Some Inconvenient Accounting and the Fall 2008 Fiscal Update
Ah, the confluence of the events! The tabling of a â€œprudentâ€ federal budget for uncertain times, followed a week later by news of slowing economic growth. Of course, rumors of the economyâ€™s imminent decline may be greatly exaggerated, given Januaryâ€™s jobs report and trade data. But letâ€™s carry forth with the economic accounts data.
Earlier, Erin and Toby drew our attention to the Q4 2007 current account deficit and the more comprehensive Canadian economic accounts data. Following Tobyâ€™s line of analysis, the sector accounts allow us to observe the impact of shifts in the current account on the net lending/borrowing (NLB) relations between the three Canadian domestic sectors – households, corporations and government – and the non-resident sector. (See chart here.) Employing a Wynne Godley sector balance approach (see here for a recent article that reviews the methodology), the current account position is mirrored in the non-resident NLB, which balances with the NLB positions of the three domestic sectors. This is an accounting identity. For every credit, there is debit. They all sum to zero.
The fourth quarter current account deficit helped reduce the net borrowing position of non-residents vis-Ã -vis Canada by about $14.4 billion for 2007. Likewise, household net borrowing grew by $12.2 billion for the year to a record deficit. Corporations cut their net lending by $2.9 billion, while the total government surplus remained virtually unchanged.
Now, this particular alignment was not always the case. Prior to 1997-1999, as Toby also notes, households and non-residents tended to be net lenders, posting annual surpluses, while the corporate and government sectors tended to be in deficit. The magnitude of these surplus/deficit positions would fluctuate with the business cycle. In both the 1981-82 and 1990-92 recessions, household net lending would peak at the end of the recession and then fall, signifying a rebound in consumer spending. Corporate net borrowing would expand leading up to the recessions, peak and then recede over the downturn, corresponding with reduced business investment. Governments saw sharp increases in their deficits position during these contractions. Also noteworthy is that between the two recessions, the government sector deficit widened, reaching an historic high in 1992, while non-resident net lending (to finance the current account deficit) expanded, peaking in 1991.
These movements in NLB positions had implications for effective demand both in the near-term and longer term, to the extent that borrowed funds finance expenditures by households, businesses, governments and non-residents.
In the 16 consecutive years of growth that have followed the 1990-92 recession, a great structural flip-flop has occurred. Around 1997-1999, the households and non-resident sectors became net borrowers while the corporate and government sectors have trended into surplus positions. The reasons behind this flip-flop will be explored in future posts.
In the meantime, how does this structural re-alignment situate the Canadian economy in the event of a near-term slowdown and possible contraction? With the external engine sputtering and perhaps on the verge of conking out (Merrill Lynch forecasts a current account deficit of $20 billion in 2008 and $36 billion in 2009), the domestic sectors will have to pick up the slack and spend more. Corporations may surprise us and ramp up domestic investment spending, perhaps even going beyond oil patch engineering projects. However, the current financial market uncertainty may have exorcised any such animal spirits. The household sector may plod on, providing the main thrust of demand through personal expenditure and housing investment. But to a growing extent, these household expenditures over the last 16 years have been debt-financed. In 2007, the aggregate household deficit hit $65 billion, the same level as the total government deficit at its highest in 1992. Alarm bells rang then about fiscal sustainability. There are limits to amount of debt a sector can amass before fears of default lead to a change of course. The question: has that time come?
That leaves us with the government sector, led by a federal government determined never again to run a deficit. A slowdown in output, and thus income, will reduce tax revenues. Even without any policy response, the government sector could run a deficit. Here then is the big question. Will the federal government choose to defend the surplus and cut spending (reduce the size of government and cut transfers to individuals and other levels of government) or, shudder, raise taxes? Or will it choose to provide fiscal stimulus and run a countercyclical deficit in the near-term, following the U.S.â€™s recent policy example? Or will it choose something in between?
My eyes are on the fallâ€™s Economic and Fiscal Update 2008, a perennial event which seems to have become the more popular occasion for making grand policy statements (recall income trusts in 2006, tax cuts in 2007). Whether it is this New Government or another new one giving the update, either will likely face deficit pressure from slower growth induced by a current account deficit, coupled with highly leveraged households and cash-flush corporations. The Department of Finance has two more quarters of economic accounts data and four more monetary policy announcements to digest before it enters budget prep mode in September and molds a fiscal response.