Q for the Demand-Shock Naysayers. What are you forecasting and would you like to make a wager on it?
TL;DR The economists and pundits saying that this is a supply-side only recession are making implicit non-stated forecasts about the path of economic variables such as nominal inflation. I think they’re wrong, and I’d like to wager them on it.
There have been a bunch of pieces arguing that Canada is in a supply-side only shock, that the demand-side forces are so small they can be ignored, so we’re entering a 1970s period where stimulus would be counterproductive. Here’s one by Christopher Ragan and Andrew Potter. Ken Booessenkool makes a similar argument, though at least acknowledges the demand side component. Paul Boothe made a similar argument on Twitter.
I know, respect, and like all of these men. But I think they’re wrong and I’d like to offer a friendly challenge.
My argument is simply: While no one would argue that there isn’t a supply-shock happening, Canada is also facing a demand-shock of roughly similar proportions, if not larger.
What I think the demand-shock naysayers are missing is that supply-side triggers can induce demand-shocks. A couple of hypothetical examples, to illustrate my point:
- Suppose a tornado rips through the U.S. midwest and takes out several auto assemblers. Classic supply shock. But in Canada, this would largely manifest itself as a demand shock, as our autoparts suppliers would have lost all of their customers. Foreign supply shocks can trigger domestic demand shocks.
- Now suppose that the tornado instead hits Southwestern Ontario and takes out auto assemblers there. Obvious supply shock in Canada, but there’s a demand component to it as well, as those workers are no longer employed, autoparts suppliers still take a hit, etc.
My argument is that versions of both are happening during this crisis and will continue to persist.
Whether or not there’s a demand-shock worth talking about may seem like an academic point, but it drastically alters the path of the economy over the next few years. In particular, each view of the world generates drastically different paths for economic variables:
- Supply-side only: 1970s-style stagflation (as Boessenkool acknowledges). Moderate economic decline. Substantial increases in nominal interest rates. Inflationary pressures that either force the Bank of Canada to abandon the 2% inflation target or cause them to hike interest rates even further.
- Supply and demand-side shocks: Much larger economic decline. Relatively modest impact on inflation and interest rates (the pressure could be upward or downward, depending on the relative magnitudes of the shocks). No stagflation.
That’s two very different set of predictions, particularly when it comes to nominal interest rates. So I offer two questions to the demand-side shock naysayers:
- What is your prediction for the path of the overnight rate? What will it be a year from now? 3 years from now? 5 years from now?
- Would you care to wager on it, with the proceeds going to charity?
Here’s the history since 1960 of the overnight rate. What will the next 1–5 years look like? The 70s? The 80s? The 90s?
I look forward to hearing from you.