There are two competing views on how economic policy should proceed in the coming year.
One view, led by the fiscal hawks, says that nothing is more important than eliminating budget deficits as fast as possible.
The other view says that the first priority must be to restore sustained economic growth and that without growth, the cuts necessary to balance budgets will be draconian.
This necessary debate is taking place at a time of pessimistic economic forecasts and even risks, as International Monetary Fund managing director Christine Lagarde has warned, of a repeat of what happened in the 1930s Great Depression.
“The outlook for the global economy in 2012 is clear, but it isn’t pretty: Recession in Europe, anemic growth at best in the United States, and a sharp slowdown in China and most emerging-market economies.” This is the grim view of Nouriel Roubini, the closely watched New York economic forecaster.
The problem is that we have not gone through an ordinary recession, where today’s near-zero interest rates would have triggered a return to growth-driving investment and consumption.
Instead, we are in what Richard Koo, the highly respected economist at Nomura Securities in Tokyo, calls a balance sheet recession. In a balance sheet recession, governments, households, financial institutions and businesses strive to reduce their debts so even if monetary policy drives interest rates to zero there is no increase in borrowing for spending or investment. The lack of borrowing explains the weakening of earnings by Canadian banks.
Unless government steps in, through fiscal policy, to make up for the lack of private spending, then growth will fall and countries can become trapped in a lost decade much like Japan experienced, Koo warns.
Yet in Canada, the federal, provincial and municipal governments are withdrawing stimulus and putting us on a path to slower growth.
“Fiscal stimulus is essential in keeping both GDP and the money supply from contracting during a balance sheet recession,” Koo says in a warning to resist the fiscal hawks. “Although shunning fiscal profligacy is the right approach when the private sector is healthy and is maximizing profits, nothing is worse than fiscal consolidation when a sick private sector is minimizing debt.”
One form of fiscal stimulus that would help now is to boost incentives to business to invest.
Right now, Canadian non-financial corporations are sitting on about $490 billion of cash and highly liquid investments. In the U.S. the number is about US$2.1 trillion.
“Such incentives, which may include investment tax credits and accelerated depreciation allowances, should be exceptionally generous in order to attract private sector attention,” Koo argues.
Governments can provide direct support as well, for example in Canada through new funding for the Industrial Research and Assistance Program, which helps small and midsize companies innovate.
Governments can also invest heavily in infrastructure projects, either directly or through public-private partnerships. And governments can offer tax incentives to companies to put some of their profits into venture capital pools to help cash-hungry innovative entrepreneurs.
Bank of Canada governor Mark Carney has also warned that the process of deleveraging poses great risks to the economy. There are, he says, only three ways to reduce government deficits and debt — restructuring, inflation or growth.
“The most palatable strategy to reduce debt is to increase growth,” he argues.
But Canadian households have too much debt, he argues, so they should not be borrowing more to finance consumption. “Canadian households are now more indebted than the Americans or the British,” he says, so should be saving.
This leaves the business sector, with its $490 billion of cash or cash equivalents. Companies should be investing heavily, Carney says, to improve their productivity and expand their market reach into emerging economies such as China, India and Brazil.
“Canadian companies, with their balance sheets in historically rude health, have the means to act — and the incentives,” he says, delivering a jaw-boning message similar to the one Finance Minister Jim Flaherty has been sounding, yet which has been falling on deaf ears.
But as Koo argues, in these extraordinary times, this will require more incentives and continued fiscal stimulus until the economy is on a much firmer growth path for restoring balanced budgets and putting public debt once again on a downward path.
But the first order is to generate the growth and employment that will provide the tax base and the room of for fiscal restructuring.
The fiscal hawks, in the meantime, should cool it.
Economist David Crane is a syndicated Toronto Star columnist. He can be reached at crane@interlog.com.