The following paper was Commissioned by the Canadian Security Intelligence Service (CSIS) for Her Majesty the Queen in Right of Canada, as part of the 2014 CSIS Academic Outreach program titled Of Threats and Opportunities Exploring Canada’s National Security Interests in 2025 The Global Economy and Canada’s Place in It.
In a repeated, premature rush to declare the crisis over, the world is serially misreading the distinctions between short-run and long-run economic imperatives. National short-run stimulus efforts, while bold, have been unduly curtailed by long-run concerns about inflation and sustainability; as a result, these initiatives have been insufficient to push many advanced economies on to a path of ongoing growth. At the same time, global efforts to coordinate action on long-term, structural reforms have tended to unravel as countries and companies have pursued narrower, local short-term interests. As a result, there is a risk that short-run stagnation will be turned into a chronic condition that, by 2025, would leave the global economy on fundamentally unstable long-run ground.
A decade of middling domestic economic performance, weak global demand and mounting instabilities would have profound implications for life in Canada and its interests abroad. As a small, open, resource-exporting economy, Canada is particularly exposed to international policy mistakes. And at home, a decade of stagnation would likely fuel citizen detachment from the state, reducing the latitude for Canada to act boldly on the global stage.
This paper outlines how timidity in the short run and insufficient collaboration in the long run threatens to create persistent stagnation over the next decade. It also highlights some national strengths and weaknesses on which Canada could focus to transform some of these threats into opportunities.
I. We need a more stimulated short run
The withdrawal of monetary stimulus is premature
The February 2014 G20 communiqué underscores that the global economy remains sluggish, fragile and vulnerable to shocks. The nascent recovery underway is fundamentally driven by policy-makers and their stimulus efforts.
At the outset of the crisis in 2008, economic authorities worldwide reacted with swift and radical action. But since then, the world’s dismal scientists have uncharacteristically erred towards too much optimism in anticipating the end of the crisis. Stimulus efforts have been prematurely curtailed. Worldwide, there is a tendency to overweight signs of improvement and underweight indications of continued stagnation.
The US Federal Reserve is now in the midst of its third attempt to withdraw from quantitative easing (QE). Central banks in, inter alia, Europe, China, Australia and New Zealand have also allowed monetary conditions to tighten. In the UK, forward guidance was undone by falling unemployment.
After only a few months of tightening, macro-indicators are already recording weaker prints. Inflation continues to decline in many advanced markets. This shouldn’t be a surprise: balance sheets are still impaired, corporate deleveraging still has far to go, household deleveraging has not begun, excessive cash reserves are high, credit growth is weak, investment is constrained and employment is low. The implementation of Basle III’s enhanced bank capital requirements implies a further brake on near-term credit growth.
It is possible that the world has slipped into a ‘QE trap’: every time real economic indicators tick upward and the prospect of reduced monetary stimulus is discussed, market yields back up, monetary conditions tighten, and the circumstances that would allow for the withdrawal of exceptional monetary stimulus disappear.
The spectre of deflation is still with us
In fact, prices in many countries are signalling that the world is still enmeshed in the crisis. Although inflation recently edged up in Canada, this is an anomaly: in the US, Japan, UK and Europe, inflation rates continue to decline.
Monetary policy has virtually no additional room to move: nominal interest rates cannot be pushed below zero, and neither can real interest rates if deflation sets in. Forward guidance could be adjusted and inflation targets raised, but neither appears likely to have much impact in the short term.
Short-run monetary impotence has long-term implications. Unexpectedly low inflation produces an effective increase in real interest rates. Savings become more valuable, so consumers and companies sit on their cash and wait for prices to fall. Debts become more burdensome, cash-constrained borrowers get knocked closer to bankruptcy, productive capacity gets lost and unemployment remains persistently high.
Fiscal stimulus and structural reform: time for more
Monetary policy has been stretched to its limits in advanced economies. These countries need to return to fiscal stimulus and structural reforms to generate growth and put themselves on a long-term path to sustainability. With interest rates at historic lows and inflation weak, the prospect of public borrowing crowding out the private sector appears non-existent. And yet, fiscal policy in most advanced economies has been tipped toward austerity. Hard, medium-term fiscal targets were Canada’s signature 2013 G20 issue.
Granted, debt ratios across the industrialised world have increased since 2008 by 30 percentage points to around 105 percent of GDP. Such a big ramp-up in advanced country debt happened only twice in the 20th century, both times fuelled by wars; post-conflict growth recoveries quickly brought debt ratios down.
It seems obviously paradoxical, but advanced countries are likely going to have to borrow more to get these debt burdens down. If the industrialised world is in anything close to a QE trap, then low interest rates will not stimulate growth enough to reduce debt-to-GDP ratios. If exceptional monetary stimulus continues to be withdrawn, effective interest rates could move higher than GDP growth rates, worsening debt dynamics further. Demographic pressure on spending and tax bases from ageing populations will only make this dilemma more difficult in coming years. By 2025, advanced economies could be faced with average debt burdens of 150 percent of GDP, on par with today’s Greece; wide-spread and potentially destabilising restructurings would become likely. Fiscal stimulus, investment and structural reforms focused on enhancing productivity and growth appear to be the only way to create a virtuous path toward long-run debt sustainability.
Canada has an opportunity to point the world away from a long, slow slide to 2025. Having introduced inflation targeting, the country can lead the charge to keep monetary policy loose—perhaps by replacing inflation targets with price-level or growth targets, even on a temporary basis. Having retained its triple-A credit rating throughout the crisis, Canada has the credibility to advocate for looser fiscal policy. Canada is said to have—rightly—played a key role in brokering the February 2014 G20 commitment to boost global output by US$2 trillion over the next two years. Now it needs to make sure it happens.
II. We need a more collaborative and engaged long run
We all need to chip in
Focused structural reforms are needed over the medium term just as critically as increased fiscal stimulus in the short term—to raise growth and to maintain social cohesion in Canada and abroad.
The spike in joblessness touched off by the 2008 crisis has masked a secular decline in employment across many industrialised and emerging countries that began in the 1990s and has taken employment-population ratios down to their lowest levels in decades. This is not just a by-product of crisis-induced weaknesses in labour demand, but rather a supply-side issue: too few people have the right incentives to work, and an ageing workforce only makes this problem more acute. Taxes, entitlements and pensions need to be reformed to encourage people to accept employment and to facilitate women’s labour-market participation. Having made substantial reforms to the Canada Pension Plan and Old Age Security, Canada can help other economies undertake structural reforms to increase incentives to work.
More inclusive growth
In 2012, the World Economic Forum highlighted severe income inequality along with chronic fiscal imbalances as the most likely risks of the next decade. Across many advanced economies, these risks have already been realised. In Canada, the inequality gap is amongst the widest of its industrial-economy peers, owing in part to the fact that Canada’s tax and benefits systems do relatively less to mitigate this spread compared with other advanced countries.
jobs that carry far less generous pensions. As a result, they are less likely than their parents to identify themselves as members of the middle class.
Recent IMF (2011) research has found that inequality tends to be bad for growth. In fact, the IMF has argued the recent global financial crisis “may have resulted, in part at least, from the increase in inequality.” As inequality rises, the poor borrow to maintain their consumption patterns, which deepens macro-vulnerabilities. Severe inequality leads to underutilization of skills and capabilities, increased social and political instability, and reduced foreign investment. Corak (2013) has demonstrated that countries with higher inequality also suffer lower income mobility.
As younger generations move in to the electorate, the political pressure to address inequality and mobility issues will increase.
A stronger partnership with emerging markets
The year 2013 was to have been the first year in which emerging markets would account for more than half of global growth and world-wide production, but they got side-swiped by the Fed’s taper and sagging Chinese commodity demand. Commentators have tended to blame the victims, arguing that the worst hit emerging markets are those that wasted years of easy access to advanced-economy capital by accumulating big current account deficits rather than investing in structural reforms.
There are two problems with this line of analysis: first, it is needlessly antagonistic to the emerging partners Canada and other advanced countries will need to buy their debt and sustain developed-market growth in the years to come. Forty percent of the companies in the S&P500, for instance, are critically dependent on demand from emerging markets. Excluding China, emerging markets are running a cumulative current account deficit of around US$250bn that they have largely spent on advanced country exports.
Second, this line of argument is not supported by data. Since the outbreak of the crisis, historical determinants of capital flows have broken down and capital has tended to flow back and forth between developed and emerging markets in lock-step, driven almost wholly by impressions of global risk. Eichengreen and Gupta (2013) show that fundamentals in emerging markets have not provided insulation from these whipsaws.
Even worse, relatively large and liquid emerging markets have tended to experience more pressure because international investors can move in and out of them easily. In short, there is a penalty for success, which has prompted several emerging countries to press the IMF to soften its opposition to capital controls. In 2011, they succeeded. If this continues, international capital markets will simply become more fragmented, and global growth prospects will be put under greater pressure.
More flexible and effective international institutions
Emerging markets missed a chance during the crisis to renew our multilateral institutions. They held enormous leverage: Europe desperately needed fresh capital and emerging markets held about two-thirds of global foreign-exchange reserves. In return for financing Europe, emerging countries could have insisted on deep reform of the IMF, the World Bank and the WTO. Through the G20, they negotiated in 2010 increased voting power and more IMF Board chairs, as well as more resources for the Fund; however, they did not seal US Congressional ratification of this deal, and it remains in limbo.
The whole world loses if emerging markets are penalised for failing to seize their moment. Most immediately, the IMF will remain too small to be an effective firefighter. Many of the IMF’s lending arrangements since 2008 have been so large that the Fund has had to override its own credit limits. The implication is stark: if industrialised countries stumble in the years ahead, the IMF doesn’t have the resources to pick them up. There is no lender of last resort.
Both advanced and emerging market countries are already engaging in costly self insurance—by accumulating inefficiently large foreign exchange reserves, by creating standing swap lines between their central banks, and by creating regional alternatives to the IMF. While individually, each of these initiatives may help protect a particular sovereign, together they make the entire international system more prone to volatility. With the prospect of more advanced country debt restructurings in the years to come, the world needs a proper process for sovereign crisis resolution.
Canada has a seat at all of these policy tables. It should use these chairs to drive reform.
III. Concluding remarks
The next ten years present a multi-layered set of macroeconomic challenges for Canada and the world that will need to be addressed concurrently. In the short run, enough stimulus needs to be provided to get national and global economies to take-off velocity. At the same time, economic authorities need to begin engineering the conditions to sustain this growth over the long run. Finally, our international institutions need to be renewed to keep them legitimate and effective.
Works cited
Berg, Berg and Jonathan D. Ostry (2011). “Equality and Efficiency.” Finance and Development, 48(3), September. Washington, DC: International Monetary Fund, p. 13.
Corak, Miles (2013). “Income Inequality, Equality of Opportunity, and Intergenerational Mobility.” Journal of Economic Perspectives, 27(3). Pittsburgh: AEA, pp. 79-102.
Eichengreen, Barry and Poonam Gupta (2013). “Tapering Talk: The Impact of Expectations of Reduced Federal Reserve Security Purchases on Emerging Markets.” Unpublished paper. Berkeley: University of California (Berkeley).