My fellow economists: Bay Street might be right this time

Bay Street is sounding the alarm for stimulus spending, but academics are waving them off. Time to call a truce

Bay Street office towers, seen looking up

Bay Street office towers. (Gloria Nieto/Globe and Mail/CP)

A rift has emerged in the Canadian economic community, with Bay Street economists calling for fiscal stimulus from the federal government while academic economists are openly hostile to the idea. At the risk of being ex-communicated from my tribe, I believe Bay Street might be right. At the very least, they have a point that should not be so quickly dismissed.

The academic economist case against stimulus has been very capably made by my colleagues Stephen Gordon, Kevin Milligan, and Trevor Tombe. In my view, the most important anti-stimulus argument can be summarized as “even if you accept that stimulus is appropriate for a downturn of this magnitude caused by a terms-of-trade shock, it an open economy with flexible exchange rates like Canada, it is best left to monetary, not fiscal, policy.” This is standard economic canon derived from New Keynesian economic models. I have personally taught (and tested) a generation of students on these ideas.

So why might Bay Street be right? It’s simple: academic economists have failed to allow for the possibility that our models are leading us astray because they are inadequate for current economic conditions.

The idea that our models may be inadequate should not be controversial, as they have proven themselves to be in at least two major ways over the last decade. The first is in properly capturing the nuances of the financial sector, which became apparent after the financial crisis of 2007-08. Our profession has worked hard to address this, as one cannot go to an academic conference without encountering papers with titles like “A model of financial instability and bank leverage.” The second big inadequacy was addressed in Stephen Gordon’s piece, when he stated “[w]e used to think that the effective lower bound [on interest rates] was zero, but recent experience in Europe suggests that central banks can actually push interest rates below zero before people stop using banks to hold their money.”

Canadian academic economists need to entertain the possibility that our models do not adequately address the potential for harm caused by very low nominal interest rates.

Look at the current situation from Bay Street’s point of view: Real estate prices have escalated under a low-interest-rate environment, with data that looks eerily similar to the U.S. housing bubble that proceeded the financial crisis and great recession. You have a boom in residential real estate construction that appears completely unsustainable given Canada’s slow population growth and aging population. And now a bunch of academics are saying that if there’s a solution to Canada’s current economic woes, it is to throw more fuel on the residential real estate fire, rather than stimulating the economy by building more schools, roads and hospitals. If you were them, would that make any sense to you?

Academic economists do not need to concede the fiscal stimulus point to Bay Street—but we should at least acknowledge that they may have one.


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