Thesis: A government committing to outlawing deficit spending may sound nice in theory, but it makes providing fiscal stimulus incredibly tricky and ties lawmakers hands when trying to design stimulus packages.
Next Tuesday, April 21, Canadian Finance Minister will deliver his budget proposal, including an unprecedented piece of legislation that would outlaw government budget deficits, per the Wall Street Journal. The bill includes a necessary clause that would make exceptions for recessions or extraordinary circumstances such as wartime or a natural disaster. It’s a proposal that seems to be addressing a problem where one doesn’t exist – Canada has historically run a fairly responsible budget, ranking 51st in the world in net government debt to GDP ratio (Wiki), a list where the top is dominated by the most highly developed countries. And as one of the most politically and economically stable countries in the world, it doesn’t cost Canada much to borrow.
Basic economic theory dictates that governments should spend during economic downturns in order to prop up aggregate demand, financing itself by issuing debt, which it then pays off during economic booms. This law tries to make this behavior a mandate by forcing the government to cut spending during good times, but it may make the use of fiscal policy to stimulate recessions a bit tricky. Specifically, a problem arises when the government tries to define where a recession actually ends – cutting a stimulus package the moment a quarter shows a positive growth rate (however small) is rarely ideal. In fact, we only have to look back a few years to demonstrate this. Canada’s stimulus package for the recent global recession was introduced in 2009 and continued throughout 2011, according to The Star, even though the Canadian economy showed positive growth rates as early as mid-2009. By allowing stimulus to continue past the point where a recession technically stops, the government can ensure that the spending has boosted the economy throughout the entirety of the massive and diverse country, since growth rates in some outlier areas may be keeping the aggregate growth rate positive even when certain areas are still hurting.
What the Canadian Finance Minister is proposing would force stimulus packages to be reluctantly designed in small, short-term packages, which may require the government to respond to a recession multiple times, dragging out its length. And that’s not even the worst-case scenario, since the increased scrutiny on deficit spending might make lawmakers reluctant to even consider introducing stimulus proposals. Since the spending would have to be so short-term (and maybe even cut off if the economy recovers prematurely), the government can’t commit funds to infrastructure projects – a major part of the US government’s incredibly successful Recovery and Reinvestment Act.
The Eurozone has been in trouble as of late. A lot of the problems have come from Italy. Italy is one of the countries who most needs the help recently placed out by the European Central Bank. This past weekend, according to the article, “German Chancellor Angela Merkel and Italian Prime Minister Matteo Renzi said Friday that Italy and other European countries need to push ahead with structural changes following the much anticipated move by the European Central Bank to help boost the eurozone’s struggling economy.” http://www.wsj.com/articles/merkel-renzi-agree-reform-pace-must-continue-1422020519. The much anticipated move these two men are referring to is the massive bonds buying program that will seek to boost the economy and improve struggling countries such as Italy. Italy, while not being the biggest economy, is certainly important for its stability. The Italian prime minister has run into problems due to labor unions and even legislators from his own party. The fact that he is seeking resistance from his own party indicates that the bills he is attempting to pass are indeed controversial. However, this may not be a bad thing as Italy certainly needs a little change. Opposition of any kind, unless it is stubborn partisan lockups, can spur creativity and idea creation. Overall, this is a positive sign coupled with the bond buying program. Some of the resistance Prime Minister Renzi is facing include aggressive labor guidelines, economic and institutional changes. The minister is seeking investing and a shift away from fiscal lockup. Angels Merkel recently said, “I already see the first signs of the effects of these reforms in Italy. But they need to be completed.” This is a positive sign as the aggressive stimulus begins to take effect. More than $1 trillion in newly created money has been pumped into the economy. The European Central Bank President Mario Draghi recently suggested that, “In light of Europe’s underlying problems of stagnant growth, high debt and rigid labor markets, the central bank’s largess alone won’t be enough to right its economy.” http://www.wsj.com/articles/ecb-announces-stimulus-plan-1421931011 . This can create growth for the economy and help lower rates, but it can not solve all these problems. However, after seeing what the US went through, each country in the eurozone can seek to set its own fiscal policy to supplement what the European Central Bank has already done. It is a tougher situation in Europe than in the US due to the fact that the United States only has one set of fiscal regulations to couple with the Fed’s stimulus. It will be incredibly interesting to see what happens in Europe. I think the recovery could be long and hard. If I were an investor, I would seek to invest in the US due to the fact that we seem to be the only safe move right now given troubles in China and in emerging markets. Between all these things and with falling gas prices, it has certainly been an interesting start to 2015!