Fiscal Balance and Unemployment

As we all know, Canada will be running deficits well into the foreseeable future.  Based on the figures from the 2016 Federal Budget, as a percentage of GDP Canada will see its deficit go from a surplus of 0.1% in 2014 to -1.5% in 2016 and then will range from a low of -0.6 percent in 2020 to a high of -1.4% in 2017.  Canada will be in good company as the accompanying figure shows.

Figure 1 uses data on major economies from the April 2016 Consensus Forecast from Focus Economics and plots their anticipated fiscal balances along with Canada's (taken from the 2016 Budget). Despite the hue and cry, Canada's deficits are going to be relatively minor compared to those of most of the G-7 as well as the three BRIC economies depicted. Only Germany has a superior performance compared to Canada when it comes to fiscal balance.  Among the G-7, Japan is anticipated to be the worst fiscal performer while when it comes to the the BRIC countries, Brazil is certainly in a league of its own. 

Figure 1

Figure 2 plots the unemployment rates both actual and forecast for the 2014 to 2020 period for these same countries.  Canada is not anticipated to do as well on the unemployment rate front compared to the United States but we are forecast to do much better than France or Italy and pretty much match Germany.  Relative to GDP, we will be running smaller deficits than the United States but are going to have a higher unemployment rate.  This might suggest to some that the Americans are stimulating their economy more than ours and if we ran higher deficits we could bring our unemployment rate down.

 

Figure 2

Now a deficit can be the result of business cycle factors as a slowdown reduces revenues and boosts spending as a result of automatic stabilizers kicking in (a cyclical deficit) it can be the outcome of explicit stimulus spending (a structural deficit).  I really have no way of sorting out these two effects from this data.  Yet a key question is with so many countries running deficits, if we can expect there to be any effect on the unemployment rate.  What I might expect to see is if more deficit financing (as a share of GDP) can indeed be correlated with lower unemployment rates.  I present a plot of the unemployment rates and fiscal balances (both actual and forecast) for the period 2014 to 2020 for the G-7 countries and three BRIC countries used above to see if running large deficits can be correlated with lower unemployment rates. 

Figure 3 plots a polynomial smooth of the unemployment rate against the fiscal balance and the results show that there does not appear to be a strong relationship between higher deficits and lower unemployment rates for these countries.  At the risk of being labelled a deficit scold, I could conclude that running large deficits does not really stimulate the economy and lower the rate of unemployment.  Or, at the risk of being labelled a deficit cheerleader, I could conclude that the reason for the absence if a strong effect is that these deficits are not really stimulative at all but merely the result of a weak economy adversely depressing revenues and truly stimulative deficits need to be a much larger share of GDP.

Figure 3

These are ultimately two very different policy positions and yet I think this is at the heart of the policy debate over the current global growth slowdown. Are current deficits too small and therefore should be increased to truly stimulate activity or are deficits ineffective in boosting economic activity and therefore budgets can be balanced with little harm.  I am not sure I could devise a conclusive test but for the time being in Canadian policy circles I think the larger deficit prescription has won out.  The current Liberal government has gone from their election deficits of ten billion to three times that.  Yet, even these deficits are quite modest by international standards.   If Canadian economic growth does not pick up substantially over the next year, one wonders if even larger deficit proposals will be floated in advance of the next budget.

Have a nice weekend.

Comments

[Richard McKean]

I wonder whether, given the role of the Provinces, it would be better to include sub national deficits rather than just the Federal deficits.

[Livio Di Matteo]

That is a good point Richard given the large deficits that have been run up by Ontario and New Brunswick and now Alberta and Newfoundland & Labrador. It would make our deficit to GDP ratio higher.

[Pmj]

if you are going to include the provinces in Canada then you need to consolidate the states and municipalities in the US and the laender and large cities in Germany. Other federal countries should also be consolidated. Canada would still end up looking pretty good. No one invests on a country simply because of its low deficit but no one will invest in a country with poor infrastructure and deficient social capital. The latter is the legacy of institutional changes at various levels government brought in by politicians who believed their own rhetoric and doctrine rather than reasonable economic perspectives. The trouble with the chart is that it is a plot of state for those countries. The issue is the change in the deficit and the impact on growth.

[Jim Sentance]

I would think there are a variety of structural reasons why unemployment rates differ from country to country. Perhaps you should be looking at the change in rates rather than the levels.

[Livio Di Matteo]

That is a good point too Jim.