Reflections on Macro Policy after the Great Recession
As the communique from the Pittsburgh G20 put it,Â “it worked.”Â Unprecedented macro-economic stimulus in the form of ultra low interest rates and large government deficits pulled the global economy back from the abyss.Â 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.Â 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 ofÂ government finances to curb the rise ofÂ government debt to GDP ratios. Alarm at the potential impact of loose monetary policy on inflation is understandably less widespread given the reality ofÂ 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.Â In Canada, then, interest rates might rise only a bit, and at a slow pace, from ultra low levels as fiscal stimulus is withdrawn.Â This would echo the experience of the 1990s recovery when the macro-economic impact of deep spending cuts was offset to a significant degree by relatively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.Â Interest rates are already as low as they can go.Â To be sure,Â “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.Â Operating below capacity means low levels of public and private investment which in turn lowers the potential for future growth.Â Â In human terms,Â 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 ofÂ 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.Â Unfortunately,Â in the context of rapid US dollar depreciation, all of the impact of low interest rates has been on debt financed domestic consumption.Â 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.Â 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.Â 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 ofÂ 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.Â 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 ofÂ monetary policy as and when we get a real recovery.
Consider the advantages of emphasising fiscal stumulus.Â 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.Â 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.Â 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 investmentsÂ which create jobs and restructure our economy in positive ways.Â 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,Â 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.Â 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.