Canadian Budget Cuts Didn’t Rely on “Offsetting Monetary Expansion”
I manage to take on both Keynesians and Market Monetarists in this blog post, while sparing David R. Henderson. It’s like in the arcade when you shoot the bad guys without hitting the civilians. (David R. Henderson might even call himself a Market Monetarist; I’m not sure. Don’t ruin my joke.) The conclusion:
The experience of Canada in the mid- to late-1990s shows that it is entirely possible for a government to engage in relatively large spending cuts without plunging the economy into recession. The fact that Canada’s “fiscal austerity” went hand-in-hand with plunging interest rates and soaring net exports isn’t a lucky coincidence to be attributed to wise central bankers, but instead is the natural outcome from reversing the government’s siphoning out of billions from the loan market. The Canadian government simply reversed the familiar stories of “crowding out” and “twin deficits” with beneficial results for its citizens. Other governments should learn from the episode.
(1) “The experience of Canada in the mid- to late-1990s shows that it is entirely possible for a government to engage in relatively large spending cuts without plunging the economy into recession”
And whoever said that this was not possible, if the domestic private sector or demand for exports provides sufficient aggregate demand?
“The federal government very quickly went from borrowing 4% of GDP to running a string of budget surpluses. When a huge player drops out of the market for loans, what happens to interest rates? They fall.”
That assumes the false loanable funds model of interest rates, when in reality the Bank of Canada sets the relevant rates, especially the “overnight rate”, the rate at which the financial institutions lend to each other borrow for short term funds.
Modern nations have endogenous money supply, where most money is credit money which comes into existence because it has been demanded, and in turn the central bank supplies reserves as demanded by the private banks. There is no truly independent money supply function in such a system and attempts like yours to analyse interest rate changes under loanable funds are flawed and pointless.
If interest rates fell in Canada in the 1990s it was because the central bank set them exogenously, and whatever effect on investment and consumer credit interest rates had aren’t due to government austerity.
At any rate, Canadian household private sector debt soared in the 1990s offsetting the austerity, in addition to rising demand for exports.
“At any rate, Canadian household private sector debt soared in the 1990s offsetting the austerity…”
What about just the mid- to late- 90s, which is when the austerity happened? Look at chart 1 here: http://www.bankofcanada.ca/wp-content/uploads/2012/02/boc-review-winter11-12-crawford.pdf
Debt to income did go up slightly, but I wouldn’t call that soaring. It actually dropped in the late 90s, and increased much slower than the early 90s, the mid- to late- 80s, and after 2001. So the mid- to late- 90s was actually a slow-down period between two periods of fast increasing household debt.
As for the exports, wasn’t that partially because of the government reducing borrowing, as Bob argued? The Krugman quote from Bob’s piece: “The fallacy is following the chain of thought that says that higher national savings would lead to a lower trade deficit — which is true — and that therefore this would strengthen the dollar. What this misses is that higher savings lead to a smaller trade deficit precisely because they weaken the dollar.” If austerity partially contributes to higher exports by increasing savings, then it seems like the austerity could offset the austerity, which doesn’t really make any sense.
Also, LK, I’m confused about your discussion on interest rates. Note that I’m not an economist and have very little knowledge on this sort of stuff.
If the government stopped borrowing money, there would be more money available for loaning. So, if I was loaning the government $50 a year, and then suddenly they stopped borrowing money from me, it seems likely I would put some of it in a bank. The bank then, say, has $25 more, and so has less demand for new credit from the central bank. I assume you agree with this so far. But the central bank doesn’t literally set interest rates, correct? They do so through lending/borrowing. If the Central Bank keeps how much they lend constant, wouldn’t interest rates fall under this case?
“So, if I was loaning the government $50 a year, and then suddenly they stopped borrowing money from me, it seems likely I would put some of it in a bank. The bank then, say, has $25 more, and so has less demand for new credit from the central bank. I assume you agree with this so far”
No, I don’t. For one banks demand high-powered money (or reserves) from the central bank (CB), not credit. Even when they borrow from CB, they borrow reserves.
Broad money supply is most “bank money” = credit money represented by the IOUs from demand-deposits, transactions accounts, etc.
Loans create deposits and hence broad money. Banks use reserves to clear obligations between themselves In turn, if the system gets short of reserves, private banks demand reserves from the central bank, and the central bank supplies new reserves by creating them.
The money supply is endogenous, and loanable funds is entirely the wrong model to understand it.
Okay, I’m definitely lost somewhere then. When the CB buys bonds or lends money to banks, are you saying none of that money is later loaned out? If so, how does the CB lending effect interest rates at all? If only a couple of people put money into a bank, then they would have very little money to lend out, so I don’t see how the interest rates could be low regardless of how much high-powered money they have. On the other hand, if a ton of people put money into a bank, I don’t see why they would keep rates high unless if the bank borrowed regular money (or sold bonds for regular money).
“When the CB buys bonds or lends money to banks, are you saying none of that money is later loaned out?
The private banks use reserves/high powered money for clearing their obligations to other banks and bank clients.
When you get a loan from a bank, they create a new bank deposit for you which means new braid money, because any demand deposits is form of broad money.
When banks “borrow” reverses from a CB, the this process sis different form how banks “lend” to clients.
What he is saying is that there is basically two kinds of money.
Reserve money (the kind the central bank creates) sits either in accounts at the central bank or is in circulation as cash. The account holders at the central bank are typically only banks, however there are certain institution who also hold directly accounts at the Central Bank. At the FED this would be the US government, other Central Banks and I don’t know if other governments or institutions have that privilege. In any case you won’t get an account there.
However all money people have on usual bank accounts, are just that accounts/numbers that inform them how much “reserve money” the Bank owes them, not how much reserve money is actually there. But those accounts are considered in the broad money supply because people treat them basically the same way as they treat cash (reserve money).
If you want to transfer money from Bank A to Bank B, then it is not enough for Bank A to transfer your account, because Bank B doesn’t accept an accounting number from Bank A. Bank B only accepts “real” reserve money, either cash or a transfer on its account at the central bank. This means that Bank A either needs to cart cash to Bank B or more likely will tell the central bank that it should transfer money from their reserve account of Bank A to the reserve account of Bank B.
So whenever a real payment between different parties actually takes place, real reserve money from the central bank is needed to settle the transaction. And with this it should be clear why the central bank affects interest rates with their purchases of bonds or ABS. Whenever they increase reserve money (base money supply) more reserve money is available to the economy to settle transactions.
Thanks for the responses LK and skylien.
Alright, so the more reserves the central bank transfers to the private banks (either through lending or buying bonds), the more transactions the private bank is able to do. But, if I put cash in the bank, wouldn’t they be able to perform more transactions for the same reason (because other banks and clients accept cash)? Also, if just the credit in the bank increased, wouldn’t they actually demand more reserves from the central bank so that they could perform more transfers with the money? So even if the increase in credit doesn’t lower interest rates directly, it would pressure the central bank to lower them, correct?
You open a demand deposit at a bank, then the bank has more reserves, yes.
But they can obtain them at the CB by selling bonds or borrowing at the discount window.
“Also, if just the credit in the bank increased, wouldn’t they actually demand more reserves from the central bank so that they could perform more transfers with the money?”
Correct. And the central normally supply reserves as needed: the monetary system is endogenous.
“A bank’s ability to expand its balance sheet is not constrained by the quantity of reserves it holds or any fractional reserve requirements. The bank expands its balance sheet by lending. Loans create deposits which are then backed by reserves after the fact. The process of extending loans (credit) which creates new bank liabilities is unrelated to the reserve position of the bank.
The major insight is that any balance sheet expansion which leaves a bank short of the required reserves may affect the return it can expect on the loan as a consequence of the “penalty” rate the central bank might exact through the discount window. But it will never impede the bank’s capacity to effect the loan in the first place.”
http://bilbo.economicoutlook.net/blog/?p=14620
LK:
“And whoever said that this was not possible, if the domestic private sector or demand for exports provides sufficient aggregate demand?”
This comment presupposes the unwarranted assumption that demand is the primary cause for economic growth.
People do not just spend for the sake of spending which then causes growth. It is the other way around. Demand is a consequence of healthy economic growth.
If a reduction in government spending is accompanied by a rise in private spending, it is incorrect to claim that if it weren’t for the rise in private spending that there would have been unhealthy effects on people. The rise in private spending is a result of a growth caused by something apart from spending.
“The federal government very quickly went from borrowing 4% of GDP to running a string of budget surpluses. When a huge player drops out of the market for loans, what happens to interest rates? They fall.”
“That assumes the false loanable funds model of interest rates, when in reality the Bank of Canada sets the relevant rates, especially the “overnight rate”, the rate at which the financial institutions lend to each other borrow for short term funds.”
Murphy was referring to interest rates, meaning not just fed funds rate.
“Modern nations have endogenous money supply…”
That is just one theory among more than one, and upon close inspection can be shown as untenable.
What you call “modern nations” is just any nation with a central bank. The most reasonable theory is that money is at any given time both exogenous and endogenous, in that both commercial banks and central counterfeiter institutions are capable of adding to the money supply on a given day, but in the long run, in terms of binding constraints, the causality goes from counterfeiting to credit created money. For if the counterfeiter ceased inflating, then it would be impossible for banks to continually expand loans/credit money ad infinitum. At some point, banks will no longer be able to expand loans unless they have more counterfeit money from an external to the banks institution. Now if we consider the vice versa, the same result of dependency does NOT hold. To wit, if the banks stopped expanding loans, then the central counterfeiter will not reach a point at which an absence of further bank loans prevents increading the base money supply.
In other words, whereas credit money is ultimately comstrained to the base money supply, the base money supply on the other hand is not constrained to the quantity of credit.
Money in central bank economies is ultimately exogenous, but in the short run it is both.
, where most money is credit money which comes into existence because it has been demanded, and in turn the central bank supplies reserves as demanded by the private banks. There is no truly independent money supply function in such a system and attempts like yours to analyse interest rate changes under loanable funds are flawed and pointless.
If interest rates fell in Canada in the 1990s it was because the central bank set them exogenously, and whatever effect on investment and consumer credit interest rates had aren’t due to government austerity.
At any rate, Canadian household private sector debt soared in the 1990s offsetting the austerity, in addition to rising demand for exports.
It presupposes that aggregate demand is a meaningful and measurable quantity that economists can benefit from studying.
Why exactly is credit constrained to the base money supply? I thought that anyone could offer credit to anyone else, if they should choose to do so. I don’t see why I should ask the central bank for permission, I’d be more concerned about the character of the person I offer credit to.
The problem here truly begins with the use of the term “demand” in the sense that 1) as an aggregate it is both a “thing” and b) it is a thing that can and should be rightfully manipulated by the omniscient government. Such as use of the term allows the state to enforce shifts of wealth and purchasing power to solve a problem that does not exist, the alleged failure of the market.
Use the term in practice means the end of private property, private contracts and due process of law.
TYPO: Such A use of the term allows…….
Yet another definition of “austerity”.
Now we have to measure private debt… hurrah!
We are going to need a flow chart diagram to help people figure out which definition to apply, in order to keep Keynesian logic intact.
There is no “new” definition of austerity. It is same one I have always used: government fiscal policy that contracts demand from the economy.
And if you seriously think there is no meaningful definition of austerity, then you had better break the news to Murphy, for his WHOLE argument depends on it.
So you are defining policy in terms of the outcome of that policy? Thus, using your methodology I could say that every investment earns at least 5%, based on the definition that anything earning less than 5% is not regarded as an “investment”. It is impossible to prove such a tautology wrong, but there are a few practical consequences of such a design:
* You cannot use this to make policy recommendations.
* You cannot determine causality either (umbrellas make it rain).
The reason for these problems is that you can only discover the definition of “austerity” after the fact. Thus we can look back and say that Reaganomics was not “austerity” because demand grew. However, that would have been no help to President Reagan at the time, he needed to come up with a policy without assistance from future hindsight.
It is not a tautology: it is a straightforward empirical statement of what government fiscal policy does.
“The reason for these problems is that you can only discover the definition of “austerity” after the fact”
That is B.S. If the UK government now were to announce plans for next financial year to raise taxes by 40% across the broad and eliminate any budget deficit, that would be contractionary fiscal policy, no doubt.
So “austerity” is defined by the policy of raising taxes then?
Not defined by the outcome: “contracts demand from the economy”.
You may personally believe a relationship exists, but the definition can only be one or the other… else you are just presuming what you set out to prove.
Raising taxes and holding spending steady would be one type of contractionary fiscal policy, yes.
Contractionary fiscal policy is a type of activity that has a given effect, yes, but you can predict its effects in a qualitative, conditional manner, like a lot of other things.
The idea that you cannot make policy recommendations or “determine causality” is stupid beyond words.
Plenty of Keynesians predicted that Irish austerity would be a disaster, and it was.
Would a declining but positive government deficit that is associated with rising aggregate demand be contractionary because of the deficit or be expansionary because of aggregate demand?
The fiscal effects per se would be contractionary.
If AD were rising as this happened that would be because of private domestic I or C increasing or foreign demand increasing, which is expansionary.
There is no contradiction here.
I think LK is essentially correct here. The Post Keynesians and MMTers mock Austrians because they think not knowing this explanation is part of Austrian theory. My opinion is that this explanation exposes the current funny money system as even more adsurd, ad hoc, kleptocratic and evil than previously thought.
Quite apart from which, the Canadian central bank runs a monetary policy that excludes crowding out:
“[sc. in the Canadian banking system] … there is reverse causation, with loans giving rise to deposits, without any role being played by reserves. In other words, money is shown to be created ex nihilo, based on the creditworthy demand of borrowers, as assessed by the bankers, while the money multiplier mechanism, so dear to lecturers and textbook writers, is totally eliminated. The implementation of monetary policy at the Bank of Canada, with its corridor system and its reaction function relying on interest rates rather than any measure of the money supply, is also presented in some detail. We show how reserves are being transferred from one bank to another through the clearing and payments system, and how payments occur between the government and the private banking system, thus leading to the conclusion that a government deficit, all else equal, leads to an increase in bank reserves and therefore downward pressures on the overnight rate – the exact opposite of the mainstream crowding-out argument.”
Lavoie, M. 2013. “Teaching Post-Keynesian Economics in a Mainstream Department,” in Jesper Jespersen and Mogens Ove Madsen (eds.), Teaching Post Keynesian Economics. Edward Elgar, Cheltenham, UK. 12–33, at 27.
“thus leading to the conclusion that a government deficit, all else equal, leads to an increase in bank reserves and therefore downward pressures on the overnight rate – the exact opposite of the mainstream crowding-out argument.””
This would be true of an unfunded deficit. But if the deficit is funded entirely by bond-sales , and the economy is at full employment , why would this be true ?
I agree with rob. LK’s quote doesn’t sound right.
Bob,
I’m curious on what role that Canada, being a resource based economy, had on this effect during this time period in question.
Oil prices were very low until about 1999. NAFTA certainly did help the fruits of the U.S. stock bubble expand to Canada (but not to Mexico, which has enormous domestic problems preventing significant economic growth).
I vaguely remember that Australia and Brazil experienced similar growth at about the same time… a time when China was moving out of communism and taking on Western technology and boosting their productivity.
IMHO, China’s run is not over, but they are already hitting diminishing marginal returns and their tech level is catching up rapidly with the West so improvements will be incremental from here. Those days in the 1990’s aren’t coming back.
Is there a good correlation between growth in central bank assets and monetary easing ? There are other factors (such as reserve requirements etc) that are also relevant.
Quick research (see blow) shows that M2 increased at a faster rate (just by eyeballing anyway) than (possibly) before and (definitely) after in Canada for the period in question.
http://www.tradingeconomics.com/canada/money-supply-m2
Too bad devaluation of the Canadian dollar took place BEFORE the austerity budget was even announced
$1 CDN = $0.71 U.S in Feb 1995
$1 CDN = $0.89 U.S.. in March 1991.
The weaker CDN provided the export boost which offset the contractionary effects of Austerity.
Nice point. Another nail in the coffin of Bob’s analysis.
In brief, the US is Canada’s largest trade partner, taking most of its exports (e.g., in 2008 the US took a huge 77% of Canadian exports)).
Canadian austerity began from 1995, but most of the depreciation in the Canadian dollar relative to the US dollar happened from 1991 to 1994 before the austerity.
Poor old Bob: his story even on the depreciation is problematic too.
Why would depreciation cause exports in future years to increase? The depreciation did indeed seem to stop from about 1995 to 1998, which is interesting.
Regardless, exports actually didn’t seem to increase in 1995 and only slowly increased in 1996. The big jumps in imports seemed to happen before 1995 and after 1998: http://www.tradingeconomics.com/canada/exports (zoom in to just the year 1995 to see it more clearly; interestingly, exports actually fell until about half way through the year). Unless if this source is incorrect, I don’t think exports can explain why there was no recession in 1995.
Another thing to note is that interest rates actually seemed to already hit a low before the austerity. It would not fall back to the early 1994 level until late 1996. Here is the overnight rate:
Feb 1993: 6.36
Aug 1993: 4.62
Feb 1994: 4.01
Aug 1994: 5.74
Feb 1995: 8.10 (austerity begins)
Aug 1995: 6.79
Feb 1996: 5.37
Aug 1996: 4.38
(source: http://www.bankofcanada.ca/rates/interest-rates/key-interest-rates/ – I averaged for each of the months)
The benchmark interest rate seems similar: http://www.tradingeconomics.com/canada/interest-rate
So I guess the question is, if in 1995 there was austerity, a relatively high interest rate, no growth in exports, no monetary depreciation and very low growth in the central bank’s assets, why was there no recession?
There will generally be short term “contractionary effects” as the result of “austerity” when illicit government spending ends and people need to re-adjust to life off the dole. Since people are not only unaware of the process but are actively mis-educated about it by the statist school system, it might often be politically expedient to dilute the value of the local funny money so that exports sell for less than they would otherwise. There might be some evidence of “sticky prices” when there are shifts in a Keynesian spending and funny money regime because average people do not understand the process (which is intentional on the part of the authorities).
None of this is evidence to support the claim that the market fails or requires “stimulus”, government spending or funny money dilution. When the apparent free lunch is cut off, the voters will generally be angry and must be dealt with.
LK keeps wondering why I ask for “austerity” to be well defined, but here is an excellent example. If you use the “debt accelerator” definition, then it comes down to government budget. So the highest Canadian deficit (as % GDP) was… 1986 at 8% GDP.
There was a round of deficit reduction (maybe this is “austerity” but some will no doubt say otherwise) up to about 1990 where it held fairly steady at about 5% of GDP until 1995.
A second round of deficit cutting happened after 1995 and the budget hit balance in 1999 then nudged to into surplus for a while.
At the same time per-capita GDP (PPP) showed good increase from 1993 up to around 2008 so at least we can say that the two rounds of deficit cuts did not significantly hamper growth, and no particular “stimulus” was required. There isn’t a perfect correlation here, but when giving up the booze there is some delay before you start feeling good again (so they tell me).
Speaking of Canada,
http://armstrongeconomics.com/2014/09/24/canada-warns-its-citizens-not-to-take-cash-to-usa/
I’ve been reading this website for years and still learn something new. Holy protection racket Batman, this isn’t looking good.
Anyone else find it a little ironic (I mean in a good, jovial way) that a Christian (Bob) who is absolutely sure about God, has to educate those scientists, who are absolutely sure about their theories, to be more skeptical?
It’s like scientists are saying be absolutely sure about scientific conclusions but doubt God, and theists are saying be absolutely sure about God but doubt scientific conclusions.
Interesting. The seminal work on 1990s Canada was by Pierre Fortin (1996), who pointed out that Canadian monetary policy was tight at the time, not loose.
http://www.scribd.com/doc/70654436/Fortin-1996-The-Great-Canadian-Slump
In 2012, Krugman wrote about Canada and drew approvingly on the Fortin paper:
http://krugman.blogs.nytimes.com/2012/03/24/lessons-from-the-great-canadian-slump/
“Let me add something more to the mix: the case of Canada in the early 1990s, the subject of a classic analysis at the time by Pierre Fortin. For idiosyncratic reasons, Canada imposed tight monetary and fiscal policy, leading to a very severe slump in employment.”
So was it tight, or loose? Or is this just a question of needing more clarity on Krugman’s timing regarding the shift from the one to the other.