Why Fiscal Expansion is Needed Now

Monetary policy is reaching its limits in terms of stimulating economic activity. It has carried that burden well beyond what was envisioned immediately after the 2008 crisis. More and more, policymakers are debating the merits of expansionary fiscal policy. The head of the IMF, Christine Lagarde, stated that some countries “may have room for fiscal expansion", citing Canada as one country that has " made the most of this space" Indeed, the Governor of the Bank of Canada  (BoC)  has made it a selling point that they believe that Canada's latest fiscal stimulus measures will have a positive effect on the real GDP. In part, the fiscal policy shift has allowed the BoC to refrain from cutting the its lending bank rate.

With nominal rates of interest at zero or even less, governments can borrow money at negative real rates of interest (i.e. the nominal interest rate less the rate of inflation). This implies that there is no additional burden to the nation in terms of real dollars, should it assume more debt. Measured in real terms, the amortize cost of the additional debt is negative. In fact, Canada’s recent budget proposal, the Federal government proposes to borrow at rates in the 3-5 year range, putting the real rate of borrowing at around minus 0.5 percent.

What are the benefits of fiscal expansion?

Not all fiscal stimuli act with the same degree of potency. The accompanying chart separates the type of stimulus between "investment" and "tax" measures. The greatest bang for the buck comes when governments undertaken infrastructure projects, both for their immediate impact upon jobs and income and for their longer term benefits in adding to productive capacity (e.g. urban transportation systems). Next in importance are stimulus programs generated by increasing government consumption of goods and services (i.e. day-to-day expenses associated with government operations).

Source: Bank of Canada, Discussion paper 2010-1

Tax measures, on the other hand, have not proven to be any where nearly as effective in promoting growth.The impact of reductions in personal or corporate tax cuts are de minimis. Since some portion of a tax cut is usually saved rather than entering the spending stream, tax multipliers are lower than government spending multipliers. By and large, economists have concluded that the United States, Germany and the United Kingdom have sufficient financial room to adopt a more expansionary policies without adverse effects on debt service levels or  the national inflation rate. So why are they holding  back?

A lot of reticence is wrapped around ideology. Some argue that, once the economy recovers, governments will fail to cut back on deficit spending, arguing that  spending will become additive. But this argument is false. Governments regardless of their ideology can pursue bad economic policies. Whereas, the tangible economic benefits of stimulus - growth, wage gains, and greater business investment and improved infrastructure - should be emphasized.  The Eurozone countries have resisted fiscal expansion, citing the alleged benefits of austerity. They are paying a heavy price in terms of stagnation, high rates of unemployment and deflation. In the US, so far, the political debates have not centered around deficit financing as a means of stimulating growth, and in some quarters, debt reduction is the primary concern. The Canadian experience is quite different. The election of the new government came on the heels of promises of fiscal expansion centered on infrastructure investment.

Right now, there is resistance to countercyclical macroeconomic policies. In Europe the resistance is being led by Germany and its fears of uncontrolled inflation and rising debt levels. In the US, the right-of-centre factions in Congress continue to hold sway.  But the longer monetary continues without really generating growth, the more the governments will have to reconsider the merits of fiscal tools. The time is ripe to do so.