The Output Gap and Fiscal Policy

Media coverage of the Bank of Canada’s much anticipated Monetary Policy Report inevitably focuses on the prospect of “unconventional” measures, such as quantitative and credit easing. But the verbs in today’s headlines – “may use” , “ready to” , “lays out” , “sets stage” – reflect how little was actually announced. The Bank provided three pages explaining quantitative and credit easing as well as some general principles for applying them, without committing to do so.

Of course, it is good that the Bank is explicitly discussing the possible  options. An advantage of finally reaching the end of the road on interest rates is that it advances the debate about other policy avenues.

However, what most interested me in today’s Report was not the three pages on unconventional monetary policy, but the preceding thirty pages on the state of the economy. Buried in the middle is an updated estimate of Canada’s “output gap”.

This figure used to be positive. In 2007, Canada’s economy was operating 2% above the Bank’s definition of “production potential.” I would suggest that, with a million workers officially unemployed, our economy was operating well below full capacity even then.

The Bank estimates that Canada’s economy operated 3.5% below potential in the first quarter of 2009. We seem likely to remain at least this far below potential for the rest of the year.

As Paul Krugman has pointed out in the US, the output gap is essentially the hole that fiscal policy needs to fill. To get up to the Bank of Canada’s definition of “production potential”, we would need a stimulus package worth 3.5% of GDP this year. A return to the heady days of 2007 would require about 5.5%.

How do these gaps compare to Canada’s actual stimulus plan? The Government of Canada has paid lip service to the idea of stimulus worth 2% of GDP, which is reasonable insofar as it was the International Monetary Fund’s benchmark. However, as outlined previously, the federal budget provided new federal spending and tax cuts worth only 0.7% of GDP.

Of course, some provincial governments are also providing stimulus, both on their own initiative and to match available federal funds. The Government of Ontario, which used to have a balanced budget, projects a $14 billion deficit in 2009-10. Provincial revenues fell by $6 billion because of the economic downturn, leaving perhaps $8 billion of new budget measures this year.

In addition to 0.7% of federal stimulus, Ontario’s stimulus is worth almost 1.4% of provincial GDP. Other provinces would have to finance proportionally as much stimulus to push the national total to 2% of GDP. Even then, this total would fill only about half of the output gap identified by the Bank of Canada.

Today’s Monetary Policy Report provides a compelling, if implicit, case for another round of fiscal stimulus. The federal government should be expected to finance a second stimulus package, both because its first attempt was so weak and because it enjoys lower borrowing costs than provincial governments. But more stimulus from the provinces would also be welcome.

One comment

  • I cannot believe Mr. Carney came out and stated the USA has tripped up on its economic stimulus and is blaming them for the economic Woes in Canada. Did you see that statement.

    Somebody within Harper’s cabinet must be a huge fan of Shakespeare as the the Irony is so so so Shakespearean by this statement.

    Harper had better watch it, they may seem to be only media antics to some within the power that be on the hill, I am sure the Obama administrators are not as policy challenged as the last bunch that filled the white house.

    I cannot believe with the meager Stimulus put out by Harper, he is blaming Obama for his own shortfalls. Economic stimulus given our integrated economies is a two way street, and the fact is, when you have a look at the numbers, we are free riding on the American taxpayer stimulus backs. WTF is wrong with this Harper crew, pretending and pontificating is not what is needed right now. Making enemies with Obama is about as constructive as taking shots at the CAW right now.

    Wow that is some nerve and audacity, where do they get this stuff from and we as tax payers actually have to pay these consultant fees?

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