Canadian Public Policy

The Environment for Canadian Fiscal PolicyAuthor(s): John GrantSource: Canadian Public Policy / Analyse de Politiques, Vol. 2, No. 4 (Autumn, 1976), pp. 616-620Published by: University of Toronto Press on behalf of Canadian Public PolicyStable URL: http://www.jstor.org/stable/3550202 .

Accessed: 18/06/2014 20:06

Your use of the JSTOR archive indicates your acceptance of the Terms & Conditions of Use, available at .http://www.jstor.org/page/info/about/policies/terms.jsp

.JSTOR is a not-for-profit service that helps scholars, researchers, and students discover, use, and build upon a wide range ofcontent in a trusted digital archive. We use information technology and tools to increase productivity and facilitate new formsof scholarship. For more information about JSTOR, please contact support@jstor.org.

.

University of Toronto Press and Canadian Public Policy are collaborating with JSTOR to digitize, preserveand extend access to Canadian Public Policy / Analyse de Politiques.

http://www.jstor.org

This content downloaded from 195.78.108.81 on Wed, 18 Jun 2014 20:06:15 PMAll use subject to JSTOR Terms and Conditions

Views and Comments/Commentaires

The Environment for Canadian Fiscal Policy

JOHN GRANT* / Wood Gundy Limited, Toronto

This is a time when it is more important to recognize similarities in national economic policies than differences. The nations of the OECD, having finally vaulted themselves (mostly) out of the recession of I975, are evidently in a new mood of caution, and this will probably dominate their strategy through

I977. The common thrust consists in keeping consumption and public sector expenditures under a tight rein, providing some slackness in resource use to mitigate inflation, and making room for private investment growth in order to provide a foundation for a gradual but sustainable growth in living standards. Canada's current policies are, on the whole, typical of this common approach. However, the strategy carries some political and social risks. Our own varia- tion appears to have more ambitious aims than most, and carries a few unique risks too.

The common risks are clear enough. The strategy sacrifices output and employment in the near term for the sake of a more stable expansion path. It makes room for private investment, but cannot guarantee that the investment will expand rapidly to fill the gap. Since it does not pull the inflation rate down quickly, it provides no obvious short-term 'successes' to offset its short-term costs.

In Canada, the Government appears embarked on a rather more stringent course than many, with the aim of reducing the huge current-account deficit in the balance of payments that opened up in 1975 when we borrowed our way around the world recession. But the unique component of Canadian policy is certainly the Anti-Inflation Act, whose regulations, controlling both wages and profit margins, are both far-reaching and difficult to assess. The Act is partly a legacy from the Prices and Incomes Commission of 1971 which, when it was dismantled, fathered a group in the Department of Consumer and Corporate Affairs charged with designing an incomes policy suitable for use in an eventuality such as 1975's inflationary spiral.

Monetary policy in Canada, although it wears a new 'monetarist' face, is * Dr. Grant is Director and Chief Economist, Wood Gundy Limited

This content downloaded from 195.78.108.81 on Wed, 18 Jun 2014 20:06:15 PMAll use subject to JSTOR Terms and Conditions

Views and Comments/Commentaires / 617

not necessarily up to new tricks. Fiscal policy, as exemplified by the May Budget, studiously avoided any initiatives which would be described as new and different. It is as if Ottawa has shot its innovative bolt for the moment with the Anti-Inflation guidelines, and, given the heavy drain of skilled economists and accountants to the Anti-Inflation Board to administer the Regulations, this may be a realistic assessment.

In announcing the Anti-Inflation guidelines last fall, the Government an- nounced a target of a four per cent inflation rate by I978. Nothing it has done since then suggests that its intentions have changed. The environment in which policy is made does change, however, and one of the key questions a forecaster asks himself today is whether to assume that the Government will stay with this target (or, more to the point, what could happen that would cause a revision). The concentration on inflation-fighting at this stage of the cycle, in the face of an unemployment rate greater than seven per cent, has already surprised some observers. The astounding inflation explosion of 1973-75 passed its crest at least eighteen months ago. The major price in- creases now being felt in Canada represent either lagged pass-throughs of previous cost increases (as in the case of property tax rates and insurance premiums) or administrative decisions (as in the case of energy prices). Although some commodity prices have moved up sharply, it is too early to say that either the world or the Canadian part of it has re-embarked on another boom. But there is a very widespread recognition by central bankers and by governments that overly-expansive monetary conditions were central to the price explosion of 1973. Some European governments, recognizing this, nonetheless resorted to stimulative measures in late 1975. But these cases were associated with shaky political regimes and very high unemployment rates. The Canadian government can probably afford to take a line more unpopular in the short term, in the expectation that it will not have to fight an election until 1978. More important, perhaps, Canada's last few years have been relatively good ones and the 'belt-tightening' required to turn the bal- ance of payments around will not choke off domestic expansion.

Canadian policy makers can probably count on a period of sustained economic expansion in the United States. It is a matter for concern that capacity utilization in some industries is already close to the peaks attained in the previous cycle. A Carter Presidency could add to the strains if, in order to pursue the rejuvenation of us urban areas, he failed to persuade Congress to free the required resources for other uses. There is a strong possibility that monetary restraint, masterminded by the Federal Reserve Board, will bring about a slower period of growth during 1978, but it seems likely to be a very temporary respite. Congress seems likely to act to stimulate more rapid investment growth in the private sector through tax changes, and not even the foreign sector can be counted upon to act as a drag on expansion.

The nations of the OECD piously committed themselves in June to a five-year growth rate of roughly five per cent, a target quite clearly attainable without necessarily re-igniting higher rates of inflation. The astonishing strength of the first quarter of I976 in many countries showed clearly that consumers had put the bad dreams of 1974-75 behind them. If policymakers take the hint, they will not hesitate to throttle back the growth of personal

This content downloaded from 195.78.108.81 on Wed, 18 Jun 2014 20:06:15 PMAll use subject to JSTOR Terms and Conditions

618 / John Grant

income for awhile, allowing capital investment spending to accelerate. Evi- dently it is no mean trick to establish an economy with enough slack to discourage inflation, but enough demand pressure to stimulate growth in capacity. But from the point of view of Canadian exporters, the prospect of sustained growth in OECD markets has materially improved.

The Canadian strategy during 1974 and I975 was a deliberate offset of export weakness by stimulating domestic demand. Income tax and sales tax rates were cut, energy prices were subsidized (at the expense of the us consumer of our oil) and as a result, Canada's spending abroad ran far ahead of income. It is fortunate that the burden of financing fell as heavily as it did on the government sectors and on the electric utilities. By holding down tax and price increases while costs were exploding, they set themselves up as massive borrowers at home and abroad. Given their excellent credit ratings, they found little difficulty in bringing home the required funds (albeit at high rates of interest) and in the process, the Canadian dollar was not only stabilized but even strengthened. In retrospect it is somewhat surprising that Canada 'got away with it.' The daring policy gamble appears to have paid off, although Canada's inflation rate is still roughly two percentage points above that in the us and the balance of payments is still deeply in deficit.

The strain on Canadian corporations was very real during this period. This sector was deeply committed to rapid expansion in capital outlays, and inventory accumulation did not slacken until relatively late. The sharp reduc- tion in revenue growth during the recession produced a major shortfall in funds and a forced recourse to heavy borrowing, primarily from the banks but also in the bond market. Common share prices had fallen so far as to make equity financing almost prohibitively expensive for most candidates.

The suddenness and intensity of the inflation wave produced a clear re- sponse in saving behaviour in 1974 and I975. Individuals and financial institu- tions both sharply altered their preferences toward nonvolatile, highly- secured financial assets, as their sense of security lessened and their confidence about the future evaporated. Bank deposits soared and Canada Savings Bonds were purchased in unprecedented volume. Common shares, (the most volatile, least secured of all marketable instruments) fell sharply in price. The banks, the chief mobilizers of short-term loanable funds, found themselves uniquely positioned to meet the borrowing requirements of firms and governments both at home and abroad.

The repair of weakened balance sheets continues to be a priority item for many participants in the economy. While cash flows have improved markedly from their low points, the tendency has been to use the improvement to build liquidity. Asset management by financial institutions has been dominated by a desire to shorten the average life of their assets, which can be seen as a measure designed to improve their flexibility in meeting a new inflation crisis should it arise. ('Shortening term' is a classic manOeuvre for lessening the risks from rising interest rates, since the prices of short-dated bonds generally fall much less when yields increase than do the prices of long-term bonds.)

Even pension funds, whose liabilities for payout generally are concentrated far in the future, sharply concentrated their investment purchases in short- term paper and in mortgages with five-year terms. The same has been true of life insurance companies.

This content downloaded from 195.78.108.81 on Wed, 18 Jun 2014 20:06:15 PMAll use subject to JSTOR Terms and Conditions

Views and Comments/Commentaires / 619

Corporations have been slackening the pace of their investment outlays and husbanding their cash. Governments have raised tax rates and cut back expenditure growth.

The point of this digression on behaviour is to illustrate the universality of the mood of 'conservatism' which has swept Canadians as it has other countries. But this sort of 'prudence' is not without its own costs. Long-lived assets, both 'real' and financial, typically contribute substantially to produc- tivity or rates of return. By opting for flexibility in the short-term, the nation pays a price in future productivity foregone or deferred. This is one of the 'hidden' penalties that will be paid in the longer run as a result of our 'prudent' response to the inflation cycle.

The foregoing discussion is not so much an argument for low rates of inflation as it is for stable inflation rates. There is much evidence which suggests that the traumatizer is rapid changes in the rate. Individuals, corpo- rations and governments all choose the assets and liabilities they will hold in the context of a view about future inflation rates (however uncertain or imprecise). When the rate of inflation suddenly changes dramatically, as it did during 1973-75, the assumptions on which these positions were constructed suddenly come into question. House rental versus house purchase, short- term versus long-term bonds, physical assets versus cash; all these choices must be reassessed. Windfall losses are imposed on some, windfall gains on others. It is in this context that the government's commitment to a four per cent inflation rate by 1978 may be viewed. There is little difference, in principle, between a move from zero inflation to a five per cent rate of deflation, and a move from nine per cent inflation to four per cent. Those who have now 'acclimatized' themselves to high inflation rates will find it costly and possibly embarrassing to adjust to a regime of lower rates. A specific example would be a family committed to heavy mortgage payments in the expectation that their nominal income and the price of their house would continue to rise swiftly. A slowdown in the inflation rate would strain their credit-worthiness and constrain their living standards.

This is by no means an argument against the Government's policy: indeed, it suggests that the decision to spread the decline in inflation across a three- year period was the right one. The real difficulty I have in assessing the Government's stance is with the Anti-Inflation Act itself. In the first place, Government spokesmen have been somewhat at variance in forecasting when the controls might be removed. The Prime Minister has suggested that per- manent controls might be necessary, while some ministers have urged us to consider them temporary. The problem they create is that the relationships they are building into the economy, wage differentials, profit margins and, as time goes on, capital investment itself, are not those which normal bargaining would establish. If and when the controls are lifted, then, there is a prima facie case that wages, profits and capital spending decisions will be dominated for a time by a reassertion of effective relative bargaining strengths at that time. Even if there has been success in the meantime in reducing the inflation rate to four per cent, thus reducing inflationary expectations, relative wage rates and relative profit margins are likely to go through a period of readjust- ment which could be extremely unpleasant. Unless the Government were prepared to enforce a controlled set of wage and profit relationships over an

This content downloaded from 195.78.108.81 on Wed, 18 Jun 2014 20:06:15 PMAll use subject to JSTOR Terms and Conditions

620

indefinite future period, it is hard to see how the country can avoid this process of working out the distortions.

Moderate monetary and fiscal restraint, of the variety now being applied, may be able to bring us close to the four per cent target by 1978 without causing unbearable unemployment or idle capital. If so, we may expect that the Government will progressively relax the restraints under the Anti- Inflation Act, while retaining the Act itself, in order to permit an orderly re- turn to market-determined bargaining relationships in the private sector.

SJudith Maxwell

The I976 Budgets: A Shift Toward Restraint

JUDITH MAXWELL / C.D. Howe Research Institute

The shifting economic and political forces of the past year have encouraged both the provincial and federal governments to introduce fiscal restraint in their spring budgets. The new environment includes at least three forces: the recent backlash against the growth of government, an increased awareness of the linkages between fiscal policy, monetary policy, and inflation, and the growing realization that Canada must set national goals that are consistent with its economic potential.

The change in public opinion concerning the growth of government in the past year or so is basically a healthy one, because it indicates that Canadians are beginning to realize that they cannot expect governments to come up with some new program to provide the solution to every economic and social problem. However, there is a risk that the pendulum of public opinion has swung too far too fast and that many commentators are looking for a severe cutback in government expenditure. There are two persuasive arguments against this:

First, government spending has been one of the driving forces in each economic recovery of the past decade. In 1970, for example, government spending in real terms increased by ten per cent. This year the provinces are planning an increase of less than three per cent in real terms and the federal government somewhat more. That in itself means a more modest recovery than we have experienced in the past. It would be foolhardy to curb spending dramatically now and jeopardize the recovery.

Second, short-run efforts at cutting spending are not only inefficient but unsustainable. Inevitably, the cuts occur where a program is postponable or where it is discretionary. They do not occur where inefficiencies exist. What is really required is control of government expenditure. Canada has made a commitment to provide a wide range of services on a collective basis and there is no reason to think that we have to back away from those commitments. This means that governments should be making a careful attempt to consolidate and rationalize the proliferation of new programs introduced in the past decade. They need to seek ways to control costs and to get more value for the money spent.

This content downloaded from 195.78.108.81 on Wed, 18 Jun 2014 20:06:15 PMAll use subject to JSTOR Terms and Conditions