Louis-Philippe Rochon is an associate professor at Laurentian University and co-editor of the Review of Keynesian Economics.
There currently exists a considerable degree of contradiction between fiscal and monetary policies that can only end up hurting the country's economy. The Bank of Canada and the federal government must better co-ordinate their policies to ensure that, at least, we don't fall back into recession, and even better, that we get out of our current stagnation.
The contradiction arises because on the one hand, monetary policy is expansionary. In theory, keeping interest rates low should help the economy expand. Think more consumer spending, more bank lending, more business investment.
On the other hand, however, fiscal policy remains inadequate and is having the contrary effect: It contributes to keeping the economy weak. This has been especially true for the past few years, while Ottawa was actively vying to balance the federal budget.
In other words, fiscal and monetary policies are out of sync.
And when policies collide, it is unclear what the net effect will be on the macroeconomy. This is why we need both policies in sync. This is particularly the case since monetary policy, on its own, is never able to be the driver of economic growth. Bank of Canada Governor Stephen Poloz has been hinting at this recently, strongly encouraging Prime Minister Justin Trudeau to prime our fiscal pump.
In reality, monetary policy is very uneven in its effects. This is because monetary policy is very asymmetrical. When interest rates are high enough, monetary policy can easily collapse the economy on its own. This has happened before, here and abroad. Sure enough, in wanting to combat inflation, central banks will repeatedly raise interest rates to the point where they will eventually contribute to slowing down the economy and inflation with it (if we are lucky, usually, it simply engineers a recession). It is a very ineffective way of fighting inflation, but it's how the central bank operates.
However, at low rates, as we have now, monetary policy is incapable of achieving liftoff without the help of fiscal policy. This is because private-sector investment, contrary to popular belief, does not respond simply to interest rates. Rather, it depends on aggregate demand and economic growth: While high growth encourages investment, a climate of low growth and high uncertainty is a recipe for disaster. And in these dark days of secular stagnation, companies have few reasons to embark on expensive and risky investment projects. So they wait for better times.
This is why lowering interest rates again is a misguided policy. Interest rates are already low enough, and lowering them even further – which the Bank of Canada will probably do anyway – will have zero effect on the economy.
While monetary policy has done all it can, what we need now is an injection of fiscal expenditures. Yet politicians are unable to grasp this rather basic fact. Take Europe, for instance. Although interest rates are very low, politicians still hold on to their cherished policy of austerity. But austerity depresses the economy, making a bad situation worse.
But it is important to understand how precisely fiscal policy works. When governments spend, they essentially transfer funds from the public coffers to the private sector, which then multiplies through the economy. In doing so, it helps to reduce uncertainty, and creates a positive environment for private-sector investment to flourish.
The problem with fiscal policy under Canada's new Liberal government is that it essentially committed itself to a mere $10-billion in spending. This is grossly insufficient. Most studies have said it will add perhaps half a percentage point to economic growth. It may be better than nothing, but barely.
To have a real impact, the government will have to take a hard look at the numbers. It will conclude that we need expenditures many more times the current projections to have a real impact. Only this way will the government have a chance of breaking the pessimistic mood that currently reigns in Canadian markets.
Mr. Poloz recently referred to John Maynard Keynes by acknowledging that markets are governed by "animal spirits." He is right. Keynes spoke of "bursts of optimism and pessimism," and we are living through a spectacular phase of pessimism.
To break this mood, we must co-ordinate monetary and fiscal policies, and the government must be prepared to spend on a large scale – much more than what it campaigned on. Yes, it will create higher deficits, but we must embrace them or continue to suffer the perils that come with an inadequate response to what is shaping up to be what International Monetary Fund managing director Christine Lagarde has called "the new mediocre."