Worthwhile Canadian Initiative

Temporary vs permanent fiscal policy in a small open inflation targeting economy

Just a short note as a backgrounder for the current Canadian debate about fiscal policy.

This is totally unoriginal boring textbook stuff (at least I hope it is, anyway). Prerequisite: intermediate macro (or special permission to skip to the results if you promise not to ask me daft questions about where they came from).

The simple second year textbook Mundell-Fleming ISLMBP model under flexible exchange rates makes two assumptions that we need to modify:

1. The simple textbook version assumes the money supply is fixed. In other words, it assumes the Bank of Canada targets the money supply. But the Bank of Canada targets the inflation rate, and it adjusts the money supply (adjusts the nominal interest rate and allows the stock of money to adjust, if you prefer) to keep its internal forecast of the inflation rate at 2%. The easiest way to build this into the textbook picture is to assume the Bank of Canada shifts the LM curve to try to keep the ISLMBP equilibrium point at (what the Bank of Canada thinks is) potential output Y*.

2. The simple (or simplest) textbook version (normally) assumes the exchange rate is not expected to change. The expected rate of appreciation/depreciation is assumed to be zero, so the BP curve is horizontal at the exogenous world interest rate. But if the change in fiscal policy (e.g. an increase in Government expenditure) is temporary, the exchange rate will appreciate when G increases, and will depreciate again in future when G falls back to normal. And if the foreign exchange market is not "dumber than a sack of hammers" (in Stephen Gordon's unforgettable phrase) it might figure this out. If so, the expected exchange rate depreciation following the initial (surprise) appreciation will cause the BP curve to shift up. Canadian interest rates will rise relative to world interest rates, because the Looney is expected to be depreciating back to its original level. But if the change in fiscal policy is expected to be "permanent" (or at least be wound down slowly enough that this effect can be ignored) the BP curve will not shift up.

Is Two the new Zero? Why Divine Coincidence failed

Speculative, as Tyler Cowen would say.

When people play the Dictator Game Ultimatum Game [thanks Alex] they don't play the way economists would predict. The Nash Equilibrium is for the first player to propose a 99:1 division of the pie take-it-or-leave-it offer, and the second player to accept. Because 1% is better than nothing, so the second player will accept, and the first player knows this.

But proposals like that tend to get rejected. And 50:50 splits tend to be common. (But IIRC non-WEIRD people do play Nash, but I can't find a link.)

50% is a magic number, if there are two players. (I wonder what would happen if the Dictator Game were played with three apples, or one bottle of scotch and one bottle of beer?)

Old Keynesian vs New Keynesian fiscal policy

Mostly for non-macroeconomists.

I first learned macroeconomics in the very early 1970's in the UK. I learned that the macroeconomy was not automatically self-equilibrating, and that the government should use fiscal policy to target "full employment" (aka "potential output"). The government should loosen fiscal policy when the economy was below potential and tighten fiscal policy when the economy was above potential. We didn't pay much attention to monetary policy. And we didn't pay much attention to inflation either, at least in the models, though it was getting harder and harder to ignore in reality. I think we hoped for what we would nowadays call "Divine Coincidence": that if we were successful at targeting "full employment" then inflation would take care of itself. And if it didn't, then maybe we needed some additional policy lever, like wage and price controls.

Let's call that "Old Keynesian" fiscal policy. Many people will still think of "Keynesian" fiscal policy as something like that.

But times change.

One awkward question about Stephen Poloz's speech (on Integrating Financial Stability into Monetary Policy)

Suppose the Bank of Canada were following a 5% NGDP level-path target. And suppose that actual NGDP was on target, and was expected to remain on target in future. And suppose you were Governor, and one of your advisors gives you some important news. Financial markets are in a bubble, so the prices of financial assets are above their fundamental values. And you know your advisor is always right about this sort of thing (just suppose).

You are an economist. You know there are almost always trade-offs. Keeping NGDP on target is important, but so is financial stability. And there are always diminishing marginal benefits to everything. So it seems rational to sacrifice a little NGDP stability to gain some financial stability at the margin. Who knows, you tell yourself, sacrificing a little NGDP stability in the short run might even help NGDP stability in the long run, because it's harder to keep NGDP on target if financial markets are doing silly things like bubbling and bursting.

But you also believe in transparency, so if you depart from your NGDP target temporarily you must announce that you are doing so.

What would you announce?

Keynes just left Canada

Paul Kugman's post title is "Keynes comes to Canada". Paul is wrong. Keynes was in Canada, but he just left.

Look at this graph from Matthew Klein (a very good article, by the way):

The other bit of information you need to know is that the Bank of Canada hit the Zero Lower Bound in April 2009, and lifted off the ZLB in June 2010. (The Bank of Canada considers [update: did consider] an overnight rate target of 0.25% to be the "effective" ZLB.) Compare those two dates with the above graph.

New Keynesians, like Simon Wren-Lewis for example, prefer to use monetary policy in normal times, but advocate fiscal policy be used at the ZLB. (Just like Keynes doubted the effectiveness of monetary policy in a liquidity trap, and the ZLB is just another way of thinking about Keynes' liquidity trap.) And bringing forward government investment expenditure seems to be a very sensible way to implement a New Keynesian fiscal policy (though some lags are inevitable). Faced with the ZLB, the government invests sooner, rather than later.

And that is what Canada's recent Conservative government did.

No, it doesn't fit the narrative, does it. Too bad.

[Update 2.Lifted from comments: JKH: "Krugman's title more accurately should have been "Summers comes to Canada"."]

[Update 3: As Frances Woolley points out below, that graph shows combined (federal+provincial+municipal) government investment spending. But I think that's the right measure in this case, because a lot of federal money went on incentives for investment by lower levels. Plus, for example, my university got two big new semi-free buildings out of those incentives, and I have no idea whether that gets counted.]

How much revenue will the Liberals generate with a new tax bracket on high earners?

[I started writing this post in May, but I stopped when it looked like the Liberals were not going to be in a position to implement this measure. Happily, I didn't actually delete it.]

[An earlier version made a stupid mistake; I did everything under tha assumption that the increase was 3 percentage points, and not 4. Gah.] 

The Liberal Party of Canada is proposing to increase the federal tax rate on taxable income above $200,000 from the current rate of 29% to 33%. According to the LPC, this measure will generate $3b in revenues:

Labour market flows revisited

It's been a while since I've looked at patterns in gross labour market flows; the last time was here. The basic methodology is taken from Stephen Tapp's  CJE article, in which he extracts labour market transitions from the Labour Force Survey Public Use Microdata Files. Not all transitions are covered by the LFS questionnaire, but we can get recover some of them:

1. Hires: People who are employed, and who have been at their current job for one month or less.
2. Layoffs: People who have been unemployed for 4 weeks or less, and who were laid off from their previous job.
3. Leavers: People who have been unemployed for 4 weeks or less, and who left their previous job of their own accord.

Lumbering Along in the Finding Data Process

Well, all I was trying to do was introduce a set of lecture slides on the nineteenth century timber trade with a simple overview of the Canadian logging industry's employment in the twentieth century.  Well, three hours later it has proven to be a more frustrating exercise than I would have expected but here is what I have.

Interest-free loans from the central bank to the government

What is the difference between:

A. I print $100, and give it to you as an interest-free loan.

B. I print $100, lend it to you at 5% interest, so you give me $5 per year, and then I give that $5 per year straight back to you.

C. I print $100, lend it to Tom at 5% interest, so Tom gives me $5 per year. You borrow $100 from Tom (or Dick or Harry) at 5% interest, so you give Tom (or Dick or Harry) $5 per year. And then I give you the $5 per year that Tom gives to me.

I can't see the difference either.

Fencing In Canada

Wisconsin Governor and potential presidential candidate Scott Walker apparently thinks it is not an unreasonable idea to consider building a wall between Canada and the United States in order to secure his country’s borders from security threats.  Now, to be fair, he did not say that a wall should be built along the 5,525 mile long border – only that it was an issue worth looking into.  According to Walker: “Some people have asked us about that in New Hampshire.”  This of course comes on the tail of Donald Trump and his call to build a wall on the US-Mexico border – and have Mexico pay for it.

"King of deficits"??

I normally stay out of politics on this blog. But with the upcoming election, the political conversation on fiscal policy is starting to get stupid. In particular, for Paul Martin to accuse Stephen Harper of being the "King of deficits" was really stupid.

Is there anything Stephen Harper could have done to have prevented a fiscal deficit over the recent recession?

Good shocks, bad shocks, and shocks that cause a monetary coordination failure

Just because a shock is a bad shock doesn't mean it should cause a recession. A recession is a monetary coordination failure. Monetary coordination failures are caused by monetary policy.

Start with a Robinson Crusoe economy. By assumption, Robinson Crusoe always allocates his resources perfectly to maximise his expected utility given his information about the constraints he faces. There are "good" shocks that raise his (expected) utility, and "bad" shocks, that lower his (expected) utility. But there are no shocks that cause a coordination failure in this economy, because Robinson Crusoe doesn't have anyone else to coordinate with. And he doesn't use money, so a "monetary coordination failure" is doubly nonsensical in a Robinson Crusoe economy.

Recessions are a bad thing, but they are not bad in the same way as a bad shock in Robinson Crusoe's economy.

Why did (Canadian) inflation-targeting work in 1996 but fail in 2008?

In both 1996 and 2008 the Canadian economy was hit with a big shock. The 1996 shock was the change in fiscal policy, turning a large deficit into a large surplus. The 2008 shock was the global financial crisis. (Canada didn't really have much of a financial crisis; no banks failed, as usual.)

In both 1996 and 2008, the Bank of Canada kept inflation (more or less) at the 2% target (in 2008 total inflation fluctuated above and below target, but core inflation stayed close to trend).

In 1996 there was no recession. In 2008 there was a recession. Why? (I don't have an answer to that question, sorry.)

In my view, the main thing we are looking for when we choose a monetary policy target is that it prevents recessions. Inflation targeting passed that test in 1996, but failed that test in 2008. I used to be a supporter of inflation targeting, because it seemed to work well in practice. When it became clear to me that inflation targeting had failed in 2008, I stopped supporting inflation targeting, and switched to supporting NGDP level-path targeting.

But I would feel a lot more confident in my support of NGDP targeting if I understood why inflation targeting worked in 1996 but failed in 2008.

On defining "recession"

The precise definition of "recession" seems to be topical in Canada right now. (I know this because my daughter phoned to ask me the definition.) It's a mug's game. I won't play. (Do geographers waste their time arguing about the precise definition of "mountain"?)

I hear that the "technical" definition of "recession" is two consecutive quarters of (real) GDP growth below zero. But what the hell is the meaning of "technical" in this context? I only learned that "technical" definition by reading newspapers, not by reading economists. If I want the "technical" definition of "horsepower" I will ask an automotive engineer, and I figure I will get a more precise and accurate answer that will be useful if I want to compare two cars' engines. Well, the so-called "technical" definition of recession is certainly precise, but it's neither accurate nor useful.

What's so special about two quarters? What's so special about zero? What's so special about GDP? Precisely nothing.

There is absolutely nothing "technical" about the "technical" definition of recession. It's an arbitrary definition of recession, not a technical definition of recession.

Ottawa as Robin Hood

As the eurozone bumps along from major crisis to minor crisis to existential crisis, the point is often made that a key feature of successful monetary unions that is missing in the eurozone is a system of transfers. These transfers act a sort of compensation for renouncing the option of pursuing an independent monetary policy.

The Great Convergence: Federal Transfer Revenue Shares 1980/81 to 2013/14

Well the Council of the Federation began meeting in St. John’s yesterday and given we are on the cusp of a federal election, there will no doubt be a targeting of Ottawa’s role in provincial finances.  Naturally, there will be some lamentations about the Prime Minister’s absence – once again – from this annual meeting.  As Ontario’s premier has already noted: ““I think that is very important. Now, even that shines a light on how much better it would be if we were having a conversation with the prime minister all along. If the prime minister were there, had always been there, I think it would be a much better launching point for this discussion, but you know.”

Bad news on GDP vs good news on employment

Here is a macro exam question:

Q. You are the New Keynesian governor of an inflation targeting central bank. Two bits of information arrive simultaneously: GDP is lower than you expected; employment is higher than you expected. Relative to what you had otherwise planned to do, how do you respond to the news? Do you loosen monetary policy (because of bad GDP news), or do you tighten monetary policy (because of good employment news)?

Bank of Canada Governors and Economic Performance: A Canada Day Celebration

Another Canada Day, another year of Confederation – we are now 148 years old– and another opportunity for taking a historical look at some economic aspects of Canada. For your Canada Day musings, I decided to take a look at economic indicators according to the tenure of Bank of Canada Governors since 1934 (the legislation was passed in 1934, the institution opened its doors in 1935) – when our venerable central Bank began its operations.

The Bank of Canada's "stitch in time"

Steve Poloz is good at economics, but not always so good at finding the best metaphor.

Greg Quinn says "Bank of Canada Governor Stephen Poloz said his “controversial” decision to cut interest rates in January could be compared to life-saving surgery for the economy and any resulting increase in household debt should be viewed as a necessary side effect."

A better metaphor would use the old proverb "a stitch in time saves nine". (If you delay stitching a tear in your jeans, the tear will get bigger, and you will need even more stitches later.) If the Canadian economy did need a cut in interest rates in January, a delay would have weakened the economy more and more over time, requiring the eventual cut in interest rates to be even bigger.

So if there are bad side effects from cutting interest rates (if stitches are necessary but costly), that actually strengthens the argument for doing a stitch in time.

Of course, if you delay stitching the tear in your jeans forever, then your jeans will die. Which is where Steve's metaphor comes back to life.

We should learn from Sweden's Riksbank's recent mistake. It kept interest rates too high for too long, for fear that cutting rates would lead to increasing debt, which meant it eventually had to cut interest rates even lower than if it had done so in a timely fashion.

(I'm still not sure whether the Bank of Canada really did need to cut interest rates in January, but if you think you probably need to cut interest rates, you should cut now. "Let's wait and see if it gets worse" is not a good strategy. And this argument for a "stitch in time" works in reverse too, if you think that interest rates probably should be raised, but are worried about the side-effects.)

The Historical Statistics of Canada Are Back!

If you recall, several posts ago I lamented that the downloadable csv files that used to be part of archived web edition of Historical Statistics of Canada seemed to have disappeared or were not working.  I am delighted to say that the files are back.