The Output Gap and Fiscal Policy
Media coverage of the Bank of Canadaâ€™s much anticipated Monetary Policy Report inevitably focuses on the prospect of “unconventional” measures, such as quantitative and credit easing. But the verbs in todayâ€™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 easingÂ 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 possibleÂ 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 todayâ€™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 Canadaâ€™s “output gap”.
This figure used to be positive. In 2007, Canadaâ€™s economy was operating 2% above the Bankâ€™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 Canadaâ€™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 Canadaâ€™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 Canadaâ€™s actual stimulus plan? The Government of Canada has paid lip service to the idea of stimulus worth 2% of GDP, whichÂ 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, Ontarioâ€™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.
Todayâ€™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 soÂ weak and because it enjoys lower borrowing costs than provincial governments. But more stimulus from the provinces would also be welcome.