Sunday, January 04, 2009

Fiscal Stimulus Part 4: Deficit Implications

Harper/Flaherty have repeatedly implied that a fiscal stimulus will cause a deficit that would not occur without the stimulus spending. This is just not so.

In a recession, government revenues fall with declining economic activity. In this economy, the more we try to cut funding to avoid a deficit, the larger the recession will become and the larger the deficit will be.

An effective stimulus will increase economic activity, which will increase government revenue and result in a smaller deficit.

Increased government spending is currently the most effective way to stimulate the economy. If we didn't have near-zero interest rates we could rely on monetary policy to stimulate the economy. Monetary policy is usually just what's wanted. But now that we're in a liquidity trap, monetary policy is ineffective. The IMF says, "the room for further monetary easing—at least in a traditional sense—is shrinking: in some countries, policy interest rates are approaching zero. Moreover, the effect of lower interest rates on demand is weakened by the disruption in credit markets."

In the words of Paul Krugman, Harper is being a Herbert Hoover.

There are two types of deficit: structural and temporary. Structural deficits are like the deficits that Brian Mulroney gave us: they are situations where government spending exceeds its revenue year after year, even in boom times. Jean Chretien and Paul Martin worked hard to rid Canada of structural deficits, and we do not now have one at the federal level. Temporary deficits are not problems in the same way structural deficits are, and if they are used to effectively stimulate the economy, they can actually avoid structural deficits.

For a more wonkish explanation of the deficit implications of fiscal stimulus, see here.

See also:
Fiscal Stimulus Part 1
Fiscal Stimulus Part 2: Size
Fiscal Stimulus Part 3: Federal Spending v Tax Cuts


Ferd said...

Thank you Yappa for these posts on how to deal with the economic crisis. We need a wide discussion of the issues, so we'll be prepared to react appropriately when the PC stimulus plan is announced later this month.

I'm no expert, to say the least, but I wonder whether putting money in the hands of the least well off would provide much of a stimulus. I think it is a good idea for humanitarian reasons and should therefore be done anyway. But if a major issue for this group is debt and the new money goes to pay off their debts, does that provide a stimulus? By contrast, the idea of spending on infrastructure, which Krugman [along with many others] has stressed, looks like a winning strategy. Just so enough money is spent. As he said, and you have noted, better to err on the side of spending too much rather than too little.

Leonard said...

>>Structural deficits are like the deficits that Brian Mulroney gave us: they are situations where government spending exceeds its revenue year after year, even in boom times.<<
Actually, structural deficits began in mid-1970, during Trudeau's 3rd term in government. Mulroney trimmed spending so that government revenues covered the program expenses, but kept borrowing money to cover the interest charges which by then had swollen to over $30B. That's what produced those ill-famous $30B-$40B deficits.

Anonymous said...

In your Nov. 27 blog you wrote:

“We let developers plan our cities. When the economy hits bottom and people can't afford to drive their cars, we should have policies in place to work in a more efficient, less polluting, more sustainable way”.

I didn’t read this until today, Jan. 4. I then worked up to your current entries and I see you have written a lot about the economic state we find ourselves in; you have expanded on this argument and others, and written several extensive accessible analyses, offering ideas and tangible suggestions for Canadians to think about. I find much of the popular press that I read, the major national press and the local community level newspaper, to be obtuse, or ideological or written in such a way that I and millions of other average readers can’t be bothered to struggle with. How helpful it would be to be able to find this sort of analysis, argument and reflection in our daily press. Thank you for your clear and very articulate commentary. As well, I was reminded while reading your comments that a large part of our problem is that we tend to forget that our PM really snuck in through the backdoor as far as Conservative politics go in Canada. He is indeed a dyed in the wool far, far right Conservative, born and bred Alliance, which is so UnCanadian, I cannot believe that we can continue behaving as though this is Canada – what once was easily recognizable as a more humane, progressive and rational country.