A number of Bay St. economists are urging the federal government to loosen its purse strings even more and run larger deficits than announced during the election campaign in order to “stimulate” the Canadian economy. This short-term perspective, however, fails to take into account several important considerations.
First of all, the Keynesian macroeconomic theory upon which these economists base their recommendations suggests boosting the economy through public spending only during periods of recession. But Canada is not in a recession, nor was it in a recession in 2015, and according to the Bank of Canada’s latest forecasts, it will not be in one in 2016 either, regardless of the size of the federal deficit. In fact, the economy should experience slow but gradually accelerating growth.
Second, even if we were to experience an economic downturn, it is not obvious that additional government spending would be the solution. Several Nobel Prize-winning economists believe that even in periods of recession, the government cannot boost the economy by substantially increasing its spending.
Indeed, in the aftermath of the 2008 financial crisis, it is the OECD countries that reduced both their public spending and their revenues that succeeded in achieving the fastest average annual growth. Conversely, countries that chose to increase both their spending and their tax burdens experienced very slow growth, and even economic contraction if Greece is included in the calculation.
Economist Valerie A. Ramey of the University of California in San Diego reviewed the recent literature on this question. She shows that an increase in public spending does not stimulate private spending, and even has the effect of substantially reducing it in the majority of cases. According to Ramey, public spending can only create jobs in the public sector, and no sustainable employment in the private sector.
Other research suggests, in the short term public spending cuts have a modest negative effect on economic activity, since there is a short delay before private spending can take up the slack. In the longer term, though, the positive effects on economic growth become overwhelmingly dominant.
To all of this, supporters of a large deficit invariably reply that we need to take advantage of the fact that interest rates are currently very low. Even at low rates, however, loans have to be paid back sooner or later — and when the government is the one doing the borrowing, they have to be paid back with future taxes.
The best way to stimulate growth is to remove the obstacles keeping entrepreneurs from launching new projects and companies from putting labour and capital to work. Increasing government spending, however, will just pull resources out of the private sector and postpone a sustainable recovery.
— Mathieu Bedard is an economist with the Montreal Economic Institute