Thursday, January 22, 2009

How Effective will Projected Deficit Spending Be?

The BoC released its updated monetary policy report today, forecasting a significant 4.8% contraction in the economy in the first quarter of 2009 and an overall average annual contraction of 1.2% ( Calculated as the average year-over-year growth rate). The BoC is a little more pessimistic about Q1 growth than I am, and much more optimistic about a second half recovery. I’m not sure where the recovery is going to come from but my guess is the BoC’s model includes significant stimulative effects from a year of historically loose monetary policy as well as substantial Canadian and US fiscal stimulus.

Few details about the composition of the Canadian stimulus are known, though it was leaked today that the Canadian Government is going to run a deficit of approximately $34 billion for at least two years. A deficit that large amounts to a little over 2% of GDP which is in accord with the general consensus for the recommended size of a stimulus package.

The composition of the stimulus, between spending and tax cuts, may have important implications for a second half recovery - unfortunately, as Nick Rowe points out, there is very little agreement on the effectiveness of spending vs. tax cuts. A recent OECD study by Roberto Perotti, using the SVAR approach of Blanchard and Perotti (2002), revealed that a tax cut in Canada equal to 1% of GDP provides a boost to the economy of about 0.3% after 4 quarters and 1.8% after 12 quarters. However, a 1% increase in Government expenditures actually leads to a small decrease of in GDP after 4 quarters and a cumulative decrease of about 2% after 12 quarters.




Does this mean that there is no room for government spending in the Jan 27. budget? No. Given the state of credit markets and investment conditions, it is unlikely that government investment would be displacing private investment. Moreover, while I would like to see permanent middle class tax cuts compose a significant portion of the budget, the down-side is that we may see much of the tax relief funneled into the new TFSA's - not a bad thing for the long-run but not great as stimulus.


The Government has a very difficult task ahead, lets hope they get it right.

4 comments:

geoff said...

There is an recent IMF staff position paper surveying the fiscal policy mechanisms for the "crisis". Unfortunately the conclusion is:
"there is a lot of heterogeneity across fiscal multiplier estimates, depending on the identifying assumptions, the type of fiscal policy, and the country of interest."

So, hmm, picking the right mix of spending and tax measures will be dependent on: throwing dice, ideology, maximizing potential votes, 50/50 split, ... . Not exactly reassuring all these years after 1930 but maybe, at least, there is agreement on a role for gov't this time?

The tinyurl link to the IMF paper: http://tinyurl.com/crhmkm

Shock Minus Control said...

Thanks for the link Geoff - i'll check it out.

There should be no question that there is room for fiscal policy when monetary policy brushes against the zero bound - unfortunately you still hear the argument that the government should sit on its hands.

Nick Rowe said...

Your post inspired me to post this: http://worthwhile.typepad.com/worthwhile_canadian_initi/2009/01/three-reasons-to-believe-the-canadian-fiscal-multiplier-might-be-bigger-than-we-think-it-is.html

Marc said...

There will be a cyclical deficit due to the decline in revenues from a tanking economy. That part is not stimulus -- indeed, trying to cut spending to balance a budget would worsen economic outcomes. The real stimulus is new spending (or tax reductions) above and beyond the cyclical component.

As for multipliers, both Moody's and Informetrica have multipliers for public spending well over 1 and well under 1 for tax reduction. The figure you show seems totally implausible ...