How liberating it must be for Stephen Poloz to go to work everyday knowing Stephen Harper is two time zones west of Ottawa and never coming back.
The Bank of Canada governor these days talks about Keynes almost as much as Twitter talks about Trump. If not a champion for Justin Trudeau’s deficit-spending plan, Poloz has emerged as important defender of the intellectual soundness of the young prime minister’s big economic idea. None of these things came out of his mouth while the guy who hired him was around, as Harper had no time for Keynes and deficits. Poloz said little about Harper’s obsession with a balanced budget, which in retrospect speaks volumes. Monetary policy and fiscal policy were out of sync, and there apparently was nothing the central bank governor felt he could say about it. As the central bank would tell you if you asked, that’s not its job.
Conservative central bankers such as Poloz stay clear of subjects outside their remits because they don’t want to give politicians an excuse to resume telling central banks how to manage inflation. Poloz and others talk about their independence as being “sacrosanct.” They believe that without distance from government, the public would question their ability to keep their promises to meet their inflation targets. And then the credibility that central banks have worked so hard to build since the double-digit interest rates of the 1980s would unravel.
That’s probably true. But it is also true that we have come a long way since Paul Volcker, the iconic former chairman of the U.S. Federal Reserve, induced a recession to break the back of the high inflation that plagued economies through the 1970s. Is it still reasonable to assume that monetary policy should simply react to fiscal policy, even if the choices of politicians make the inflation and financial stability goals of central banks more difficult to achieve? For a couple of decades, most central bankers thought that all they had to do to engineer a stable economy was hit their inflation targets. The collapse of global financial system in 2008 wrecked that fantasy. Every central bank on the planet now is rethinking how it should do its job. One of the things they might have to do is redefine their relationships with politicians.
Poloz delivered a lecture at the Canadian Economics Association’s annual conference in Ottawa on June 4 that raised important questions about the relationship between monetary and fiscal policy. He used the Bank of Canada’s main forecasting model—the one that prompted the central bank’s surprise interest-rate cut in January 2015—to go back in time and muse about how things might have turned out if the monetary and fiscal mix had been different. One of the periods Poloz chose was 2011 to 2015. Instead of a rush to balance the budget, he assumed the government aimed to cover all its expenses with the exception of interest payments, or a “structural balance.” He also assumed the same level of economic output as was actually achieved through those years.
The model produced results that should resonate with those who worry that ultralow interest rates have pushed Canada to the verge of a financial crisis. The benchmark interest rate would be 2.5% now instead of 0.5%, and household debt would be lower by an amount equal to 5% of GDP, according to Poloz’s calculations.
Household debt still would be high—about 90% of GDP. That would be a concern, but not to the extent it is now. As the Bank of Canada noted in its last policy statement, “household vulnerabilities have moved higher,” despite all of Ottawa’s warnings that Canadians should get their debts under control. Obviously, the federal debt grew under this scenario: to about 37% of GDP instead of 31% of GDP at the end of Harper’s tenure. That wouldn’t have been much of a burden; Canada’s debt-to-GDP was about 70% in the 1990s.
Poloz insisted this exercise had nothing to do with second-guessing choices made by previous governments. “We will refrain from evaluating the pros and cons of alternative policy mixes,” he said. But he does want to start a discussion about how central banks and governments interact. He told reporters after his speech that he hoped a few of the smart people in the room to dig into the questions he raised. One of those questions is the economic implications of high government debt versus high personal debt. Poloz’s research suggests there is a tradeoff: loose fiscal policy combined with higher interest rates leads to one, while tight fiscal policy and low interest rates lead to the other.
If we came to learn that excessive household debt posed a bigger threat to economic growth than does a certain level of government debt, then policy makers would want to take that into account when setting interest rates. They might also need to have a serious discussion with the finance department and the Prime Minister’s Office about what they should be doing at any given time. But for that to happen, the prime minister and the finance minister would have to be willing to listen. That didn’t happen in 2014 and 2015; that is, if you assume Poloz said then in private some of things he is now advocating in public.
Harper and his finance minister, Joe Oliver, were guided by ideology and politics. But they did leave those of us who prefer to be guided by research with a natural experiment of what could be wrought by a sub-optimal policy mix. “A better understanding of the medium-term trade-off of private sector versus public sector debt will be helpful in developing stronger guidance around the monetary/fiscal policy mix,” Poloz said in his speech. “No doubt, over the next few years in Canada, we will learn more about this trade-off at a practical level.”
Wonder if he had his fingers crossed when he said that?
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