Monetary vs. fiscal policy

A three-quarter-point cut in the Bank of Canada’s overnight-rate target, while it came as no surprise to the capital markets, was a drastic measure. To those used to quarter-point adjustments, such a radical loosening of monetary policy spoke volumes about the way the Bank sees the economy moving.

It would be wrong to call it desperation: shifting the bank rates lower signals confidence in the currency, for the Bank is the guardian of the U.S.-Canadian exchange rate, and also signals unconcern with inflation, for the Bank’s record of hitting inflation targets is well-established. But there is definitely another signal in the rate cut: the Bank thinks we are in a recession.

The Bank is doing what central bankers do when they face an economic slowdown. They open the doors and do their best to shovel some money out. Over the past fifteen years or so, the central bankers of the major industrialized countries have done a good enough job of maintaining economic growth that some people even claimed that the business cycle had been “tamed.”

That was unduly optimistic, as the bursting market bubbles of the late 1990s showed us all, but at least we can look at monetary policy as showing the best record against inflation and recession. It certainly has a better batting average than fiscal policy.

So the proponents of tax cuts in both Canada and the United States can drop several pages out of their prepared text. No, you ain’t gonna cure this recession by cutting taxes, any more than you would have by pumping up spending.

And the current tax-cut plan in the United States — sold by the Bush administration as a recession-fighting program — is probably bad medicine even in bad times.

In the early 1960s, the United States had a fierce tax burden in the upper brackets, and a recession. Tax cuts by the Kennedy administration, often held up as an example of the good that fiscal policy can do for a receding economy, did, indeed, help to bring the United States out of that slowdown. (Monetary policy helped too, though; and in Canada, which shared heavily in that recession, rate cuts and a willingness to allow the Canadian dollar to sink were the main reasons we got out from under it.)

The difference was that the Kennedy government’s tax cuts were front-loaded. Investors that wanted to benefit from them had to invest right away, because each year the effective rate was scheduled to creep up. They were an incentive to invest immediately.

The Bush tax cuts, on the other hand, increase over time, and peak in nine years. Thus a delay in capital investment — to a later time when larger tax cuts provide additional liquidity, lowering the cost of capital — is economically rational. Future tax cuts are an incentive to defer investment.

Yet even the most pessimistic forecasts don’t see a recession lasting until the biggest tax cuts kick in. For example, Warren Buffett made a discreet show of despair last August, when the Daily Telegraph reported he was privately predicting an eight-year slowdown.

So what tax cuts on the Bush pattern are likely to do is postpone investment and economic growth — precisely the opposite of what the Bush government has said it intends. Moreover, the effect of the cuts on government finances, particularly with increasing spending looming, pushes long-term interest rates higher. That, in turn, pushes the long-term cost of capital up and brings the economy into Keynes’s classic condition for recession: that it be better to save than to invest.

Fiscal policy such as that leaves the Federal Reserve desperately priming the monetary pump at the same time that the Treasury is over at the next well drawing the water table down.

There are a lot of budgets, both here and in the United States, to be tabled between now and the end of the decade. It would be best if those budgets helped, rather than hindered, the monetary efforts of the central bankers.