The Deficit Battle and the Economic War

Evidence continues to mount regarding Canada’s lousy economic trajectory, and there is now a pretty broad consensus among Canadian economists that the economy was likely in recession in the first half of the year.  That’s not a sure thing, of course: we won’t know until September 1 if second quarter GDP grew or shrank.

Here’s my post from a month ago which set the odds at 60-40 of an “election recession.”  I think I’d put the odds slightly higher today, in light of recent negative numbers on investment, exports, and building permits.  On the other hand, it’s certainly not certain: there are contrasting data points, as well: housing starts were strong in June, and employment grew over the second quarter (if slowly).  Friday’s Labour Force numbers showed a big decline in private sector jobs and a small decline in overall jobs (although full-time jobs grew, as did hours worked).

So an official recession is not a done deal, and I am somewhat concerned that if the 2Q number turns out NOT to be negative, but rather weakly positive (or even just zero), the Tories will somehow try to claim “victory.”  That would certainly take the prize for most optimistic “glass is half full” interpretation of economic data in recent memory: because the mere fact that Canada is even flirting with recession (on the sixth anniversary of an economic recovery that has chronically disappointed) is a damning indicator of economic mismanagement.  For this reason I think we should be cautious about stating that a recession is underway; it may be likely, but it isn’t inevitable.

The federal government’s response to the bad economic news has been predictable.  First fallback: deny reality.  Finance Minister Joe Oliver initially unequivocally denied that a recession would occur (in this interview with CBC Radio’s The House).  In subsequent days he has softened his line somewhat, saying we’ll have to “wait and see” what the numbers say.  And just in case, Tory spin-doctors are already softening us up with words like “technical recession” or “short-lived recession,” trying to pro-actively discount the importance of a negative number on September 1.  This approach is offensive and will not, I suspect, convince many Canadians.  If this is just a “technical recession,” then Canada’s 2 million jobless (counting discouraged workers and involuntary part-timers) are just “technically unemployed.”

Second fallback: blame the rest of the world.  Prime Minister Harper did that on Friday, as reported by the Toronto Star.  Of course, if the economic numbers were good, the government would claim full credit.  (Just like they perpetually do with their claim to have created 1.2 million net jobs since the trough of the last recession.  They take credit for what the whole economy does, but never mention that within their own domain–federal public administration–employment has actually declined by nearly 50,000 positions since mid-2011. Remember, those are the jobs that they are actually in charge of, not the whole labour market.)  But when the economic numbers are bad, it is all someone else’s fault.  While they have generated lots of worrying headlines, I have a hard time seeing how recent turmoil in Greece and China has affected Canada’s GDP by a single dollar.  The oil price decline, of course, has had a meaningful impact: but while it reflects global forces, Canada’s decision to expose its national economy so fully to that single volatile variable was our choice, not the world’s.  The responsibility for Canada’s weak recovery since 2009, and our subsequent slip back into negative growth, is overwhelmingly ours.  World GDP, and most industrial economies, continues to grow; it is hardly credible to blame the world for our own uniquely weak performance.

Third fallback: strong fiscal policies will get us through.  Never mind the fading economy.  The Conservatives balanced the budget, and that’s what counts.  Yet in fact, the government’s vaunted balanced budget for 2015-16 is now in some jeopardy because of the weak economic numbers.  The budget was based on a 2% forecast of real GDP growth (the consensus of private sector forecasts in the pre-budget hearings).  Most of the standard contingency wiggle-room was stripped out of the budget to support the Finance Minister’s quest for the all-important zero deficit.  The government’s own numbers suggest a one-point shortfall in real GDP growth reduces the balance by $4.1 billion in the first year, and more in subsequent years (see pp. 375-76 of the Budget Plan).  So 1% growth this year (still optimistic, I suggest) would open up a $1.7 billion deficit (after deducting the planned $1.4 b surplus and the $1 b contingency fund).  Zero growth would cause a $6 b deficit.

In the grand economic scheme, a deficit incurred as the economy slows is neither surprising nor undesirable.  But the Tories’ commitment to deficit elimination, no matter what, is all about politics.  First, it justified the big “social engineering” tax cuts (income splitting, so-called child support, etc.) that they announced last year as the centrepiece of their re-election campaign.  (Recall, in 2011 they promised those would go ahead only if the deficit were eliminated; that core promise is now on very thin ice.)  And now it is the most important remaining evidence for their traditional claim to be the “best economic managers.”  The government’s elevation of deficit elimination to all-encompassing priority, and its damaging but inconsistent pursuit of that objective (with unnecessary and damaging cutbacks imposed just as the economy was slowing) should be forcefully critiqued — not the existence of a deficit in itself.

Most curious of all is the government’s implicit and sometimes explicit assumption that merely eliminating the deficit itself will spur macroeconomic recovery.  This, of course, goes against everything we all learned in Macroeconomics 101.  How does not having a deficit do anything to strengthen economic growth?  And if getting to zero deficit means big cuts in public spending and employment, then it will obviously harm growth.

For further arguments on the non-relevance of a deficit for economic growth, see my column for the Globe and Mail on Saturday.  It tries to explain, for the benefit of Mr. Oliver, exactly what is meant by the formula Y=C+I+G+(X-M).  Clearly, while the Conservatives claim (not entirely convincingly) to have won the deficit battle, it is losing the economic war.