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Does Canada Need a Fiscal Stimulus Package?

21 Jan 08

Fortunately for Canada, it doesn't need a fiscal stimulus package—at least not yet

Now that President Bush has presented a fiscal stimulus package directed at avoiding a recession in the United States—should Canada follow suit? There is widespread support for a fiscal stimulus package in the United States, ranging from the Fed to Congress, to many economists including those at Global Insight. Global Insight economists in the United States support a fiscal stimulus package of about 1% of GDP if it is quick, cost effective, and temporary. However, they place the probability of a successful effort at just over 50/50.

Canada Doesn't Need a Fiscal Stimulus Package (Yet)

This note concludes that Canada does not need a fiscal stimulus package, at least not yet. First, the U.S. economy is forecast to be a bit weaker this year, at just under 2% growth, than the Canadian economy at just over 2%. The U.S. economy will dip much lower; likely having no growth this quarter. More importantly, the downside risk to the base case forecast is much greater and more serious for the United States. Global Insight assesses the probability of recession in the United States to be rising towards 50%, while in Canada it is in the 25% range. The U.S. housing sector is in desperate shape, with housing starts now running at only about half of their 2006 level. More importantly, the sharp and widespread declines in house prices have eroded consumer confidence

and are threatening consumer spending. In Canada, housing starts are just beginning to weaken slightly from their 2006 pace and housing prices are holding up well. Consumer and business credit have become much tighter in the United States than Canada. There has recently been a sharp increase in the level of unemployment in the United States, not yet seen in Canada. There will likely be several more quarters of weak growth in the United States. Canada's weakest quarter is probably already behind us, and by the third quarter of this year, the Canadian economy is expected to be moving along reasonably well.

Further complicating the situation in Canada is that the current weakness, along with the downside risk, is not widespread, it is very centralized on Ontario. Growth in Ontario this year will again be well below the Canadian average. The risk of recession in Ontario this year is about the same as in the United States; that is, about 50%. Pressures to avoid recession would be much more appropriately addressed to Ontario's Premier McGuinty than Prime Minister Harper.

Countercyclical Fiscal Policy is Generally a Bad Idea

Cutting taxes or increases in spending to avoid the pain of an impending recession sounds like a good idea in theory. However, besides an accurate economic forecast, to be effective, countercyclical fiscal policy needs to be quick, cost-effective and temporary. Not surprisingly, what sounds like a good idea in theory, very often turns out to be a failure when implemented in the real world. Plans to cut taxes and/or increase spending to avoid a forecast recession often end up taking too long to implement, not having sufficient "bang for the buck," and/or being off target.

There is a definite downside risk at attempting countercyclical fiscal policy. Needless to say, sometimes the economic forecast turns out to be inaccurate. Often, by the time the policies are implemented, the economy is strong again. In such a case, the stimulus fuels inflation, and interest rates must be higher than otherwise to thwart inflation. Often, the fiscal package is ineffective and taxpayers end up paying dearly for the failure. In Canada, it is very difficult to take away a tax break or increase in government spending once granted.

While the Canadian political system can sometimes implement fiscal actions quickly under a majority government, this obviously is not one of those times.

Countercyclical Policy is Primarily a Job for Monetary Policy Not Fiscal Policy

The Bank of Canada can and does react quickly to an expected downturn in the economy. A reduction in interest rates can be an effective stimulus to economic growth and it can be reversed when appropriate. The Bank reduced its policy rate in early December. Global Insight expects and recommends that the Bank of Canada reduce their policy rate by another 25 basis points on their next announcement date, January 22.

"Never Say Never"

When it comes to economic policy, wise economists "never say never." This particularly applies to the issue of countercyclical fiscal policy. While countercyclical fiscal policy is generally a bad idea—fraught with too many ways it can turn into an expensive and ineffective effort—it does have its day. If we are most certainly in a recession, which most certainly appears to be with us for several more quarters in spite of the best efforts of monetary policy, it is my view that it is time to seriously consider a quick, cost-effective and temporary fiscal stimulus package. It may or may not get the job done. However, in this situation, the downside risk of not attempting to supplement monetary policy with fiscal stimulus becomes overwhelming.

The time for a fiscal stimulus package for Canada has not yet arrived, and hopefully it never will.

by: Dale Orr

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