Smoothing out the wrinkles in the business cycle

Ron Kneebone All economies suffer the consequences of temporary booms and recessions. Recessions leave resources unemployed while booms spark periods of inflation which distort price signals and so lead to misallocations of resources. Western Canadians have been made acutely aware of these problems as they cope with fluctuating housing prices and soaring construction costs during the recent boom sparked by extraordinarily high commodity prices. Most can also recall the consequences of low commodity prices during the 1980s.

The same high commodity prices that have sparked a boom in western Canada have also resulted in an economic slowdown in central Canada. But twenty years ago the economy of western Canada was in recession while central Canada was enjoying a strong economic expansion. The fact that the economy of western Canada often moves in the opposite direction of central Canada produces a difficult problem for the federal government and for the Bank of Canada: To which economic problem – the boom in western Canada or the recession in central Canada – ought national fiscal and monetary policies respond?

Unfortunately, monetary policy – the setting of interest rates and policies with respect to the exchange rate – is unable to simultaneously aid a recession-bound regional economy and an over-heated regional economy. This is because the tools of monetary policy – interest rates and the exchange rate – are applied equally in all regions of the country. In an economy like Canada’s, the central bank can either promote a monetary policy appropriate for one region to the detriment of others or, what has in fact been the experience, promote a monetary policy that is not fully appropriate for any region.

This difficulty of monetary policy makes it important that federal and provincial fiscal policies exert a strong and appropriate influence. Fortunately, most of the impact of government budgets on our pocketbooks is felt through what are known as “automatic stabilizers.” Thus, the amount of tax we pay increases and decreases automatically when our incomes rise and fall and we become eligible for Employment Insurance and social assistance when we lose our jobs. As a consequence of these automatic stabilizers, the federal government’s budget does a very effective job of stimulating provincial economies that have slipped into recession and putting the brakes on economies that have become over-heated.

While income stabilization from the national level has been surprisingly effective in western Canada, provincial government budgets have exerted a significantly smaller stabilizing influence. One reason for this is that provincial governments have tended to introduce instability into their economies via their policies with respect to transfers paid to local governments. Provincial governments have fallen into the habit of decreasing grants to local governments during economic downturns and increasing them during strong expansions. This instability of financing has long been a bone of contention for local governments.

Another reason for provincial governments being less able to stabilize their economies is the fact it has become a mantra for governments to avoid budget deficits; to avoid spending in any year more than they receive in revenue. But during a recession governments find it is difficult to collect sufficient revenue to pay their bills and so find it difficult to avoid budget deficits. This problem is especially acute in western Canada because our economies are so heavily reliant on volatile world commodity prices – prices for oil, gas, grain, potash, and forestry products – and falls in those prices can be sudden, unexpected, and large.

To avoid deficits even during recessions, provincial governments have chosen to maintain higher tax rates and lower levels of spending than would be necessary if they allowed their budgets to slip into deficit during periods of relatively weak economic performance. Our governments respond in this way because we scold them should they run a deficit even when, through no fault of their own, they suffer revenue losses due to falling world commodity prices.

A sensible policy is to lower tax rates and/or increase spending on worthwhile projects and allow deficits to occur during recessions. This is a standard recipe for economic success long advocated by economists and with appropriate safeguards there is no reason that it should put us on the slippery slope to debt accumulation such as we saw in the 1970s and 1980s.

What is required is for voters, who regularly increase and decrease their savings during good and bad times, to recognize that the wisdom of this behaviour applies to their governments as much as it does to them.

Ronald Kneebone is a Professor of Economics and Director of the Institute for Advanced Policy Research at the University of Calgary. His paper, “National Stabilization Policy and its Implications for Western Canada,” can be downloaded at no charge from the Canada West Foundation (www.cwf.ca).

Keywords: Ron Kneebone, economy, boom and bust, commodity prices, monetary policy, income stabilization, provinces, deficits, lower taxes, increase spending, economic success

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