Economic Forecasts and Fiscal Policy

It would have been interesting to listen in on the discussion of  Bay Street economists with Finance Minister Flaherty earlier this week.

Not all of the banks have current forecasts on line, and they differ somewhat in terms of detail and relative degree of  optimism or pessimism. Nonetheless, it seems clear that growth in 2011 will likely be significantly lower than assumed in federal and provincial budgets introduced in 2010.  Both CIBC and TD expect real growth in 2011 to be just 2.0%, 1.3 percentage points less than forecast in the 2010 federal Budget.

These growth forecasts also imply little or no improvement in the national unemployment rate, which CIBC expects will rise to 8.2% over the next two quarters.

It is unclear what the private sector forecasters are assuming about 2011 fiscal policy.

The federal government and the provinces basically committed to fiscal retrenchment starting in the fiscal year 2011-2012, which means the withdrawal of stimulus amounting to some 1.6% of GDP compared to 2010-11 (according to the OECD).  Little wonder the recovery is expected to run out of steam.

The implications of fiscal retrenchment on short-term growth will be particularly severe if private investment remains very depressed and if  – as seems highly probable – the dollar remains very high against the US dollar as  the US economy also stagnates. The effects of fiscal restraint cannot be offset by easier monetary policy, which remains highly stimulative.

One key question to be posed is whether it really makes sense to completely withdraw fiscal stimulus measures when this will almost certainly flat line unemployment at or even above 8%.

But it could be even worse.

As growth forecasts fall, governments will have to cut spending significantly more than planned IF they are going to stick to their original 2010 deficit reduction plans.

We badly need a sensible debate about how rapidly to reduce deficits. Given continuing high unemployment, sluggish growth and record low interest rates,  the pending sharp turn to fiscal austerity just doesn’t make a lot of sense.