Why Does the Bank of Canada Now Believe that Fiscal Stimulus Works?

Here are some quotes from a famous article in the November 1963 issue of the Canadian Journal of Economics and Political Science by Nobel Prize winning economist, Robert Mundell, then of McGill University. He is writing about the effect of a fiscal stimulus generated by an increase in government spending financed by borrowing in an economy with a floating exchange rate in a global environment of extremely high international capital mobility.

Increased [government] expenditure creates excess demand for goods and tends to raise income. But this would increase the demand for money, raise interest rates, attract a capital inflow and appreciate the exchange rate, which in turn would have a depressing effect on income. In fact, therefore, the negative effect on income of exchange rate appreciation has to offset exactly the positive multiplier effect on income of the original increase in government spending. Income cannot change unless the money supply or interest rates change. ... Fiscal policy thus completely loses its force as a domestic stabilizer when the exchange rate is allowed to fluctuate and the money supply is held constant. 

If my assumptions about capital mobility were valid in Canada, it would mean that expansive fiscal policy under flexible exchange rates [would be] of little help in increasing employment because of the ensuing inflow of capital which keeps the exchange rate high and induces a balance of trade deficit: we [would observe] a zero or very small multiplier. 

Of course the assumption of perfect capital mobility is not literally accurate... To the extent that Canada can maintain an interest rate equilibrium different from that of the United States, without strong capital flows, fiscal policy can be expected to play some role under flexible exchange rates... But if this possibility exists for us today, we can conjecture that it will exist to a lesser extent in the future.

Mundell's classic "Capital Mobility and Stabilization Policy Under  Fixed and Flexible Exchange Rates" clearly laid out that in a global economy with a high degree of capital mobility, fiscal stimulus in a small open economy operating with a flexible rate is likely to have little if any lasting impact on real GDP growth.

Fast forward 50 years and empirical studies by the US National Bureau of Economic Research (NBER) and by the Bank of Canada confirmed that fiscal multipliers for Canada are very low.

The NBER summarized its results as follows:

Based on a novel quarterly dataset of government expenditure in 44 countries [including Canada], we find that (i) the output effect of an increase in government consumption is larger in industrial than in developing countries, (ii) the fiscal multiplier is relatively large in economies operating under predetermined exchange rates but is zero in economies operating under flexible exchange rates; (iii) fiscal multipliers in open economies are smaller than in closed economies; (iv) fiscal multipliers in high-debt countries are negative. 

Specifically, the NBER found that for economies, like Canada, that are "open to trade or operating under flexible exchange rates, a fiscal expansion leads to no significant output gains. Further, fiscal stimulus may be counterproductive in highly indebted economies. Indeed, in countries with debt levels as low as 60% of GDP, government consumption shocks may have strong negative effects on output".

The Bank of Canada found that while Canada benefits greatly from fiscal stimulus conducted by the United States and other G20 trading partners, "Canada’s high level of openness sharply curtails the effectiveness of a domestic [fiscal] stimulus." Specifically, the 2010 study by BoC researchers found that, for Canada, fiscal multipliers for government spending were very low: ranging from virtually zero for increases in general transfer payments, to 0.40% for government investment expenditures, to 0.80% for government spending on goods, to .98% for spending on government services.

The findings of the NBER and the BoC, corroborate Mundell's theoretical insight and support his view that as global capital markets became ever more efficient, fiscal policy has become ever less powerful in small open economies with flexible exchange rates.

So it is somewhat surprising to me that in recent days, the Governor and the Senior Deputy Governor of the Bank of Canada have gone out of their way to tell members of the press that they believe that Canada's latest fiscal stimulus will have a substantial positive effect on real GDP.

Governor Stephen Poloz told the Canadian Press, "we're fortunate in Canada that we have that fiscal capability right now to shift our policy mix ... as the government has done... This is exactly the setting where fiscal policy is its most effective and its also where monetary policy is its least effective." 

Bloomberg News reported Poloz as saying that the size of the fiscal multiplier depends on the “situation you start in.” When the economy is in equilibrium, government spending triggers higher interest rates and higher currency, crowding out private spending. In equilibrium, fiscal policy “has no effect except it changes the mix of what is going on in the economy. So this gives rise to sort of cavalier statements from some that would say, 'well that won’t have any effect.'" Poloz went on to say that in low growth settings, “fiscal policy begins to add demand in the economy (and) basically nothing else happens except that demand goes up and what happens then is that you get the maximum effect of fiscal policy because there are no offsets such as upward creep in interest rates or movement in the exchange rate.”

BoC Senior Deputy Governor Carolyn Wilkins was singing from the same hymn book in an interview with Macleans magazine, where she opined that fiscal policy is more effective than monetary policy in boosting productivity and growth when interest rates are low. In the interview, she said "If fiscal policy can do some of the heavy lifting, that’s a positive thing. Fiscal policy at low interest rates is also just more effective. In a world where growth is going to be structurally slower because of demographic changes, monetary policy can’t fix that. If we want sustainable growth, we need to boost productivity, not only in Canada [but in] the global economy. That’s the only place growth can come from."

Mr. Poloz seems to be basing his enthusiasm for fiscal policy on the degree of slack in the Canadian economy. Indeed, some studies do indicate that government spending multipliers for OECD countries, on average, are near zero in periods of expansion or low unemployment but are higher in recessions or in periods of very high unemployment. But Canada is not in recession and unemployment is close to the threshold level of 7%, only above which fiscal multipliers might be somewhat higher. And Canada is not an average OECD country; it is a smaller, much more open economy than the US, the Eurozone or Japan and it is much more sensitive to movements in its exchange rate.

Mr. Poloz and Ms. Wilkins seem to be arguing that one of Robert Mundell's Nobel prize winning theoretical insights does not apply to the Canadian economy, the very economy where Mundell pointed out that his theory was most likely to be true. They seem to be arguing that the 2010 empirical results of the NBER and of the BoC's own researchers, which showed zero or very low fiscal multipliers are not to be believed.

I am not convinced. On the contrary, I believe that Mundell's theory is more valid today than it ever was. The economy has some slack as Poloz suggests, but not so much, as by the BoC's estimate it was operating somewhere between 98.3% and 99.4% of full capacity in the first quarter of 2016. One can concede that fiscal stimulus may lead to a short run pickup in growth. However, the market's perception of improved short-term growth even before the budget measures were implemented and the market's anticipation of a further fillip to growth from fiscal stimulus has already raised interest rate expectations compared to what they were when the BoC was still perceived to be in easing mode prior to January 20, when the BoC signalled that it would stand pat. The higher interest rate expectations for Canada, combined with more accommodative monetary stances by the US Fed, the ECB and the BoJ, have already caused the Canadian dollar to appreciate by 15% against the US dollar from its January low. The stronger Canadian dollar has already caused the BoC to downgrade its export growth forecast. As the fiscal stimulus feeds into the economy in 2016 and 2017, growth of private sector production for export markets will be suppressed by the stronger Canadian dollar and will be supplanted by increased public spending on infrastructure and on low multiplier transfer payments. With Canada's G20 trading partners not moving to large-scale fiscal stimulus, the result will be what the BoC researchers predicted in 2010: Canada’s high level of openness and flexible exchange rate will "sharply curtail the effectiveness of domestic fiscal stimulus."

It also seems to suggest that the stance of the BoC's monetary policy relative to our major trading partners is still a very powerful policy instrument.

The eventual outcome of the fiscal stimulus being applied in a non-recessionary economy without similar actions in Canada's trading partners is unlikely to be sustained stronger economic growth. Instead, the cumulative impact on the level of real GDP is likely to be negligible. However, the composition of real GDP and the level of government debt will be affected. 

Real GDP will be shifted away from private sector output of goods and services toward public sector construction output and subsidized green energy projects. With private sector construction of pipelines and LNG terminals stalled by government regulations, and with coal-fired power plants being shut down, productivity seems more likely to fall than to rise, as Ms. Wilkins argues.

Public debt to GDP is already rising and will continue to rise. According to the National Balance Sheet Accounts, total government debt rose to 76.2% of GDP at the end of 2015 from 72.8% a year earlier. Recent federal and provincial budgets suggest that the increase in total government debt to GDP will accelerate over the next few years. This could put Canada quickly into the situation described by the NBER researchers in which fiscal multipliers in high debt countries may have strong negative effects on real GDP.

Finally, even if one believed that fiscal stimulus would work to boost real output and employment on a sustained basis [which I don't], one can only wonder why an independent Bank of Canada did not voice this opinion a year ago when the economy was actually contracting, but then praised stimulus after the newly elected government tabled a budget promising much higher spending and deficits.