More Evidence That Canadian Success Story Didn't Rely on Loose Money

More Evidence That Canadian Success Story Didn't Rely on Loose Money
Profile photo of Robert P. Murphy

In a previous post, I reviewed the great Canadian success story involving relatively large budget cuts as a way Canadian-Flag-08to turn around the fiscal crisis of 1995. On the surface, this seems anomalous to those who think Aggregate Demand is the key to understanding recessions, because at the time Canada was coming off the heels of a bad slump. Even so, the massive reversal of budget deficits into a string of 11 consecutive surpluses went hand-in-hand with falling unemployment.

As I further explained in that post, today’s Keynesians and Market Monetarists try to reconcile the episode with their theoretical framework by claiming that the Bank of Canada offset the “fiscal austerity” with expansionary monetary policy. In other words, today’s Keynesians and Market Monetarists say that the only reason the Canadian government’s budget cuts didn’t plunge them deep into recession was that the central bank saved the day. In the present post, I will show that this is simply not correct; by various measures, the Bank of Canada arguably tightened monetary policy right when the federal government was slashing spending. This is the exact opposite of what the Keynesians and Market Monetarists need for their story to work.

Krugman Comments on Canada in 1996

Before diving into the details, let me reproduce a commentary by Paul Krugman from August 1996, where he used the example of Canada to illustrate a more general point Krugman was making about the danger of targeting a low price inflation rate:

[N]ominal wage rigidity means that trying to get the inflation rate very low impairs real wage flexibility and therefore increases the unemployment rate even in the long run. Consider the case of Canada a nation whose central bank is intensely committed to the goal of price stability (the current inflation rate is less than 1%). In the 1960s Canada used to have about the same unemployment rate as the United States. When it started to run persistently higher rates in the 1970s and 1980s many economists attributed the differential to a more generous unemployment insurance system. But even as that system has become less generous the unemployment gap has continued to widen: Canada’s current rate is 10%. Why? A Canadian economist Pierre Fortin points out that from 1992 to 1994 a startling 47% of his country’s collective-bargaining agreements involved wage freezes. Most economists would agree that high-unemployment economies like Canada suffer from wage inflexibility; Mr Fortin’s evidence suggests however that the cause of that inflexibility lies not only in structural microeconomic problems but also in the Bank of Canada’s anti-inflationary zeal. 

Also, regarding Pierre Fortin’s analysis, in a previous post I also showed how Krugman referred to it as a “classic” and that Fortin–writing in 1996–had this to say about Canadian economic policy: “The last decade of this century will arguably be remembered as the decade of The Great Canadian Slump.

Rumors of Canada’s Economic Collapse Were Greatly Exaggerated

In hindsight, we know that Fortin’s warning was absurd. Above we showed Krugman wringing his hands over the “10%” Canadian unemployment rate in 1996. Well, look what happened in the years that followed:

CA unemployment

The unemployment rate in Canada peaked just about when Krugman wrote the above passage, after which it steadily fell about 3 percentage points. Remember, the Canadian government was still cutting spending in absolute terms–I don’t just mean a slow-down in the rate of growth, I mean actual spending reductions–through 1997, and thereafter it restrained the growth in spending. (It went from a 4.0% of GDP deficit in 1995 to a balanced budget in 1997.) And you can see from the chart above that Canada had suffered a very bad recession just a few years earlier in the 1990s, where unemployment topped 12%.

For all of these reasons, you can understand why it’s absolutely crucial for Paul Krugman’s worldview that the Bank of Canada must have stepped in just at this time to open up the monetary spigots. But as I’ll now show, that didn’t happen.

Growth of Monetary Base Almost Halts

In my book, the best objective measure of the central bank’s absolute policy moves is to look at the growth in its balance sheet. By that criterion, the Bank of Canada tightened exactly when Krugman’s story needs it to be loosening:

B of Canada Total Assets

As the table above shows, the growth in the Bank of Canada’s total assets almost came to a halt in 1996, even though the unemployment rate peaked mid-year. Furthermore, it’s difficult to argue that the 4.2% growth in 1997 was a “loosening” that caused unemployment to fall, since those were the types of growth rates in the early 1990s, amidst the awful recession, a period that Krugman and Fortin both described as “tight” monetary policy.

Consumer Price Inflation Remained Modest

OK, so if the growth in the Bank of Canada’s assets didn’t show a sudden loosening in 1996 or 1997, what about the CPI growth rate? In the quotation above, Krugman was lamenting that Canada only had 1% annualized (price) inflation, and that a much higher target was needed to avoid the problem of sticky wages. Well let’s look at what actually happened during the 1990s with Canadian CPI:

Canadian Unemployment


I’ve shaded the row for 1996, when Krugman lamented how stingy the Bank of Canada was being with its (price) inflation targets–it’s why Krugman thought Canada was suffering from 10% unemployment. Well, as you can see in the table above, the actual rise in consumer prices didn’t significantly increase for the next three years, even though this went hand-in-hand with budget “austerity” and yet unemployment steadily fell. Moreover, except for 1994 (with CPI inflation of 0.1%), the price inflation rates of the Canadian success story were comparable to those during the awful recession of the early 1990s.

Thus, looking at consumer price inflation rates, it doesn’t look like the Bank of Canada did anything to “loosen” and thus offset the fiscal contraction. Strike Two for the Keynesian story.

Using Nominal Gross Domestic Product (NGDP) Growth, Bank of Canada Didn’t Loosen Either

As I have been saying, it’s not just Krugman and the Keynesians who need the Bank of Canada to be loosening in the mid- to late-1990s; it’s the Market Monetarists too, as David Beckworth explicitly says in this post. Well in addition to the above points about the Bank of Canada’s balance sheet, and the rates of Consumer Price inflation, here’s yet another metric that is near and dear to Market Monetarists: growth rates of nominal GDP (with figures I got from Statistics Canada Table 380-0064):

Canada NGDP

As the table shows, the growth of NGDP during the three-year period after the large budget cuts kicked in was lower than the prior three years. If Scott Sumner or David Beckworth had no knowledge of the context, and I showed them these growth rates and asked, “When did the Bank of Canada switch from tight to loose money?” I don’t think they would say, “1996.” I think they’d say, “1999,” but that’s three years too late.

What About Interest Rates?

Finally we come to interest rates, a measure by which it looks as if the Bank of Canada did loosen. However, even here it’s not obvious that the fall in interest rates should be attributed to a “loose” monetary policy. After all, the Canadian federal government eliminated a large budget deficit from 1995 – 1997. Moreover, beyond the simple reverse crowding out effect, is the fact that international investors became reassured that the Canadian government was good for its bonds; in 1995 it was actual crisis–people were beginning to worry that the Canadians would default. So it’s not shocking that yields on Canadian debt would fall amidst the belt tightening.

David R. Henderson also wonders how much the fall in interest rates should be attributed to explicit actions by the Bank of Canada, rather than international conditions of supply and demand in the loanable funds market. Here’s one way of trying to parse out the different effects, looking at U.S. versus Canadian federal 10-year bond yields:

CA vs US 10 year bonds

This isn’t a perfect demonstration, since the U.S. government was going from budget deficit to surplus (at least on a cash-flow basis) in the late 1990s as well. In any event, the chart above suggests that at least a percentage point of the drop in Canada’s sovereign debt yields was particular to Canada. However, for all of the reasons I’ve already listed, I don’t think it’s correct to say the Bank of Canada “loosened,” rather I think interest rates fell for fiscal reasons having to do with the rapid decrease in federal government spending.


In summary, the Canadian fiscal turnaround of the mid- to late-1990s confounds the Keynesians and Market Monetarists. Like the Depression of 1920-1921, here is yet another example of a government engaging in “tight” fiscal policy without offsetting monetary policy, that nonetheless yielded a continued recovery.

Had Canada in 1997 plunged into a terrible recession with unemployment shooting back up to 12%, we can be quite certain Paul Krugman would have said, “I told you so! What did you think would happen amidst such budget cuts during a weak economy?!” But since the economy kept improving, instead the Keynesians must point to “offsetting monetary policy” that doesn’t actually exist.

  • JP Koning

    I'd just point out that in terms of interest rates, central banks may not control long rates, but they have iron control over overnight rates. A chart comparing US and Canadian short term rates would be more apropos.

  • Bob Roddis

    Excellent analysis.

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.

More in Blog

The market provides its own punishment for irrelevant discrimination

Patrick BarronMay 20, 2018

Unilateral Free Trade Would Benefit All UK Citizens

Patrick BarronMarch 21, 2018

The EU elite are ignorant of the true meaning and importance of “comparative advantage”

Patrick BarronMarch 15, 2018

Don’t Trust the “Trump Boom”

Taylor LewisFebruary 20, 2018

Inflation has Central Banks Playing Musical Chairs

Doug FrenchFebruary 8, 2018

What If Things Were Different?

Taylor LewisJanuary 30, 2018

Why Comparative Advantage Matters

Danny LeRoyJanuary 29, 2018

Can an Economy Advance Without Savings?

Patrick BarronJanuary 20, 2018

Bastiat and the Hubble Space Telescope

Patrick BarronJanuary 8, 2018