Posted: 31 Mar. 2020 5 min. read

No one cares about January and the fiscal legacy of near-unlimited stimulus

  • Statistics Canada’s latest release of monthly real GDP by industry reported that the Canadian economy expanded by 0.1 percent in January, with growth in 12 of 20 sectors – and no one cares. Although interesting, the releases highlights the lagged nature of many of our key economic indicators.  Regardless of how the economy performed in February, we know that a deep contraction took hold in March as containment efforts to fight the pandemic were imposed.  Moreover, oil prices have plunged since January creating a massive blow to the energy sector.  The one take away is that the Canadian economy was already relatively fragile before the pandemic.  After a meagre gain in Q4 2019 of 0.3 percent annualized, the economy was growing slowly before conditions took a huge turn for the worse. 
  • Many forecasters are still struggling to assess the degree of economic decline.  The reason is that we have never seen such conditions before. Economic models are not useful, because they are based on historical relationships. The plunge in activity reflects policymakers putting the economy in a coma in order to stomp out the spread of the virus.  Oxford Economics is estimating that 64 percent of global GDP is subject to lockdown.  All we can do is look at what is still in operation and its activity, then assess the loss of other activity based on shares of employment and output.  Then add on the impact of the oil shock.  The consensus is that the Canadian economy contracted about 3.8 percent annualized in Q1 – we think it is closer to 5 percent.  Then there is a range of forecasts for Q2, but all are in the double digits and the average is about -22 percent.  That is more than four times the worst quarter in 2008-09. The number at this point doesn’t matter.  It is huge. 
  • As we have discussed in past notes, the monetary and fiscal policy response has been unprecedented.  On average across G-20 nations, the fiscal stimulus announced so far looks to be around 10 percent of GDP.  Think about that for a moment.  When we discuss quarterly growth numbers it is done in annualized terms.  So, if the economy contracts by almost 30 percent annualized in the first half of the year, we are talking about 15 percent in non-annualized terms.  The fiscal stimulus is equal to about two-thirds the value of that contraction.  Assuming that a recovery starts in the second half of this year – again, in line with the consensus, the Canadian economy will contract by 4-to-5 percent, but it would have been almost triple that without the fiscal stimulus.
  •  At this stage, the bulk of the economics community have become dedicated Keynesians – a school of economic thought based on the works of John Maynard Keynes. His works included how government intervention could temper recessions and his theories incorporate lessons from the Great Depression. My view is that policymakers are responding correctly – deal with the stimulus today and deal with the deficits tomorrow.
  • It is natural to wonder how governments will pay for this globally.  There is a question of whether there could be a fiscal crisis after the recovery is underway. Canada had a much better starting point than other governments and ballpark estimates of fiscal cost suggest that the federal government can afford this. Some provinces will be in tougher shape.  Oil-leveraged provinces face enormous challenges – people will immediately think Alberta but this is an even greater fiscal problem for Newfoundland and Labrador.  Quebec had an elevated debt level pre-crisis but was running a balanced budget, so it should weather the storm.  Ontario’s fiscal position was worrying, but even if it receives credit rating downgrades after the crisis, it is a necessary cost to bear to support the economy during such an acute recession. And, sovereign credit ratings will be raining downwards in the months to come.  My main concern is governments abroad. America’s fiscal balances will be terrible but it holds the world reserve currency, the UD dollar, and investors will likely still buy US Treasuries.  Europe is a bigger concern, and this leads to memories of the fiscal crisis of 2010-2013.  That financial event escalated until 2013 when the ECB defused the crisis by saying it would do whatever it takes to preserve the euro.  The European fiscal risks are leading some governments (France, Spain and Italy) to consider issuing coronabonds (like war bonds) that could then be bought by the ECB.  In my mind central banks will play a key role post crisis in helping governments financially afford their fiscal balances.  In some cases central banks will be by buying government debt, but it will certainly involve keeping interest rates low for a very long time to keep debt financing costs low.  The pandemic-induced recession is chapter one of this story, the legacies – including the fiscal mess – will be chapter two.

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