The federal government can have a positive or negative effect on the national economy using two primary tools — fiscal or monetary policy. On rare occasions it can also use foreign exchange regulations as well.
Fiscal policy involves changes in taxation and/or expenditures. If, for example, the economy seems to overheating, prices are rising and the economy is running at close to capacity, the government would either reduce or slow down its expenditures or raise taxes in an effort to reduce demand.
Monetary policy as delivered by the Bank of Canada involves managing interest rates and/or changing the rate of growth of the money supply. It achieves this primarily by buying or selling government bonds in the open market. If, for example, the economy appears to be slowing down, the Bank may buy government bonds, thereby raising their price and lowering the rate of interest. Lower interest rates should encourage business and consumers to borrow and spend the proceeds, thereby stimulating the economy.
Only in the event of a massive and sudden inflow or outflow of funds from Canada might foreign exchange policy be brought to bear. This could involve massive buying or selling of the Loonie on the open market by the Bank or outright prohibition of any foreign exchange transactions. This has never occurred in modern times.
Monetary and fiscal policy both have strengths and weaknesses. For example, monetary policy aimed at encouraging increased borrowing and spending may not work or may only do so with a lag of up to several months. Simply stated, you cannot force people to borrow if they expect the future to be significantly worse than today. Raising rates, however, can be very effective, especially if the increase is significant. But whether trying to stimulate the economy or restrain it, the impact of monetary policy is general in nature and not necessarily predictable over time.
Fiscal policy, on the other hand, can be targeted for a particular activity. When the Minister of Finance stands in parliament and announces changes in taxation, they typically take effect the next day; for example, a tax on tobacco. Changes in government expenditures may take longer but can also be highly targeted to particular sectors or regions — an attractive feature for formulators of fiscal policy. Unfortunately, changes in either taxes or expenditures can generate reaction from voters. Increasing taxes and/or decreasing expenditures are not normally popular, so politicians are often unwilling to use fiscal policy in the face of movements, up or down, in the level of economic activity.
Thus there are two government agencies, the Bank and the Ministry of Finance, charged with promoting economic stability and fostering growth. It is important that they agree on their complementary responsibilities, communicate openly and continuously on their activities and make sure conflicts do not arise.
Towards that end, more than three decades ago the then Governor of the Bank of Canada, John Crow, and the then Minister of Finance signed an agreement that has been continuously renewed with each change in the governor or the minister. In essence, the agreement said the Bank would aim to keep the rate of annual inflation to 2% thereby providing a stabilizing force to financial markets. The finance department would concentrate on promoting full employment and continued economic growth.
That agreement worked well for more than three decades, but the impact of Covid-19 and the resulting fiscal measures taken by Finance and the Bank have raised concerns in both places as to the wisdom of the Bank’s focus primarily on inflation. There is a group arguing that the Bank should also work to promote full employment, thereby reducing the heat on the finance ministry when unemployment is high.
Current economic forecasts both within Canada and internationally are expecting unemployment in Canada to remain close to double digits for the next 18 to 24 months. The problem of assigning responsibility to the Bank for the level of unemployment is the fact that monetary policy cannot target a problem with the same effectiveness as fiscal policy.
Put simply, there is virtually no way the Bank can “win” here. That’s why it’s a dumb idea, plain and simple.
David Bond is a retired bank economist living in Kelowna.