A Primer on Pump-Priming

With a weakening US economy that may well spill over into Canada, it is time to start thinking about fiscal policy responses should recession rear its ugly head. To date much of the focus has been on monetary policy, with calls for central banks to lower interest rates. This is providing some relief, but as many economists have pointed out, the bursting of the housing bubble in the US and the resulting credit crunch due to sub-prime-heavy commercial paper is not a liquidity problem that can be fully addressed with lower short-term interest rates but an insolvency problem that will spur drops in asset prices. And that process is in danger of doing damage to the real economy.

If the worst happens, monetary policy will become ineffective – as Keynes said, “pushing on a string”. Fiscal policy will need to play a much bigger role in that instance. The Center for Budget and Policy Priorities in the US has a new report on what principles should guide a fiscal stimulus. In short,

To boost demand for goods and services, fiscal stimulus should be targeted where it is most likely to be spent immediately and thereby to boost demand.  This suggests targeting on low- and moderate-income individuals and unemployed workers who need a replacement for lost income.  People whose income is disrupted in a recession and who lack the savings to tide them over and maintain their normal consumption, and people whose incomes are so low to start with that they have difficultly making ends meet, are the people most likely to spend quickly any added income they receive.  Assisting them thus provides strong stimulus.

I thought this box from the report was really interesting:

Some Stimulus Measures Have Much More “Bang for the Buck” Than Others

A good way to assess a stimulus proposal is through its fiscal “bang for the buck” — how much immediate spending boost it would deliver for each dollar it costs.  During the debate in 2002-2003 over a stimulus package, economist Mark Zandi of Economy.com evaluated various stimulus options in terms of their effect on the economy in the first year after enactment. 

While economic conditions have changed since then, Zandi’s rankings continue to provide a useful assessment of the relative value of various measures in generating economic stimulus.  They indicate that temporarily strengthening unemployment insurance is among the most effective forms of stimulus, because most of the additional unemployment benefits would be quickly spent, while a dividend or capital gains tax cut would be among the most ineffective measures because much of it would be saved rather than consumed quickly. 


Demand generated per $1 of cost

Source: Mark M. Zandi, “Assessing President Bush’s Fiscal Policies,” Economy.com, July 2004.

The discussion on state governments is different for Canadian provinces. US states are required to balance their budgets, so downturn leads to pro-cyclical fiscal responses that worsen the situation; thus federal relief to states is more important. In Canada, provinces have their own capacity to tailor fiscal responses to local needs.

One comment

  • Marc,

    Just a couple of points on this. First I am not so sure we should weaken any mounting resolve to lower rates and discount the impact of monetary policy quite yet. In the US lower rates could help the housing market by somewhat propping up demand for housing with lower costs on mortgages. In addition the lower rates will hopefully prevent further increases in both the sub-prime and regular defaults on mortgage, and thus increase the stock of real estate. It is all about flows into and out of the housing stock, and the rates control the gates on both flows with high degree of correlation. These gatekeepers are what will directly inflate or deflate these housing asset prices.

    In Canada, the most effective measure to contain the dollar and the damage it is reaping across the industrial heartland is through lowering interest rates. ( I guess we could start running huge deficits that would most likely start a bit of a run on the dollar).

    the latest coming from the Fed in the States has Bernanke is getting set for some dramatic rate cuts. Not sure what this translates into, but I am thinking at least a half point is on the horizon, with more in the future to come. With the recessionary ground swells entering the fray in popular economic discourse over the past month, and given it is an election year, you can bet your mortgage payment dollars on some substantial rate cuts.

    We will have no choice but to keep the interest rates bands in tact, unless Harper wants to get his minority govt turfed. The BOC will have some slack in the band width to play with, but not in the longer term. The Ontario and Quebec governments will not put up with more obliterating of the industrial base. Thankfully labour and progressive groups (and some industry groups to a lesser extent) have done an excellent job in raising the public awareness of the cost of a high dollar.

    However, as you indicate, monetary policy will only take us so far. And as with the case of the US it seems as though a fairly substantive 100 Billion spending package is being recommended to the Bush regime. (see here http://www.ft.com/cms/s/0/7e8cc27a-bfa6-11dc-8052-0000779fd2ac.html )

    The Democrats have also recently started taking about fiscal spending packages, at least Clinton did unveil one today and I am sure the rest of the candidates will follow suit.

    Amazing what Mr. Bushes underling Mr Harper would only offer up a conditional $1 Billion package targeting small on horse communities. Although it is a start, it is nowhere near the type of response needed. Not just in terms of $ and back handed delivery mechanism, but also in its lack of depth. We need some comprehensive government/business/labour strategic response to the challenges that are on us now and in future. We need government action to help ward off the mounting recessionary storms and it is fairly clear from the response from the premier’s dinner date with
    Steve, that the ideologues on the hill are content to keep there invisible hands in their pockets and try their best to look like they are doing something.

    If the US is considering a $100 B fiscal spending package
    shouldn’t ours have been at least $10 B. Potentially Steve and Company have more coming, however as indicated by many with regard to the corporate tax cuts, the spending needs to be strategically targeted and implemented. I am not sure the Tories have it in them to deliver such a comprehensive and complicated type of policy package.


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