Philip CrossThe economy continues to struggle to shift the engine of growth from debt-financed spending to exports and investment, writes Philip Cross.

By Philip Cross, Nov. 3, 2017

The unexpected upturn in the Canadian economy in the first half of 2017 helped to significantly lower the federal government’s projected deficit. The question is whether higher economic growth is self-sustaining. The federal government credits its fiscal stimulus for improved growth. In reality, the government’s forecast of slower growth next year acknowledges that the upturn reflected a happy constellation of one-time events, notably Toronto’s booming housing market, the end of the bloodletting in Alberta’s oilpatch and inventory building in the auto industry. Statistics Canada, reporting on Tuesday that the economy shrank slightly in August by 0.1 percent specifically cited weakness in manufacturing and oil and gas (economists had projected 0.1 percent growth).

Last week’s fiscal update contained several contradictions. It argues that improved growth is on a sustainable path thanks to deficit spending, but then “doubles down” (in Finance Minister Bill Morneau’s words) for more fiscal stimulus with an expansion of the Canada Child Benefit and a cut to the small-business income tax rate — Morneau’s belated way of showing, at taxpayers’ expense, that he’s sorry for the fiasco surrounding small-business tax reform. If the underlying trend of growth was improving, the economy would not need the increase in the projected federal deficit from $17.8 billion this year to $19.9 billion and $18.6 billion in the next two years. Even with the stimulus, the government forecasts growth will slow to 2.1 percent in 2017 and 1.6 percent in 2018, an outlook confirmed by the Bank of Canada. So much for the efficacy of stimulative deficits.

One reason higher growth is not sustained in the government’s outlook is that the economy continues to struggle to shift the engine of growth from debt-financed household and government spending to exports and business investment. Increasing child tax benefits does not help this transition, especially when investment is being deterred by reports that NAFTA talks are floundering. In a recent interview, Bank of Canada Governor Stephen Poloz confirmed the bank has lowered its investment outlook as firms shift spending to the US.

The economy continues to struggle to shift the engine of growth.

The government attributes last year’s lower deficit to the boost incomes received from its stimulative policies. To assert that higher growth and a lower deficit were in response to fiscal stimulus means subscribing to the Laffer Curve premise that fiscal stimulus can pay for itself. No economist seriously believes this idea, three decades after it was first advanced. The lower deficit was the temporary result of the one-time factors that boosted growth, as well as difficulty in getting more infrastructure spending out the door. Windfall income gains should not be squandered on a structurally higher fiscal deficit. It is like a household winning the lottery and then spending so much that its debt load still rises.

Followers of macroeconomic policy-making were treated to a rare double header last week, with the fiscal update on Tuesday followed Wednesday by the Bank of Canada’s decision to leave interest rates unchanged. The decision to stop hiking interest rates is curious. The grand bargain of macroeconomic policy-making that the bank has offered for years was that excessive reliance on monetary stimulus would be withdrawn if fiscal stimulus were increased to take on some of the burden of supporting growth. For two years, we have had a marked move to fiscal stimulus, but only a tentative reining in of monetary stimulus. The bank declined to further increase interest rates last week despite higher federal budget deficits, leaving it to regulators to cool the overheated housing markets in Toronto and Vancouver.

It is not clear regulation alone will be enough to dampen the housing market without further increases in interest rates.

It is not clear regulation alone will be enough to dampen the housing market without further increases in interest rates. All levels of government took co-ordinated actions to slow both the Vancouver and Toronto markets over the last two years, with only small and temporary effects so far. The federal Office of the Superintendent of Financial Institutions evidently felt further steps are needed, as it recently tightened the conditions for banks lending to mortgage applicants. So far, several rounds of tightening the regulations for mortgage approvals have had the effect of driving more people into the murky world of unregulated mortgages, often without insurance. More fiscal stimulus, continued low interest rates, and a shift to unregulated mortgages increase risk in the financial system.

Why raise interest rates if the underlying trend of growth is not substantially higher? Because of the encouragement low interest rates give to risky behaviour, as we now see in the housing market and, less visibly, in public sector pension plans, that may damage Canada’s long-term growth much more than the short-term impact of higher interest rates. The underlying problem was highlighted by a recent survey that nearly half of Canadians (especially millennials) are already feeling pinched by this year’s half-point increase in interest rates. We have a generation of young people entering the housing and financial markets with no experience with anything but ultra-easy monetary policy who are in for a shock when interest rates start to normalize.

The wonder is why, given years of ultra-easy monetary policy and now two years of fiscal deficits, growth isn’t stronger than the mundane rates of two percent or less the government projects over the next two years. An even bigger question is, what will policy-makers do if Canada is hit with a shock such as the termination of NAFTA or the bursting of the housing bubbles in Vancouver and Toronto, to name only the most obvious threats. It is in response to such shocks that stimulus is needed, not when the economy is posting steady but uninspiring growth.

Philip Cross is a Munk Senior Fellow at the Macdonald-Laurier Institute.

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