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Austrians vs. The World On Canadian Fiscal Austerity

Austrians vs. The World On Canadian Fiscal Austerity
Profile photo of Robert P. Murphy

I don’t know whether this is something the average Canadian discusses over coffee, but the sharp fiscal turnaround in the mid-1990s is still providing fodder for today’s economists to argue. In September 2014, I summarized the Canadian budget triumph, in which the federal government turned its deficit into a surplus largely through spending cuts, with the economy suffering no ill effects.

But I also explained that it’s crucial for Keynesians like Paul Krugman to explain away the success of this so-called austerity by pointing to falling interest rates. Thus, Krugman argued, it’s not that cutting government spending actually helps an economy, but rather it’s that looser monetary policy can pick up the gaping hole in Aggregate Demand.

In my first Mises CA post and then a follow-up, I gave various arguments and evidence to say that the Bank of Canada did not appear to have loosened policy. For example, the growth in the Bank of Canada’s assets almost came to a halt in 1996, and it was no higher in subsequent years than it had been earlier in the decade. Furthermore, CPI inflation showed no signs of heating up during the period when Krugman must claim that monetary policy loosened.

The one metric that lines up with Krugman’s story is that Canadian interest rates fell. But, I pointed out that this is exactly what we would expect to happen naturally, as the federal government greatly reduced its borrowing and fears of a bond crisis evaporated. After all, this was just the mirror image of what happens in a situation of high government deficits, when “crowding out” and fears of a default go hand in hand with high interest rates.

The debate flared up once again last month, prompted by another Krugman post in which he (again) said that the Canadian experience in the 1990s showed the importance of loose money to offset budget cuts. This time, Market Monetarist David Beckworth jumped into the fray, taking the Keynesian position.

Now keep in mind that Beckworth is a kinder, gentler version of Scott Sumner. Although they are opponents of Keynesians when it comes to the desirability of fiscal policy, the reason is that Market Monetarists (like Beckworth and Sumner) think that central banks can continue to boost Aggregate Demand even when short-term interest rates have hit the so-called “zero lower bound.” In other words, the Market Monetarists agree with the Keynesians that recessions can occur because of inadequate demand, but the Market Monetarists think that central banks can always remedy the problem, and that therefore central government budget deficits aren’t needed.

In his post, Beckworth responds to my Mises CA posts (linked above) as well as an EconLog post by David R. Henderson, who had attracted the ire of Krugman back in 2014 because he (Henderson) had written a study praising the Canadian example.

There is some confusion in Beckworth’s critique, since he erroneously thought that I denied central banks can influence interest rates. No, of course I think they can do that; this is the basis for the Austrian theory of the business cycle, after all. (Beckworth notes the “contradiction,” but it’s not really a contradiction because he misunderstood my position.) I think what happened here is that Henderson had wondered whether central banks have such power, and Beckworth thought I was giving blanket agreement to this perspective when I tried to quantify it in my own discussion of Henderson.

In any event, Beckworth does little to show why my analysis was wrong empirically. It seems that in the Market Monetarist view–as with the Keynesians–why it just HAS to be the case that the Bank of Canada loosened monetary policy, because the Canadian government cut spending so sharply. Yet to repeat myself, standard indicators don’t show an increase in monetary inflation, and thus it’s not obvious that the fall in interest rates is due to the Bank of Canada’s “offset,” as opposed to the fiscal austerity itself.

However, there is one huge area of substantive disagreement. Beckworth produces a chart showing an apparent one-shot spike in the B of C’s monetary base in 1994. Although the timing doesn’t make the best of sense–why would a one-shot increase in the base in 1994, translate into a steady fall in interest rates from 1995 – 1997?–I can definitely see why Beckworth thinks he has easily disposed of my position.

But something was odd with all of this. After all, I had looked up the Bank of Canada’s balance sheet, and found no sharp jump in any of those years. How could Beckworth have dug up the opposite conclusion?

The answer is that his graph indicates “monetary base (excluding required reserves).” To see why this matters, in the following chart I’ll plot that along with regular “monetary base (including required reserves)”:

CANADIAN MONETARY BASE, WITH AND WITHOUT REQUIRED RESERVES, MILLIONS $

Canadian Mon Base

As the chart indicates, the total monetary base (blue line) was roughly flat from April 1994 through April 1996, and then rose gently thereafter, certainly no more aggressively than in the beginning of the decade. So it would seem there was no monetary looseness to “offset” the fiscal austerity that began in 1995.

However, what Beckworth plotted was the monetary base excluding required reserves–the red line. It jumps sharply in the summer of 1994.

So what happened? How do you explain the two different lines?

The answer is that in the early 1990s the Bank of Canada phased out reserve requirements on the banking sector. As explained in this pamphlet (thanks to Nick Rowe for providing the reference):

The phasing out of reserve requirements, which began in June 1992, when
marginal reserve requirements were set to zero, was completed by June 1994.
Previously, reserve requirements on demand and notice deposits had been
10 per cent and 3 per cent, respectively. These requirements had been
imposed on the chartered banks but not on other deposit-taking institutions.

To sum up, the one clear-cut, objective policy change that I agree would be an exogenous loosening of monetary policy was the Bank of Canada phasing out reserve requirements through mid-1994. I am not sure that that can explain the steady fall in Canadian interest rates through 1997, but even if it does, I think the Keynesian/Market Monetarist narrative on this episode can potentially be very misleading. One would think that the Bank of Canada was doing something aggressive during the period of budget cuts, when–even on their own terms–that’s not what happened. At the very best, it looks like they could argue that monetary policy offset the fiscal austerity through sheer luck. After all, the Canadian authorities in June 1992 presumably weren’t looking ahead three years to the budget cuts that would occur amidst a debt crisis.

Although Beckworth has made me realize that the situation is more nuanced than I originally thought, I still maintain that this is an open case. And on a theoretical level, I am still quite sure that cutting federal spending and thereby returning resources to the private sector will be good for the economy, without running the printing presses to “help.”

  • T B

    I need to understand how linked the US and Canadian dollars are. I live in the US but understand that when the US fiat currency collapses there will be great turmoil. I am looking for safe haven. One of the things I am examining is having a house in Canada and a bank account with Canadian currency in it. So far it seems that these would suffer also (if one looks at “prices” in terms of real money, gold and silver) but it seems as though the Canadian debt-to-GDP being .86 vs. US debt to GDP being 2.29 is an important factor. Also it seems to me that the destruction of US gold reserves (trying to defend the stock market and keep the fiat currency strong) is an important factor as well. However, I don’t understand whether the Canadian bank is engaging in the same activities and potentially bankrupting the Canadian currency. I have read the Canadian PM is trying to reduce indebtedness rather than follow the US lead.
    Looking for enlightenment.

  • T B

    I need to understand how linked the US and Canadian dollars are. I live in the US but understand that when the US fiat currency collapses there will be great turmoil. I am looking for safe haven. One of the things I am examining is having a house in Canada and a bank account with Canadian currency in it. So far it seems that these would suffer also (if one looks at “prices” in terms of real money, gold and silver) but it seems as though the Canadian debt-to-GDP being .86 vs. US debt to GDP being 2.29 is an important factor. Also it seems to me that the destruction of US gold reserves (trying to defend the stock market and keep the fiat currency strong) is an important factor as well. However, I don’t understand whether the Canadian bank is engaging in the same activities and potentially bankrupting the Canadian currency. I have read the Canadian PM is trying to reduce indebtedness rather than follow the US lead.
    Looking for enlightenment.

  • David Beckworth

    Bob,

    Interesting post as usual. The monetary base data does raise some questions for both sides as you note. But let me share what I think is the most compelling evidence for the
    market monetarist’s view by making a set of observations.

    First, Canada is a small open economy. During the period is question, Canada’s GDP was about 7% of US GDP on average. Canada, in other words, is very susceptible to external economic shocks, particularly ones coming from the US.

    Second, Canada’s financial markets are highly integrated with US markets. This is especially true with short-term money markets which means there should be over the long run very little arbitrage opportunities between the two countries short-term interest rates.

    Third, given the points above it should be the case that when the Fed (large economy) sets its short-term interest rate target in the US it also helps shape short-term interest rates in Canada (small economy). Taken to its logical extreme, this understanding would imply that the Bank of Canada generally follows what is happening to US monetary policy. That seems to be the case as seen here: https://research.stlouisfed.org/fred2/graph/?g=1CWp

    But now take a closer look at the period in question: http://4.bp.blogspot.com/-rxh6JJj2Rfc/VaA-Ay7zXkI/AAAAAAAASns/FV-evsHM7Gs/s1600/cb2.jpg.
    It shows that Canada’s central bank interest rate differed as much as 250 basis
    points for a sustained period from the federal funds rate during the period in question.

    How can this be possible given the observations above? Are not Canadian financial conditions tied closely to US financial conditions? The answer is yes, but they can deviate if the Central Bank of Canada exogenously intervenes and tinkers with interest rates. Put differently, had the Bank of Canada not intervened Canadian short-term interest rates probably would have tracked closely tracked the Federal Reserve’s target rates. As shown above, they typically do. But this time the Bank of Canada defied external money market pressures coming from the United States and struck its own interest rate
    path.

    This is kind of like a natural experiment in macroeconomics.What happens when one region exogenously sets its own interest rate instead of endogenously following the pressures of the market? This episode provides an answer. Another way of seeing this is to imagine if one were to forecast this period based on historical patterns. The forecast would be way off in this period–there would be a large forecast error or a ‘monetary policy shock’. In my view, the evidence does not get much clearer than this episode.

    • Nick_Rowe

      David: true. But we need to look at the interest rate differential and the exchange rate together, to get a more complete picture. The exchange rate depreciated a lot at the same time, which is just what you would expect, if the Bank of Canada was doing (allowing to happen) what was necessary for full monetary offset.

      But again, I don’t think there’s a useful distinction between “the Bank of Canada did X” and “the Bank of Canada allowed X to happen”. It all depends on your arbitrary definition of “doing nothing”.

      The money base thing is slightly puzzling for any reasonable story though. Regardless of your arbitrary definition of “doing nothing”, we would have expected the amount of currency to increase (because the demand for currency depends negatively on the nominal rate of interest opportunity cost). And the stock of currency did increase, but the increase in the stock of currency came a little bit earlier than the fall in nominal interest rates.

  • David Beckworth

    Bob,

    Interesting post as usual. The monetary base data does raise some questions for both sides as you note. But let me share what I think is the most compelling evidence for the
    market monetarist’s view by making a set of observations.

    First, Canada is a small open economy. During the period is question, Canada’s GDP was about 7% of US GDP on average. Canada, in other words, is very susceptible to external economic shocks, particularly ones coming from the US.

    Second, Canada’s financial markets are highly integrated with US markets. This is especially true with short-term money markets which means there should be over the long run very little arbitrage opportunities between the two countries short-term interest rates.

    Third, given the points above it should be the case that when the Fed (large economy) sets its short-term interest rate target in the US it also helps shape short-term interest rates in Canada (small economy). Taken to its logical extreme, this understanding would imply that the Bank of Canada generally follows what is happening to US monetary policy. That seems to be the case as seen here: https://research.stlouisfed.org/fred2/graph/?g=1CWp

    But now take a closer look at the period in question: http://4.bp.blogspot.com/-rxh6JJj2Rfc/VaA-Ay7zXkI/AAAAAAAASns/FV-evsHM7Gs/s1600/cb2.jpg.
    It shows that Canada’s central bank interest rate differed as much as 250 basis
    points for a sustained period from the federal funds rate during the period in question.

    How can this be possible given the observations above? Are not Canadian financial conditions tied closely to US financial conditions? The answer is yes, but they can deviate if the Central Bank of Canada exogenously intervenes and tinkers with interest rates. Put differently, had the Bank of Canada not intervened Canadian short-term interest rates probably would have tracked closely tracked the Federal Reserve’s target rates. As shown above, they typically do. But this time the Bank of Canada defied external money market pressures coming from the United States and struck its own interest rate
    path.

    This is kind of like a natural experiment in macroeconomics.What happens when one region exogenously sets its own interest rate instead of endogenously following the pressures of the market? This episode provides an answer. Another way of seeing this is to imagine if one were to forecast this period based on historical patterns. The forecast would be way off in this period–there would be a large forecast error or a ‘monetary policy shock’. In my view, the evidence does not get much clearer than this episode.

    • Nick_Rowe

      David: true. But we need to look at the interest rate differential and the exchange rate together, to get a more complete picture. The exchange rate depreciated a lot at the same time, which is just what you would expect, if the Bank of Canada was doing (allowing to happen) what was necessary for full monetary offset.

      But again, I don’t think there’s a useful distinction between “the Bank of Canada did X” and “the Bank of Canada allowed X to happen”. It all depends on your arbitrary definition of “doing nothing”.

      The money base thing is slightly puzzling for any reasonable story though. Regardless of your arbitrary definition of “doing nothing”, we would have expected the amount of currency to increase (because the demand for currency depends negatively on the nominal rate of interest opportunity cost). And the stock of currency did increase, but the increase in the stock of currency came a little bit earlier than the fall in nominal interest rates.

  • Nick_Rowe

    Good post Bob.

    “One would think that the Bank of Canada was **doing something** aggressive
    during the period of budget cuts, when–even on their own terms–that’s
    not what happened.” (my **emphasis**)

    Suppose that, contra to what actually happened, there had been a big recession and no fall in interest rates. We could have then had a lovely argument over whether the Bank of Canada had sinned by commission (keeping interest rates from falling) or had sinned by omission (failing to cut interest rates). But I don’t know whether that argument would really have gotten us anywhere.

    Scott Sumner is the one who argues that there’s no material difference between the Fed sinning by commission or omission. My preferred way of making the same point is to say that there are 1,001 different ways of defining a central bank’s “doing nothing”. Does it mean doing nothing with base money?, doing nothing with interest rates?, doing nothing with the exchange rate?, doing nothing with the price of gold?, doing nothing with NGDP?, doing nothing with M1, doing nothing with…you get my drift.

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Profile photo of Robert P. Murphy

Robert P. Murphy is the Senior Economist at the Institute for Energy Research, and a Senior Fellow with the Fraser Institute. He holds a PhD in economics from New York University. Murphy is the author of Choice: Cooperation, Enterprise, and Human Action (Independent Institute, 2015) as well as numerous other books and hundreds of articles.

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