Reflections on Macro Policy after the Great Recession

As the communique from the Pittsburgh G20 put it,  “it worked.”  Unprecedented macro-economic stimulus in the form of ultra low interest rates and large government deficits pulled the global economy back from the abyss.  Canada has now joined most countries in exiting the recession, at least very tentatively. But what is next?

The official line from the Canadian government, the IMF and the OECD is that macro-economic stimulus should be maintained well into next year, awaiting convincing evidence of a sustained revival of private sector demand.  But the application of fiscal discipline and a return to more normal interest rates are clearly on the medium-term agenda, and there is no shortage of voices on the right calling for a rapid re-balancing of  government finances to curb the rise of  government debt to GDP ratios. Alarm at the potential impact of loose monetary policy on inflation is understandably less widespread given the reality of  a large output gap and very high unemployment, but there are growing and serious concerns about the emergence of new asset bubbles.

One of the key issues that must be addressed by governments is the relative emphasis to be placed on monetary and fiscal policy. The dominant view would seem to be that fiscal tightening should come first, and that monetary ease can and should persist so long as national economies are operating well below capacity.  In Canada, then, interest rates might rise only a bit, and at a slow pace, from ultra low levels as fiscal stimulus is withdrawn.  This would echo the experience of the 1990s recovery when the macro-economic impact of deep spending cuts was offset to a significant degree by relatively low interest rates and a low Canadian dollar.

One problem with this view is that it will be very difficult, if not impossible, for monetary policy to offset contractionary fiscal policy.  Interest rates are already as low as they can go.  To be sure,  “quantitative easing” could and should be implemented today to create more expansionary overall monetary conditions by bringing down the over-valued Canadian dollar. But this is unlikely to happen unless and until the Bank of Canada is convinced that we are going to slide back into recession or face actual deflation of prices. In short, assuming we get back onto a low growth trajectory, the stage seems to be set for some combination of government spending cuts and some modest monetary tightening.

That is a pretty dismal prospect. It translates into continued very high unemployment and substantial slack in the economy.  Operating below capacity means low levels of public and private investment which in turn lowers the potential for future growth.   In human terms,  an economy bumping along bottom means no jobs for young people, rising inequality and rising poverty and social exclusion among the victims of the recession.

Another problem with the dominant view is that there are major problems with an indefinite continuation of  loose monetary policy. In Canada, more than elsewhere, ultra low interest rates have had a major impact, sustaining domestic demand in such a way as to largely offset the collapse of exports and of business investment.  Unfortunately,  in the context of rapid US dollar depreciation, all of the impact of low interest rates has been on debt financed domestic consumption.  It is pretty clear that we risk, if we do not already have, a house price bubble, and households are going deeper and deeper into debt.  Low interest rates have helped maintain demand, but hardly in a costless or sustainable way.

It would also seem to be the case that ultra low interest rates and major injections of liquidity into the banking system have fueled a new financial asset price bubble. Led by major institutional investors, the shift back into equities and some other assets has pretty evidently got well ahead of any actual or feasible recovery in the real economy.  From one perspective it is a good thing that household wealth and pension funds have recovered some of the losses of the Great Recession, but we are probably creating the conditions for future financial problems. It is somewhat ironic that one of the supposed lessons of  the Great Recession was the need for greater macro prudential oversight, but that the authorities are (not without reason) desperately afraid to derail a financial sector recovery which is pulling the big global and US banks back from the brink of collapse.

The key problem with stimulating the economy with low interest rates – virtually the only tool in the hands of central bankers – is that you don’t necessarily get the results you want.  In theory, low borrowing costs should be setting the stage for a revival of business investment, which would create jobs and increase our economic potential. But, in Canada at least and more widely, the stimulus effect is all on the household sector while business remains hunkered down.

One way out of this problem would be to control the credit process more closely so that loose monetary policy does not inflate new bubbles, We could and probably should, for example, be increasing required down payments for housing, and limiting highly leveraged financial investments. But not too many people are talking about that.

These considerations lead me to think that the dominant view is seriously at odds with the macro setting we need – continued expansionary fiscal policy, and some modest tightening of  monetary policy as and when we get a real recovery.

Consider the advantages of emphasising fiscal stumulus.  First, we can target resources to those who need them the most, the long-term unemployed and depressed communities, rather than those who need them the least, not least investment bankers. Second, fiscal stimulus can and should have a major investment component, setting the stage for higher potential growth.  My favourite example is investment in transit and passenger rail which can have big job impacts, significantly cut carbon emissions, and generate a large social rate of return to individuals and businesses in terms of reduced travel time and congestion.  But we can add the large returns from investment in areas like post secondary education and research, training, and go on to consider targetted support for desirable new business investments  which create jobs and restructure our economy in positive ways.  And even if interest rates rise a little, these public investments are quite capable of generating returns greatly in excess of the cost of borrowing.

By way of conclusion,  the dismal prospect of a very slow and uncertain recovery means we should continue fiscal stimulus, while targetting it much more effectively to the twin goals of raising our economic potential as we bring down unemployment.  Monetary policy can and should assist fiscal expansion, but there are real dangers to thinking we can rely on it to engineer a meaningful recovery.


  • I’m hung up on your first paragraph:

    “Unprecedented macro-economic stimulus in the form of ultra low interest rates and large government deficits pulled the global economy back from the abyss. Canada has now joined most countries in exiting the recession, at least very tentatively.”

    I see the correlation: a stimulus package was announced, and Canada has exited the recession. But how do we know the causation is there? Maybe we would have had exited by now even if there was no stimulus.

  • First the so called recovery is really only economists can appreciate. Second fiscal response, in government spending with a meaningful interest hike would be how Ronald Reagen with Paul Vockler crushed forming asset. We’ed argue about the saverity & duration of a fiscal expansion.

    The fact we have unused capacity & high employment, means no Inflation Is simply wrong. If we were on a gold standard unused capacity & high employment, would make inflation impossible. Typically countries with high inflation suffer from a wide output gap. Beggar thy neighbor currency devaluations wont help anyone. Globally are we not suffering from China’s peg?

    Only reason we have to worry about new bubbles is because of US policy, trust me BCs recent house gains can’t be soley attributed to federal or province measures. US produces very little, so the trillions they create help bid up prices globally, for everything. It wouldn’t be bad if there service sector economy was like singapore, which doesn’t rely off debt.

  • @David. There is no way, that had government not acted we would be existing rescession but at the same time their would be 0% chance of malinvestment, misalocation of resources and illusiory price gains. I wish Sir Keynes was still alive because his philosophy has been so perverted, that proponents seem to use it arbitrarily to fund perpetual wars & wasteful welfare.

    For an empirical link to more on base with your point. Look at how george bush inherited a rescession from a collapsing asset bubble in tech stocks followed standard economic theory for creditors. I challenge anyone to read Keynes collected writing on debtors, Bush/Greenspan lowered interest to 1% & ran deficits. Had Bush not engaged in standard economic theory then the rescession late 90’s would have been worse in hindsight their would have never been a housing bubble. Disappering lending standards with declining saving rate in all ages is because of monetary policy. Price controls & capital controls have never worked long term.

  • The authors understanding of inflation has not borne out by experience. You misunderstand inflation, because the economy doesn’t need to be fully employed, inflation can happen even with a wide output gap. The theory is that if the economy has substantial unused capacity for production, then monetary policy can be expansive without risking inflation. Unused capacity in the economic sense includes unemployed workers and idled plant and equipment that would otherwise be used to produce goods and services were there’s a demand became false the second we left the gold standard.

    Translated into English, you are saying that the central bank will continue pumping up the money supply and maintaining easy credit conditions for a “considerable period,” as it revealed in a recent statement. Its view is that the economy is like a bucket that has been partially drained: Until the bucket is full again, there cannot be inflation. Therefore, the central bank will continue stimulating demand indefinitely.

    The problem with this theory is that it is not borne out by experience. In the 1970s, there was high unemployment and low capacity utilization, yet high inflation. A key reason is that labor, plant, and equipment are not homogeneous. When demand is stimulated, it may require workers with different skills in different places to satisfy it. Similarly, producers may not have the right equipment to make the things people want. Therefore, new investment must take place first before production can rise

    capacity-utilization index may be at a historical low, much of that unused capacity however is worthless. A lot of growth was attributed to unsustainable policies and should have never existed in the first place. It is bad investments that simply must be written off. This means that inflation could easily reemerge well before capacity hits 82 percent, generally considered to be the tipping point. It also means that unused capacity is no barrier to new investment

  • If the supplies fall because of high unemployment faster then demand, take food as a volatile example, weather can wreak expectations, can create surprise shortages on top of excessive money creation will lead to higher prices despite unused capacity, its actually the unused capacity that drives the falling inventories creating shortages and higher prices.

  • “I see the correlation: a stimulus package was announced, and Canada has exited the recession. But how do we know the causation is there? Maybe we would have had exited by now even if there was no stimulus.”



    A nice article here Andrew that Prof. Harvey is kind of reflecting as well.

    It is a nice piece and I can’t wait till his book comes out next April that this is based upon.

    I have to admit his article unleashes in me this emotional response that irrationalizes a whole lot about the rationality and the economics of our times.

    1) why do we have a whole pile of capacity sitting around without productive engagement.

    2) why do we have more and more labour sitting around without productive engagement

    3) why do we have all these unmet needs of human suffering in the ideology of efficiency driving the outlay of capital assets which have been laid out in such a monstrous manner that results in mass starvation, a polluted planet and all these unmet needs. For the life of me, I just don’t get how the capitalists and the apologists have kept the barbarians at the gates for this long. Truly it is remarkable feat that those with a majority of asset control have maintained their position when you think about how phracked up things have become. It just is diabolical.

    4) how we have not had more of an organized resistance to such misplaced asset allocation is truly becoming, with the climate change and global inequity, to bear on the system of the status quo conveyor belts. The delivery of the goods that keeps it all going may truly becoming to an end.

    5) With the information age, and the prevalence of data and information and the taming of knowledge, why cannot we have a economic system that is planned. It cannot do any worse in outlaying capital than what is currently being accomplished in the name of capitalist efficiency. Systems of innovation cannot do any worse under a planned envelopment of the productive capacity than this bubbling cauldron that capitalist asset innovation has become.

    I trully believe with the information age- Schumpeter and the lot of them are now outdated and wrong on how supreme the innovative capacity of capitalism inherently brings to the table in terms of tech and innovative capacity of the production process.

    6) lastly how long will the people of the planet put up with this, before a truly legitimate alternative forms and becomes hyper organized. There are some fledgling centers that are incubating but seemingly not many ready for maturation. When will get a mature resistance.

    random thoughts inside stirred up by Prof. Harvey

  • Bank of Canada, seems to agree with my keynesian understanding of economics when involving interest rates. BoC said consumers and banks should be cautious about adding to household debts because a rise in record-low interest rates to “more normal” levels will leave some borrowers unable to pay. Citing a “stress-test” analysis the central bank did of household finances, Carney said that if interest rates rise faster than bond market yields indicate, almost one in 10 Canadian households could devote at least 40 percent of their income to paying debts, making them “vulnerable.” “It is the responsibility of households now to ensure that in the future, when the recovery takes hold and extraordinary measures are unwound, they can still service their debts,” Carney, 44, said in a speech today in Toronto. At a press conference afterwards, he repeated a plan to keep his main interest rate at a record low 0.25 percent through June unless the inflation outlook shifts, to boost an economy that has lots of “slack.”

  • The proportion of Canadians whose debt-service costs are more than 40 percent of disposable income would rise to 8.5 percent from 5.9 percent if borrowing costs rise as quickly as current government bond yields suggest, the bank’s report last week said. That is greater than a peak of 7.4 percent in 2000. If rates were to rise more quickly, the proportion of financially vulnerable households could reach 9.6 percent, the bank said. ‘Pause for Reflection’ “While these simulation results are purely illustrative, they give pause for reflection,” Carney said in the speech. “It would not be healthy to have almost 20 percent of household debt extended to vulnerable households. Nor is it necessary to secure our recovery.”

  • @Paul T.

    How do you equate capitalism for the worlds problem, in fact their is not on capitalistic system left. All we have are variations of mixed economies. Capitalism comes hand in hand with mass bankruptcies, market interest rates, unsubsidized market for everything etc.

    Every problem today is from planned choices, I do not see one capitalistic economy in the world. We don’t follow capitalism, and we still have problem. France has problems. England has problems. China has problems. Australia has problems.

    The lowest mortgage rates since the Korean War have helped fuel a 67 percent jump in existing home sales in November from their January low, with the average price up 19 percent from a year ago to C$337,231 ($317,500). Economists, including David Laidler of the C.D. Howe Institute and David Rosenberg of Gluskin Sheff & Associates Inc., have said the house-price gains signal a bubble may be forming in that market. Wasnt this what happened in the US. A failure of Socialism!!!

  • “Bank of Canada, seems to agree with my keynesian understanding of economics when involving interest rates. BoC said consumers and banks should be cautious about adding to household debts because a rise in record-low interest rates to “more normal” levels will leave some borrowers unable to pay.”

    When did basic accounting become Keynesian???

  • @ Brandon,

    you obviously don’t understand even the most basic of vocabulary so I am not sure I could respond to you and be constructive. Sorry B.L you just gonna have to go and sit in class somewhere for a few years and let it permeate your latest layer of gray matter- which is somewhere up front and on top, liberate you executive function and you will do just fine- cause you sound pretty smart just mis-informed is all.

    sorry for the jab.

  • @ Travis Fast and Paul T
    We as an individual decide to borrow money look at the interest rate which is basic accounting, rarely does that individual factor in a reset on that rate and if that will exceed is annual income. That percentage of people will be dependant on our central banks understanding of economics which is largely Keynesian will depend on the interest rate they set and how this affect other interest rates. Some people based on their credit ratings our receiving funds , that they would not receive from higher rate of 7% to 10%.

    Secondly to get to basics, and something I feel we as a nation, have overlooked and ignored. If sir Keynes were alive today would be appalled by how we perverted is knowledge.

    Keynes would argue has he did that trade must be equally balanced to create full employment. He would not argue that imports should outweigh exports nor should exports be greater than imports. If one can plan an equal balance of trade which means an interest rate that doesn’t lead to over-consumption or over-production. It was assumed by many modern economists that the countries like the US, Uk, Spain could consume vast quantities of goods and services with expanding debt-loads only enabled by record low interest rates, none of that consumption could have taken place otherwise. Also other big producing nations like China, Japan, Norway, Canada can have ever increasing surpluses and not using those resources for investment and domestic consumption without consequences. It was assumed that these problems by many modern Keynesian economists would lead to greater and unheard levels of growth. Which has been proven utterly false.

    Our central bank should increase interest rates to a meaningful level to crush forming assets bubbles and the government should fiscally spend at historic level maybe even unheard of, to support reform efforts.

    The two risks to our current approach is that remain weakness in the economy makes it impossible to stimulate demand through lowering borowing costs becasue real interest rates remain positive no matter what.

    The second and more dangerous risk is that we manage to create inflation here if we adopt inflationary policies before we determine if current economic pain is from a latency in time from the policy easing and being effective and Qe becomes reckless and ignorant, sorry for the Jab. Were grown ups

    The writing is on the wall, there will be a new reserve currency, that will be a negative on the dollar for some time to come. Central Banks globally becoming net buyers of all gold trasanctions reversing a trend for decades, We will see some form of fixed standard to gold or a combination of commodites and will probably this time around resemble the bancor original goal. Also we will import a lot from the US in coming years while competing to sell to the biggest middle class in history the chinese as the yuan will skyrocket once they figure out what to do with their US treasuries and all those savings will go to suppport comsuption. Hopefully were smarter then our competetiotors and make relations now.

    “The bancor was a World Currency Unit of clearing that was proposed by John Maynard Keynes, as leader of the British delegation and chairman of the World Bank commission, in the negotiations that established the Bretton Woods system, but was never implemented”

    “It was to be initially fixed in terms of 30 commodities, of which one would be gold. It would stabilize the average prices of commodities, and with them the international medium of exchange and a store of value. Central to Keynes’ proposal was to tax countries’ current account surpluses, encouraging domestic demand and promoting global trade balance”

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