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Thursday, February 20, 2014

Canada: Enjoy The Projected Surpluses While They Still Exist

Chart: Canada General Government Net Lending (IMF)

The Canadian Federal government unveiled a budget plan that forecasts budget surpluses starting in the 2015-2016 fiscal year, and continuing out to the end of the forecast horizon. My guess is that a hard rain will fall on those projections.

Liveo Di Matteo (at Worthwhile Canadian Initiative) gave a good overview of the situation, “Visioning The Surplus”. In it, he talks about the Federal surpluses, and whether they make new policies possible. Although interesting, I do not have the space here to discuss those policies. Instead, what I want to highlight in the article is his description of the changing role of the Federal Government within the Canadian Confederation.*

The Federal government has evolved from a provider of goods and services to a role mainly as a transfer agency transferring resources to individuals and to other governments.  Government does not always need to have a big role in directly providing public goods and services provided it is willing to develop standards and regulations and monitor their private sector provision to ensure access to services, public safety and efficient and transparent operation of markets.  This approach can also translate into the area of transfer payments.  Just because the Federal government is transferring money to the provinces to spend on areas that are nominally under provincial jurisdiction does not mean there has to be an abdication of a national policy role when it comes to designing those transfers to achieve national goals or outcomes or ensure that all Canadians receive the best health care or education that they possibly can.

Need To Look At The Aggregate Government Sector

The chart at the beginning of my post is the General Government budget balance (as a percentage of GDP), from the IMF World Economic Outlook** This balance includes the Provincial government deficits, which are substantial. This is why the chart may not appear to reflect the discussion in the Liveo Di Matteo article.

A key difference between Canada and the United States is that the Provincial governments do not operate with balanced budget laws, and are substantial actors in the welfare state. This means that if you want to know the overall direction of the Canadian economy, you need to look at the overall government sector fiscal stance, not just the Federal government fiscal stance. The breakdown of deficits between the Provincial and Federal levels only really matters if you want to incorporate supply into relative value analysis, or if you want to look at what is happening in a particular province.

As the chart shows, there was a very considerable tightening of fiscal policy overall in Canada in the 1990’s, which could explain Canada’s disinflation (another explanation was the introduction of the 2% inflation target for the Bank of Canada). The Federal government moved to surplus partly as of the result of reducing transfer payments to the provinces, which effectively shifted the Federal deficit to the provinces.

Pushing the deficits to the provincial level makes the Federal politicians look like they managing to the economy well, at least according to the financial press, which refuses to understand that a government’s finances is not like a household’s. But the unfortunate implication is that the brunt of cyclical adjustment is borne by a level of government that is a user of the currency, not the issuer. There was already a Provincial default in the 1930’s – Alberta was thrown under the bus by the Federal government for political reasons. If the Canadian economy goes downhill fast, investors may have to face the question of whether the provinces are “too big to fail”.

The Federal Fiscal Strategy

The push towards surplus is properly understood as a drive by the Conservative government to reduce the size of the Federal government. However, if they really do care about the fiscal balance, their strategy is fairly dangerous. Although the tightening of fiscal policy has not been that large, it has helped stop the improvement of the Canadian labour market in its tracks (see discussion here).

Chart: Canadian Household Sector, Change In Financial Liabilities

The Canadian household sector has taken on unsustainable debts as it bid up the price of housing (as well as a means of driving current consumption). A weakening labour market will undercut households' ability to pay, and a mass default is a plausible outcome (although probably at a slower pace than the U.S. experience). In a monetary economy, nominal GDP growth is typically associated with rising amounts of outstanding debt.***  The only way out of the trap for the Household sector is for debt growth to rebalance towards other sectors of the economy, allowing household debt service burdens to improve.

But the governmental sector is slowly tightening fiscal policy. This leaves it up to the corporate sector to ramp up debt issuance. (Alternatively, the trade balance could improve, which means that the external sector provides the impetus for growth. This would to be difficult if we assume that the economy will start growing faster.) However, modern corporate management is more interested in financial engineering than actual engineering, and so the business sector is content to let profits finance their investment. Therefore, it is not particularly surprising that the economy is refusing to accelerate - there is no sector willing to drive growth by increasing its financial deficit.

My reading of Canadian policymakers is that they are unconsciously following the rule of thumb that recessions are only triggered by monetary policy (as discussed in my previous article). For this reason, they have been willing to run the risk of fiscal tightening in the face of the over-extended household sector. However, if the “fiscal dominance” viewpoint in my previously referenced article is true, this bet may be a lot riskier than they think.

If the bet does not work out, the damage to the labour market would be comparable to that seen in the United States. Tax revenues would massively undershoot currently projected levels. The end result is that the forecast surpluses would look as silly in 2020 as the projections of the disappearance of the U.S. Treasury market (made in the early 2000’s) appears to us now.

And to close on a bond market-related note: I would only be strongly bearish on Government of Canada bonds if I was sure those surplus forecasts do actually materialise over the next couple of years; conversely I would want to own the bonds if the Federal Government has some big fat deficits coming up soon. Good luck trying to force that sentiment into a “loanable funds”-based fiscal risk premium model.


*I will note that I analyse government finance from the standpoint of Functional Finance - which is embedded in Modern Monetary Theory. From this point of view, what matters for a government that controls its currency are real constraints, not financial. Additionally, deficits are the expected state of affairs for an economy that is growing in nominal terms, under almost any reasonable analysis of fiscal policy. Taken together, I do not think that having a fiscal surplus opens up policy space. However, since I have just written an “Economic Squabbling” piece involving Modern Monetary Theory, I will not discuss that further here.

**The IMF data are from October, and probably do not reflect recent budget changes. My guess is that any changes would not be material.

***Rising debt is not a necessary condition for nominal income growth. However, it would take fairly unusual conditions for the amount outstanding of nonfinancial debt to fall when the economy is growing. Financial debt levels could fall without any impact, if the economy moves away from securitisations. Securitisations create double-counting of the same underlying loan, and so there is an artificial bloating of financial sector debt. This double-counting could be unwound without any effect on borrowing by the nonfinancial sector.

(c) Brian Romanchuk 2014

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