Real economic stimulus requires big spending now

Posted on December 17, 2008 in Debates, Governance Debates – Opinion – Real economic stimulus requires big spending now: Ottawa cannot afford not to run a large deficit to fight off recession
December 17, 2008. Nate Laurie

Heading into the straightaway in the central bank race to a zero interest rate, Bank of Canada Governor Mark Carney picked up the pace last week, cutting the bank’s trend-setting overnight interest rate from 2.25 per cent to 1.5 per cent, its lowest level in 50 years.

In reaction to an increasingly bleak economic outlook, the U.S. Federal Reserve yesterday left the Bank of Canada in the dust, setting a range for the target rate in the U.S. of zero to 0.25 per cent, a new all-time low.

Like the Fed’s move yesterday, Carney’s 75 basis-point interest rate reduction was intended to spur borrowing – and spending – to prevent the economy from falling into a bottomless vortex. Yet the day after Carney drove down the Canadian rate, he gave lenders a long list of reasons why they shouldn’t lend.

In an assessment of the risks to Canadians in its December review of the financial system, the Bank of Canada said, “With household balance sheets under pressure from weak equity markets, softening house prices, slowing income growth, and a record-high debt-to-income ratio, a severe economic downturn could result in a substantial increase in default rates on household debt.”

That certainly doesn’t sound like a recommendation from Carney to lenders to extend even more credit to the beleaguered household sector.

And as if to underscore the point, the Bank of Canada issued the following warning: “A deep, or prolonged, downturn in the economy could entail new challenges for Canadian banks in the form of higher credit losses, with potentially significant negative impacts on their capital ratios.” That, too, hardly sounds like an encouragement for the banks to ease up on lending.

While signs of a deeper and more persistent recession would no doubt lead him to move even closer to a zero interest rate, worsening conditions would give the banks even more reason to keep lending tight. The rising risk of borrowers defaulting on their loans combined with the prospect of a minimal return on new loans hardly provides an inducement for banks to take on that extra risk.

So despite Carney’s efforts last week to give the economy a boost through lower interest rates, the concerns he expressed so candidly in his December review expose the very reason why his efforts are not likely to yield the desired results. This global slump appears to be getting deeper by the day, to the point where monetary policy has lost its traction and its ability to provide the stimulus that the economy so badly needs.

That leaves fiscal policy, or deficit spending to be precise, as the only tool capable of preventing the economy from falling into a vicious downward spiral.

And the sooner Ottawa gets on with it, the better off we will all be. To wait too long is akin to putting out a fire after the house has already burned down. And so whether you are a fan or foe of the Bloc-supported Liberal-New Democratic Party coalition, you owe the Liberals and NDP a debt of gratitude for at least forcing Prime Minister Stephen Harper to move up the budget date from late February to Jan. 27 because billowing clouds of smoke are already gathering over our house, and I don’t mean the Commons. Strong action really should have been taken in the government’s economic statement last month.

We should all be clear about how big and what kind of deficit is warranted at the present time. First, consider what would happen if the government chose to do absolutely nothing. The budget would still slide into deficit because some government expenditures like Employment Insurance would automatically increase, and because government revenues would also be weak. When workers are laid off and lose their earnings, their taxes fall, and for those who qualify, EI benefits have to be paid. And when corporate profits hit the skids, corporate taxes also decline. But the resulting deficit would hardly be stimulative; rather, it would merely be a sign of how bad the situation was.

Second, real stimulus must be net stimulus. If the government were to cut taxes by $30 billion and reduce spending by the same amount, the net effect would be a zero stimulus (economic theory, in fact, says it would actually cause the economy to shrink). Putting $30 billion into the economy with one hand and taking it out with the other would be akin to a doctor giving a patient “uppers” and “downers” at the same time.

Third, real stimulus also does not include measures already taken in the past. When Harper talks about stimulus, he unfortunately always mentions the cuts in the GST he introduced in the past two years as if those cuts will stimulate spending in the coming year. But if his goal is to boost consumer spending from what it would otherwise be in the coming year, he will obviously have to take new, additional actions this year. Harper’s past tax cuts are built into what consumer spending would otherwise be – which is precisely what we want to raise because consumer spending is heading toward recessionary levels.

Real stimulus is provided only by an additional increase in the deficit resulting from a deliberate and immediate decision by the government to increase spending and/or to cut taxes. On that score, Ottawa should probably be looking at something in the order of at least $30 billion or 2 per cent of GDP, the amount recommended by the normally cautious International Monetary Fund and the size of the stimulus Harper pledged to provide as part of an international effort to combat the recession.

What all this means is that if Harper is committed to putting some real stimulus in the economy in his budget next month, the deficit he will show for the coming year will have to be at least $35 billion. That number stands as the litmus test of his willingness to battle recession.

Nate Laurie is an economist and consultant. He can be reached at

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