to rise above where the central bank wanted AD to be.

But if the central bank has a fixed exchange rate policy, and that fixed exchange rate cannot or will not be changed, the monetary offset argument does not work, and there seems to be a good case for using fiscal policy to prevent undesirable fluctuations in AD.

Ontario has a fixed exchange rate with the rest of Canada. Ontario is a province and not a country, but it takes 2 days to drive across Ontario, the population is around 14 million, the provincial government imposes income taxes and sales taxes, and spends on things like healthcare, post-secondary education, and many roads. So Ontario is not that different from a country.

The New Democratic Party (roughly like European Social Democrats or UK Labour Party) under Premier Bob Rae won the 1990 Ontario election. Ontario was in recession at the time.

I think I remember Ontario finance minister ("Pink") Floyd Laughren giving an explicitly "keynesian" justification for loosening provincial fiscal policy to increase Ontario AD.

My questions:

1. Was the Rae government's initial use of fiscal policy based on an explicitly "keynesian" perspective, or is my memory faulty?

2. Did the Rae government subsequently abandon that "keynesian" perspective, and if so why?

3. Was this the last time any Canadian province attempted to use fiscal policy from a "keynesian" perspective?

4. What lessons, if any, can Eurozone countries learn from the Ontario experience?

(Yes, a load of other stuff was happening at the same time, but I would like us to try and focus on provincial fiscal policy and Aggregate Demand, as much as possible.)

Comments

[Bob Smith]

Ontario might not be the ideal example, because while it doesn't control monetary policy, it's a big enough player within the currency union that its fiscal policy can drive national AD. So it doesn't really face a fixed exchange rate. In the Euro context it's Germany, not Greece (well, it's not even Germany, since German's population and GDP is, what, 1/6ths of the EUs, compare to Ontario accounting for roughly 1/3 of Canada's).

Course, I might just be practicing macro without a license.

[Nick Rowe]

Bob: that's a reasonable macro argument. But if Ontario is 1/3 of Canada, and if the Bank of Canada holds Canadian AD constant, Ontario should still see 2/3 of the effects of fiscal policy on Ontario AD.

[JKH]

http://www.theglobeandmail.com/globe-debate/i-refused-to-play-the-conservatives-fiscal-game-so-should-wynne/article19653699/

[Nick Rowe]

JKH: Interesting find. Only the slightest hints of "keynesian" deficit spending there. Rae's argument is more that the recession is what caused the deficit to increase, as opposed to a deliberate policy response.

[Not Trampis]

Nick,

why would the Government and the Central Bank be in disagreement about where they want AD to be?

[Sean Hunt]

Nick: Not an economist at all. But that reasoning of of "Ontario gets 2/3s of the effects" strikes me as voodoo math akin to bad statistics. Ontario being 1/3rd of Canada does not mean Ontario's economy is 1/3rd federal.

[Nick Rowe]

Sean: you are right that what I said was very sloppy. I have actually been thinking about what it would look like if I tried to do it properly. (But I'm not sure what you mean by "1/3rd federal")

Let there be 3 equal masses, A, B, and C, that create a combined mas A+B+C. Suppose we apply a force to A, that moves it 1 cm to the right, holding the positions of B and C constant. That moves the centre of gravity of A+B+C 1/3 cm to the right. Now suppose we apply a second countervailing force equally to A, B, and C, that moves the centre of gravity of A+B+C back to its original position. The net effect is to move A 2/3 cm to the right.

That was the (rather trivial) point I was making above.

But in applying that analogy to economics, we need to recognise that some of the effects of Ontario fiscal policy (the first force) will also affect the other provinces. (And the second force (the Bank of Canada's monetary offset) may not affect all 3 provinces equally.)

If a province is very large (approaching 100% of Canada), then provincial fiscal policy won't work, because monetary policy offset will approach 100% too. But if a province is very small (approaching 0% of Canada) then fiscal policy won't work either, because nearly 100% of the extra spending will be on "imports" from other provinces. I am trying to get my brain around the intermediate case.

[Nick Rowe]

Not Trampis: {Sorry, I had to fish you out of spam.}

Well,

1. It might be that the central bank wants to bring inflation down more than the (provincial) government does.

2. It might be that the central bank has a more pessimistic view about potential output than the government.

3. It might be that some shock has hit one province harder than others (asymmetric shocks). That could include the effect of a change in monetary policy being bigger in some provinces than others.

In 1990 Ontario I think 1 and 3 were in play.

[Jeff]

The strongest argument against fiscal policy is Ricardian Equivalence. To make an argument for fiscal policy, you first have to show that Ricardian Equivalence does not hold, and you have to show that this deviation is large enough to be empirically important. But you're not done yet. Next you have to show that the fiscal authority is actually able to implement an intelligent fiscal policy. Good luck with that one. Finally, as you and Scott Sumner have pointed out so many times, you have to show that the monetary authority won't offset it.

All in all, a pretty tall order. I'm not aware that it's ever been done.

[Mark]

1. Was the Rae government's initial use of fiscal policy based on an explicitly "keynesian" perspective, or is my memory faulty?

I believe the early plan was to 'fight the recession and not the deficit'. It was "keynesian".

2. Did the Rae government subsequently abandon that "keynesian" perspective, and if so why?

Later, when it became evident the recession was deeper and longer than anticipated, and interest rates were higher, the government was forced to pivot to austerity.

My exact years might be off since I don't have the data in front of me, but their Budget in 1991 showed significantly stronger nominal GDP growth than occurred. This was revised down much more than real GDP growth.

I believe the abrupt shift to a lower inflation rate in 1992, combined with the higher interest rates necessary to do so, was a double-whammy that easily overwhelmed any "keynesian" plans the NDP would have had. Revenues instantly got slammed while interest costs ballooned. Expense inflation takes longer to bring down (fixed contracts etc). That's what made Rae days so pressing.

I believe it's a parrallel, but not exactly the same, as the central bank moves last. In this case, the BoC set a lower AD target right after a 'keynesian' spending plan, instead of just managing a pre-existing target.

4. What lessons, if any, can Eurozone countries learn from the Ontario experience?

Don't engage in stimulus spending unless you think the central bank will be negligent. If you have too, be damned sure the central bank doesn't choose that time to set a lower trend growth path for nGDP.

[Mark]

The one caveat is that the NDP 'stimulus' was not as large as a casual review of the deficit would imply.

The previous gov't raised spending in a big way and, despite a balanced the budget, left a significant structural deficit. Just how big is hard to gauge b/c the subsequent recession in Ontario was likely much deeper than it had to be b/c of the BoC.

[Nick Rowe]

Jeff: I tend to think that the monetary offset argument is stronger than Ricardian Equivalence. There are all sorts of reasons suggesting that the Ricardian offset will be less than 100%. Especially for government spending increases, unless government spending is a perfect substitute for private spending (which is like the government doing our shopping for us, then giving us the goods we would have bought anyway).

Mark: I think I agree with everything you say in those 2 comments. The one big difference between then and now is that real interest rates were much higher then (and ex-post real interest rates especially increased after the initial policy was announced), so debt-service costs were much larger for a given provincial debt/NGDP ratio.

[nottrampis]

That spam problem. I wrote about your problems with that ( and mine) in the past.

I can understand that occurring if State Governments/Provinces attempt to use fiscal policy when that should be left to National governments.

However we down under have seen the Central Bank and Commonwealth Treasury having a pretty close relationship so the left arm knows what the right arm is doing.

[Kevin Donoghue]

Jeff: "To make an argument for fiscal policy, you first have to show that Ricardian Equivalence does not hold...."

Are you talking about government spending or taxes here? With Ricardian Equivalence typically dY/dT = 0 but dY/dG = 1.