Why federal fiscal spending could change the rules for the Bank of Canada: Don Pittis

The world's central banks have so far failed miserably at pushing global economies back into inflation and growth.

As Bank of Canada governor Stephen Poloz once again holds interest rates steady, there are many who now insist that despite certain risks, pumping up fiscal spending in the upcoming federal budget must do what central banks cannot — shake the somnolent world economy out of its torpor.

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At the core of the pro-fiscal-spending argument is the fact that global economies simply haven't responded the way central banking theory says they should.

Not working

Cutting interest rates is supposed to make borrowing cheap, thus convincing businesses to go out and borrow, using that money to invest in new entrepreneurial ventures, new factories and new equipment, sending the economy into a fresh round of growth.

Not only did low interest rates fail to do the job, radical strategies meant to release even more money — namely quantitative easing and negative interest rates — have not worked either.

There are a number of theories about why low rates have not worked, including a glutted supply chain caused by zombie companies and something called the liquidity trap.

But apart from the beggar-thy-neighbour effect of pushing the value of currencies down at the expense of trade partners, making money cheap has not boosted economies. It has not stopped disinflation and deflation.

Low rates have made it easier for the better-off to borrow, driving up the price of assets such as houses and shares. And it has done little to stimulate job-creating business investment, according to Scott Aquanno, a lecturer at the University of Ontario Institute of Technology and research fellow at the Munk School of Global Affairs.

'I'm good'

Offered money at zero or even negative real interest rates, the response from business is "No thank you, I'm good," says Aquanno, one of many advocates for higher inflation stimulated by fiscal spending.

Of course not everyone agrees. I am one of those who have warned in the past about the danger of increased deficits, burdening future taxpayers with overwhelming loads of debt.

But rather than repeated rounds of higher and higher government borrowing, a new burst of government spending could be seen as a one-time fiscal boost, sucking up excess capacity in various parts of the economy and shaking off the damaging effects of deflation.

To be effective, several important conditions have to come together.

Even large government fiscal measures cannot alone relaunch an economy. However, last week's encouraging job-creation figures from the United States are a sign that Canada's jobs numbers, out this Friday, may not be as bad as some have feared.

Despite the loss of high-paying jobs in oil and other resource-based sectors, stronger job creation in services and non-resource industries — the median prediction by economists is the creation of 10,000 jobs, with the unemployment rate unchanged — mean that a burst of fiscal spending would not be creating jobs from scratch.

It merely needs to tighten up the supply of labour.

Inflation expectations

Another necessary condition is that once inflation kicks in, Canada's central bank does not immediately raise interest rates to put on the brakes and stop it dead in its tracks at the two-per-cent target. Instead it must let inflation expectations rise.

Even if the Bank of Canada cannot create inflation, once created, it has the tools to let inflation rise. Even under the previous Conservative government, Poloz mooted the possibility of raising the target rate in consultation with the federal government as soon as this May.

The third condition is that labour laws must permit or even encourage workers, especially those in the private sector, to organize and bid up their wages.

So long as the job market remains relatively tight, proponents of the inflation-boost strategy say it will be good for the wider economy, increasing spending power by putting money back into the hands of those most likely to spend it. 

Not only that but as Sarah O'Connor recently reported in the Financial Times, some economists think raising wages will increase productivity by forcing employers to invest in labour-saving technology. The example O'Connor uses is automated supermarket shelf pricing, employed in high-wage France, but done by hand in low-wage Britain (and Canada).

Aquanno says the problem we are now facing is that potential investment money is sitting on the sidelines because businesses, quite rationally, realize demand for goods is weak.

"What governments can do to jumpstart the economy is to invest in people and in infrastructure," says Aquanno, who says inflation could rise as high as 10 per cent without hurting the economy. "Then people will use that money to buy goods and that signals to business to invest."

Aquanno admits there is a danger that things could go wrong and that the federal government could find itself out of step with other world economies or in conflict with domestic political interests. But he thinks that risk is small. 

"Even if there is a little bit of risk, there's a tremendous amount of social, political and economic risk to the status quo anyway."

Follow Don on Twitter @don_pittis

​More analysis by Don Pittis