How can Canada get ready for the next recession?
I need to write a much longer piece on this. Here are some early thoughts:
There’s a lot of debate this week around the question Is the North American economy heading for a recession? That question by itself is worthy of a longer piece, but we all know that eventually there will be another recession. We just don’t know when it will be or how long it will be.
There seems to be a near-universal consensus that monetary policy alone is insufficient to tackle the problem, particularly in a low-to-zero interest rate environment. I don’t entirely believe that, but I also recognize I’m in the minority.
Because of that, there are calls for the federal government (and perhaps the provinces) to amass a fiscal war chest that would allow them to pump large volumes of money into the pockets of Canadians to stimulate the economy. Kevin Carmichael had a fantastic piece on the topic: We have two economic choices this fall: Stockpile fiscal firepower for the next recession or lower daycare costs.
Expansionary fiscal policy is the standard method, and we saw the federal government use this approach during the financial crisis. I see two problems with this approach:
- It costs an absolute ton of money, which largely won’t be spent on programs that will increase Canadian productivity since the focus must be on getting money out the door quickly.
- Even with this focus, money won’t be sent out the door fast enough, when it will do the most good.
Let’s examine the fiscal stimulus from the Financial Crisis. Laurentian Bank has a fantastic chart on federal government deficits:
We can think of “cyclical deficits” as being largely out of the federal government’s immediate control. The economy tanks, spending on employment insurance goes up, tax revenue goes down. Cyclical deficits are represented by the blue bars on the chart.
“Structural deficits”, on the other hand, are things governments can control. The federal government has been running structural deficits since the 2007–2008 fiscal year, a year before the recession started. This was just masked by a substantial cyclical surplus. Since then, the structural deficit has varied in size, increasing under the current government.
Let’s turn our attention to the financial crisis. During the 2009–10 fiscal year, the government had a cyclical deficit of well over $30 billion, thanks to the recession that lasted until May 2009 and the slow economy that followed. This cyclical deficit was down to a few billion by 2011–12, and all but disappeared by 2012–13.
Now look at the structural deficits. The two largest structural deficits run by the federal government were in 2011–12 and 2012–13, a few years after the recession ended. These weren’t completely useless; they do help the economy from backsliding. But they’re not injecting money into the economy when it needs it most.
Overall, the government spent around $100 billion on structural deficits and given the timing of that money, I don’t believe it was money particularly well spent. That’s not intended as a criticism of the previous government; I don’t believe any other party would have handed it significantly differently.
How can we avoid this in the future? Roger Farmer has some fantastic research on central bank equity purchases; I can’t recommend Farmer’s book Prosperity for All: How to Prevent Financial Crises highly enough. My idea is inspired by his, but substantially different.
During the first sign of economic trouble, when the economy is plunging and stock markets are in decline, the Minister of Finance should instruct the CPP Investment Board to buy substantial quantities of equities (ideally through an ETF), paid for through newly issue bonds of a variety of durations. Over time, as those bonds become due, the CPP would sell some of those equities or otherwise reduce their equity purchases.
This would accomplish a few things:
- It would allow the Bank of Canada to be more aggressive during the downturn, as would increase interest rates and the supply of bonds for the Bank to purchase, allowing for a larger increase in the money supply.
- It would repair household balance sheets (by increasing equity prices), helping prevent a drop in consumer spending and confidence.
- It would actually make the federal government money. The newly issued bonds would have interest rates of less than 2%. Given those equities will, over time, earn substantially more than that, it would increase the size of the CPP’s portfolio, and possibly allow for a future reduction in CPP contribution rates (or an increase in pension sizes).
Naturally, this wouldn’t solve every problem with an economic downturn, other fiscal policy tools are likely needed. This would, however, get money into the economy quickly, and prevent another $100 billion in poorly timed fiscal stimulus.