Keynesian Theory and the Canadian Economic ...

Keynesian Theory and the Canadian Economic Meltdown and Recovery of the late 2000s Doug Lloyd, Szent István University

Canada’s economic landscape in the 1990s and in the crises of the 2000s was a remarkably homogenous affair. Canada has really never let the Keynesian model go. Since before Reaganomics, “trickle-down economics” and the Friedman or Miltonian models, Canada has stayed faithful to two fundamental tenets: 1. A separation of our fiscal and monetary policies. 2. The application of a Keynesian model to respond to national economic crises It can be argued that these two tenets have also underpinned the lukewarm market response to a purely Keynesian application of fund and economic management during the sub-prime crisis and the European meltdowns in 2008-2010. This paper examines how the governors and finance ministers of the Bank of Canada have shaped our fiscal and monetary policies, but more precisely how the central philosophies of John Maynard Keynes have shown Canada how to balance these two policies to regulate, stimulate and cool down the economy. Although this has proven to be successful at a macro-economic level, we can show that the clinical application of a Keynesian-style input to the economy did not increase the speed of recovery of the Canadian economy in 2009. Let us first examine how fiscal and monetary policies in Canada are used to manage the economy of Canada. Use of fiscal and monetary policy in Canada In Canada, we have separated our Fiscal and Monetary policy. This is a long-standing tradition in our country, and indeed in Westminster based democracies1. Monetary policy refers to the measures taken by the Bank of Canada to influence the economy by regulating the amount of money in circulation2; whereas Fiscal policy (sometimes referred to as budgetary policy) refers to the measures taken by the government (the Department of Finance) to increase or decrease public spending and taxes3. These two policies are used by the government and senior bureaucrats to manage the economy of Canada at a macro level, by either stimulating it, or by removing pressures from the economy and purposefully slowing it down from a too-strong growth. In Canada, it is a dynamic balance between when each approach is used, and whether or not stimulation or slowing the economy is the appropriate solution for the country.

1

Strategic Opposition and Government Cohesion in Westminster Democracies, American Political Science Review, Vol. 105, No. 2 May 2011. 2 http://www.bankofcanada.ca/monetary-policy-introduction/why-monetary-policy-matters/, retrieved 01/30/13 3 http://www.bankofcanada.ca/tag/fiscal-policy/, retrieved 02/02/13

In Canada, a relatively conservative balance between the two means that a constant communication between the governor of the Bank of Canada and the Minister of Finance is required4. This relationship has changed over the years, but a coordinated, constant injection and removal of “heat” from the economy has proven to be an effective governor for the Canadian economy. Fiscal policy is when the finance ministry uses its spending and taxing powers to change the economy. The intrinsic value of the Canadian dollar and interest rates heats up and cools down the marketplace, and imports and exports; whereas taxation and spending programmes change personal spending habits, capital expenditures in the country, exchange rates, deficit levels, etc. This is the balance which Canada has traditionally sought. Fiscal policy Fiscal policy is often linked with Keynesianism, named after the British economist John Maynard Keynes. His treatise on “The General Theory Of Employment, Interest And Money," changed theories about how a country-level economy works, and is still studied and used to explain macroeconomics today5; and is a foundational theory in Canada - much used by Finance Ministers and Bank Governors, alike. Keynes worked mostly during the depression in the 1920s, and developed mechanisms to slow down extreme movements of national economies – in the up and down turn. His theories are much used (and misused) to both balance swings and predict trends in the marketplace. Keynesian economic theories are based on the belief that proactive actions from our government are the only way to steer the economy6. Keynes felt that the government should (and needed to ) use its powers of monetary and fiscal policies to increase demand in the marketplace by increasing spending and thereby stimulate the economy by creating jobs, creating a positive psychology in consumers, and increasing prosperity. According to Keynes, monetary policy on its own can only provide part of the solution when the marketplace moves into crisis or depression, and that fiscal policy changes are also needed to address and solve a financial crisis. Fiscal policy management and adjustments were used successfully during the Great Depression; and again during minor crises to make changes and adjustments to the marketplace. In the 1980s, a period of great upheaval was represented with depressions, inflationary periods, growth and stagnation, all within a single decade. Supply-side economics (lowering tax rates to stimulate economic recoveries) and its proponents (e.g. Milton Friedman) attempted to prove that Keynesian approaches and fiscal policy management did not mediate the recession7, and did not stop the Canadian

4

http://www.mapleleafweb.com/features/bank-canada, retrieved 02/06/13 Keynesianism, Monetarism and the Crisis of the State, Edward Elgar Publications, 1988. 6 http://www.washburn.edu/faculty/rweigand/page2/HWFiles/Keynes-State-of-Long-Term-Expectation.pdf, retrieved 02/20/13. 7 What Is New-Keynesian Economics? Journal of Economic Literature, Vol. 28, No. 3 (Sep., 1990), pp. 1115-1171. 5

consumer from facing increasing interest rates (such as 20% mortgage rates which slowed our economy greatly). Fiscal policy influences both expansion and contraction of GDP. When the Canadian government lowers taxes and increases expenditures, it is attempting to inflate our economy through fiscal policy8. While on the surface, this may seem to lead to positive effects by stimulating the economy, there is an effect that resonates in our broader economy. Canada spends faster than tax revenues can be collected, and our government has accumulated both structural as well as real deficits, and our national debt is increasing9. When the government increases the amount of debt it issues during expansionary fiscal policy, issuing bonds in the open market will end up competing with the private sector that may also need to issue bonds at the same time. This effect raises rates indirectly because of the increased competition for borrowed funds. Even if the stimulus created by increased government spending has positive effects, a portion of this economic expansion could be slowed down by higher interest expenses for borrowers, including the government itself. One cannot forget in Canada that we often see foreign investors bidding up our currency in an attempt to invest in higher yielding bonds and debt instruments. In Canada, this makes Canadian goods and services more expensive to export and foreign-made goods less expensive to import. A shift to buying more foreign goods and a slowing demand for domestic products in Canada almost always leads to trade imbalances – something Canada is presently suffering under. In December, 2012, Canada recorded a trade deficit of $901 million10. One of the largest issues with fiscal policies as a market governor is that there is almost always a delay between the time when they are determined to be needed, and the time the Governor and Finance Minister can implement them; and indeed the impacts of their implementation. Canada’s money supply Monetary supply is used to ignite or slow the economy but is controlled by the Bank of Canada, with the ultimate goal of creating an easy money environment – i.e. money is easy to come by, use and generate11. Early Keynesians did not believe that monetary policy had any long-lasting effects on the economy because banks have a choice to lend out the excess reserves they have on hand from lower interest rates, and choose not to lend. As well, consumer demand for goods and services may not be related to the cost of capital to obtain theses goods. Monetary policy has proven to have some influence and impact on the economy and equity and fixed income markets; as well as how investors “see” Canada as a potential source for investment and returns12. 8

Electoral and Partisan Cycles in Fiscal Policy: An Examination of Canadian Provinces, International Tax and Public Finance, Kluwer Academic Publishers, November 2001, Volume 8, Issue 5-6, pp 753-774. 9

http://www.huffingtonpost.ca/2011/10/03/canada-debt-cfib-road-to-greece_n_992480.html http://www.tradingeconomics.com/canada/balance-of-trade

10 11

Bank of Canada, Canada’s Money Supply, October, 2011.

The Bank of Canada purchases and sells government of Canada debenture bonds in the open market which can increase or decrease reserves, influencing the supply of money whether they are buying or selling bonds. The Bank can also make changes in the discount rates to influence how much return on investment is available to debt holders around the world. So we can see that in Canada there is a place for both monetary and fiscal policies, which leaves us with a central question, debated often in Canada – which is better for managing the economy of Canada? Of course, as a true Canadian, the answer is both. And not necessarily in equal measure, or at the same time. A true fiscal policy adherent would show that, over a long period of time, the economy will go through multiple economic cycles (see Exhibit 1 – Economic Cycle). At the end of those cycles, the hard assets like infrastructure such as buildings, bridges, roads and other long-life assets, will still be standing and most likely be the result of some type of fiscal intervention (e.g. Canada’s $70B Economic Action Plan13). Exhibit 1 – Economic Cycle

Source: ACG Advisors

12 13

Overview of Canadian Foreign Direct Investment, Library of Parliament, PRB 08-33E, June 2008. http://actionplan.gc.ca/

Over that same period the Bank of Canada has adjusted rates, and other monetary policy tools, on an ongoing and frequent basis. On the other hand, using just one method is not successful in Canada, because of the lag in fiscal policy as it filters into the economy. Monetary policy has shown its effectiveness in slowing down an economy that is heating up at a faster than desired pace (inflationary fears), but it has not had the same magnitude of change affect when it comes to quickly inducing an economy to expand as money is eased, so its success is muted. Though each side of the policy spectrum has its differences, Canada uses both to manage its economy – for the reasons stated – monetary policy is quick, and shows impacts quickly, and fiscal policy is slow but has deep impacts. While there will always be a lag in its effects14, fiscal policy seems to have greater effects over long periods of time, and monetary policy has proven to have some short term success. Keynesian theory and its impact on the Canadian economic landscape How then did Keynesian theories of economics impact the Canadian landscape in the 2007-2008 crisis, and how did the theories of Keynes play into the financial meltdown and recession of the late 2000s in Canada? The worldwide financial crisis, the so-called “economic meltdown” of 2007-2008 and the following recession in Canada – has had a profound effect on industry in Canada, but more broadly, on how economists have started to review Canadian fiscal and monetary policies and their implementation. It also has brought back to light the theories of John Maynard Keynes, and their role in Canada’s reaction to the crises; and more broadly, in how successive ministers of finance and governors of the Bank of Canada have chosen to manage the economy. In fact, in can be argued based entirely on Statistics Canada’s official publications on Canada’s economy, that the application of a Keynesian-style injection of government funds into the economy may have made the recession and Canada’s recovery from it a more difficult and time-consuming effort than it had to be; or even worse for Canadian citizens, completely unnecessary. John Maynard Keynes, of course, was the British economist whose theories virtually turned the classical thoughts of economists on their heads just before, during and after the great depression of the early 20th century; although they fell out of favour in the 1970s and the 1980s. It is not surprising, therefore, that his ideas in macroeconomics have become more prevalent as we see a similar recession/depression and recovery in the early 2000s. Again, his advocacy of balancing fiscal and monetary policies to ameliorate the effects of depression and recession were taken up in Canada as a panacea to “ride out the storm”. They were applied in the crises in 1976, again in the 80s, in the 90s and finally again in the 2000s.

14

What are the effects of fiscal policy shocks?, Journal of Applied Econometrics, Vol 24, Issue 6, pages 960-992, SeptemberOctober 2009.

The Canadian context In Canada, our balance of fiscal and monetary policies were designed in the latter parts of the twentieth century to ensure a combination of long-term slow effects on the economy, balanced with quick fixes to simple problems. This was seen until the 1980s in the United States, when Friedman et al, became more in vogue with the U.S. Federal Reserve System, and the Secretaries of the Treasury at that time. Monetary policy moves by the Bank of Canada have tempered the economy in Canada by slowing down an economy that is heating up at a faster than desired pace, whereas fiscal policies result in far more sweeping changes. Though each side of the policy spectrum has its differences, Canada uses both to manage its economy – for the reasons stated: monetary policy is quick, and shows impacts quickly, and fiscal policy is slow but has deep impacts. Keynes’ thoughts and propositions were not apparent in the United States and Europe during the latter quarter of the twentieth century, but in Canada they were embraced. One of Keynes’ more well-known and infamous quotes shows how Canadians view fiscal and monetary policy makers: “Practical men, who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist. Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back.”15 In Canada, successive governors of the Bank of Canada, and successive ministers of finance have followed Keynes as their own “academic scribbler”, and used Keynesian methods to control the economy, and have hence made our recovery more ponderous and indeed less impactful than it should be. During the height of the recession of the 2000s, Canada was in a strong and unique position of both fiscal and moral authority in the financial world, and sadly, squandered both. In Canada, “Reaganomics”, “Trickledown Economics”, and the Friedman school of thought never really took hold. In this way, Keynesian thinking brought Canada, and the rest of the world into the crisis, and in a desperate move, they also supported the idea of spending tens of billions of dollars in an attempt to get us out of it. In Keynes magnum opus, “The General Theory of Employment, Interest and Money”, he proposed that a market economy will naturally tend to return to complete employment after temporary shocks; and he discussed or created supporting arguments through the consumption function, the marginal efficiency of capital, the principle of effective demand and liquidity preference. After World War II, the governments of the Western industrialized nations, including Canada, adopted Keynesianism as the basis of their macroeconomic policymaking in trying to realize full employment, while simultaneously aiming to smooth the business cycle through the efficient manipulation of fiscal and monetary policies. 15

Keynes, John M. 1991. The General Theory of Employment, Interest and Money.

In Canada, the use of the Phillips Curve attempted to find a balance between inflation and unemployment16. To reduce unemployment, inflation must increase; and to reduce inflation, unemployment must remain higher than desired. The tools used to manage the economy and inflation in Canada, are of course, monetary and fiscal policies. During the so-called “stagflation” of the 1970s – when Canada experienced both high inflation and high unemployment, and thus against the Phillips Curve, Canada abandoned the key concepts of Keynesianism for, in order: supply side economics, rational expectations, and monetarism (and let us not forget trickledown Reaganomics.) Interestingly, most former governors of the Bank of Canada: David A. Dodge (2001 – 2008), Gordon Thiessen (1994 – 2001), John Crow (1987 – 1994), and Gerald Bouey (1973 – 1987) all showed themselves to be Keynesians at heart. In 2008, Paul Krugman won the Nobel Prize in Economics, in part as a recognition of his seminal work, “The Return of Depression Economics” (1998). Krugman has stated time and again that Keynes was correct, and that our economy operates below full-employment. Both the Bank of Canada governor, and successive finance ministers agree that this is a problem to be solved using the General Theory! Keynes in Canada in the late 2000s Jean Baptiste-Say, an early 19th century French economist, shows the relation between supply and demand in that supply creates its own demand. Keynes rejected this law, largely because he believed savings do not necessarily equal investment. That is, some people will save, instead of spending, the income they receive for contributing to production, which will leave some of that produced output unsold. Moreover, Keynes claims that savings do not automatically translate into investment because the latter is driven by the so-called “animal spirits” of businesspersons. These spirits bring to the market a progressive psychology of confidence and pessimism. Another part of the Keynesian theory is that wages are sticky when the economy declines; so that unemployment can’t be cured by having workers accept lower pay in return for keeping their jobs. For Keynesians, the upshot of all this is that the general economy is not self-regulating. Market forces, left to themselves, do not cure recessions and depressions. Indeed, Keynes maintains that the economy can remain persistently below productive capacity. Keynes’ cure is two-fold: first, he prescribes an easy money policy. The aim here is to lower interest rates to incentivise investment. The second cure, especially relevant if interest rates have already been brought down to zero, is for the government to spend money. Keynes is not very particular about how the government is to go about its expenditures. At one point, he suggests burying bottles filled with bank notes and having people dig them up to create jobs. But contemporary exponents of Keynes typically 16

Khan, H., Zhu, Z., Estimates of the Sticky-Information Phillips Curve for the United States, Canada, and the United Kingdom, Bank of Canada Working Paper 2002-19

propose infrastructure projects. It’s sometimes thought that Keynes is only about fiscal policy and deficit spending. It’s vital to recognize that his thought also encompasses monetary policy. As stated above, Canada’s finance ministers and governors of the Bank of Canada, have focussed for years on keeping interest rates low. To quote Keynes himself in General Theory: “The remedy for the boom is not a higher rate of interest but a lower rate of interest! For that may enable the so-called boom to last. The right remedy for the trade cycle is not to be found in abolishing booms and thus keeping us permanently in semi-slump; but in abolishing slumps and thus keeping us permanently in quasi-boom.” And that is exactly what David Dodge, Gordon Thiessen, (Governors of the Bank); and Michael Wilson, Paul Martin, Ralph Goodale, and Jim Flaherty (Ministers of Finance) have all done. In all their cases, they followed Keynesian approaches and lowered interest rates – eventually down to 1% - where they have stayed for several years. Keynesian philosophy applied during and after the crisis Even though Canada’s Banks are institutionally limited in risks and have strict capitalisation rules and regulations, they were exposed to the commodity and housing booms of 2006-2008, and responded to the world crisis in a classically Keynesian mode. The ministers of finance and governor of the Bank of Canada used their traditional duopoly of fiscal and monetary policy to reduce interest rates, and to cool the economy. In Canada, this led to an even larger commodity boom, which saw oil prices at approximately $150 a barrel which impacted our fragile economy. Even in Canada, our banks were “leveraged” heavily in the global housing market. By bundling securities into a mortgage-backed package, our banks were holding underlying risky securities (although they pretended they were not risky), and were holding them on margin. When Ben Bernanke and Hank Paulson worked to support money market funds, supported Fannie Mae and Freddie Mac, forced bank mergers, and took interest rates down to effectively zero; they also committed themselves and asked the rest of the world (Canada included) to insert billions of dollars into the economic system through massive fiscal stimulus packages. All this was done on the Keynesian argument that the private sector was not spending and investing enough due to market psychology, and therefore, the government must spend money to compensate for the lack of private demand and raise business confidence in the process. A Recovery: No thanks to Keynes Canada’s economy began to recover in mid-2009. Statistics Canada currently holds that the recession ended in May 2009. This means there was, in essence, not a lot of time for the stimulus plans to have had any impact in Canada or in the U.S.! In the U.S., for example, the stimulus package in February 2009 and the Canadian

one in the spring of 2009 was implemented basically when the recovery was already well-underway – at least according to Statistics Canada. One of the key criticisms of Keynes is that by the time the politicians pass spending bills, the economy has already recovered. This was certainly the case in Canada. The prospect of stimulus did not raise market confidence in Canada. In fact, banks continued (and continue today), to hold onto larger than traditional reserves of cash. Canadian businesses retain more cash as well – it is patently obvious that easy money did not lead businesses to spend. In the Canadian banking sector, as stimulus monies flowed in, banks merely retained the monies, and continued to hold higher lending standards. The stimulus was not passed onto the citizen; and neither was business’ confidence raised. The European debt crisis already well under way in 2008-2009, came to a head in 2010 as Greece, Spain, Portugal and Ireland found it difficult to refinance debt on the capital markets. In most of these cases, they had already attempted to stimulate their economies by augmenting their deficits in a classic Keynesian way – the stimulus packages did not bring spending and private sector confidence as Keynes predicted. Conclusions Keynesian philosophies have been in widespread use in Canada since the publication of Keynes’ General Theory in 1936, despite the diminished esteem in which he was held by many economists over the last couple of decades. His philosophies of market psychology, government intervention, and market tendencies were felt in the policies that Greenspan and Bernanke used in their command of the Federal Reserve from 2002-2005, as well as the policies of the Bank of Canada and Finance Departments in the 2006-2010 responses to the international economic crises in Canada. In Canada, it was felt that Keynes’ philosophies assisted in recovery from the Great Depression, and therefore they would also lead to a recovery from this recession. Not only was this untrue, but it has left Canada with a larger debt, and contingent liabilities in pension and health care. It is time for Canada to reject many of the Keynesian philosophies. What made the General Theory so radical was Keynes' assertions that it was possible for a free market economy to achieve homeostasis where workers and production could be idle for prolonged periods of time; and that the only way to revive business confidence and get the private sector spending again was by cutting taxes and letting business and individuals keep more of their income so they could then spend it. Having the government spend more money directly, guaranteeing that 100 percent of it would be spent rather than saved, did not work in Canada. The private sector and banking industry couldn't or wouldn't spend, and the government in the present economic climate cannot spend for all. Neither did the middle class.

In 2009, James M. Buchanan, Edward C. Prescott, and Vernon L. Smith, signed a statement against more government spending, arguing that "Lower tax rates and a reduction in the burden of government are the best ways of using fiscal policy to boost growth."17 It has been argued that stimulus spending may be unwise, claiming the multiplier effect, one of the factors the U.S. stimulus package depends on for its effectiveness, is in practice close to zero – not 1.5. There have also been arguments that the crisis of the late 2000s was caused not by excessively free markets, but by the remnants of Keynesian policy. Luigi Zingales of the University of Chicago argues that "Keynesianism is just a convenient ideology to hide corruption and political patronage"18. In 2009, historian Thomas Woods, an adherent to the Austrian school of economics, published the book Meltdown19, which places the blame for the crises on government intervention, and blames the Federal Reserve as the primary culprit behind the financial calamity.

17

Tapia Granados, J.A., The Global Financial Crisis: Economists, Recessions and Profits, Capitalism, Nature, Socialism, Volume 21, Number 1 (March 2010) 18

The Economist, March 18, 2009, http://www.economist.com/debate/days/view/278/CommentKey:242016, retrieved 5/15/13 19 Woods, Thomas, Meltdown, Regnery Publishing, 2009.

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