Batttle of SFU Economists

Nice to see some star professors from my alma-mater (Simon Fraser University) contributing to the public debate over the effectiveness of fiscal stimlus.

Read skeptic David Andolfatto here: http://andolfatto.blogspot.com/

and stimulus proponents James Dean and Richard Lipsey here: http://blogs.ft.com/economistsforum/2009/05/will-stimulus-spending-stifle-recovery/

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.