A flawed, demand-side response, to supply-side problems

By Justin Hatherly
AIMS on Campus Fellow

The fiscal deficit for the current fiscal year is likely to exceed $30 billion, well above the $10 billion initially forecasted.  The surge in deficit spending has been justified as necessary to boost an economy still reeling from the collapse in oil prices.  However, such a response is likely to do little to revive the Canadian economy, as it fundamentally misunderstands the root causes of our economic malaise.

When faced with a nominal (demand side) shock, it is theoretically possible that expanded government borrowing can support an economy by boosting both public and private investment and consumption. However, the fall in oil prices is not a nominal problem, and instead represents a structural, supply side shock to the productive capacity of our nation.

The fall in oil prices means that Canada has suffered a deterioration in our terms of trade.  That is, for any given level of demand for our oil, we will obtain a lower level of income than at a higher price level. This means that investment in the oil and gas sectors has suddenly become less profitable. As the rate of return on investment in oil and gas declines, we are faced with a long term, painful restructuring in which labour and capital are reallocated. In our current circumstances, the Canadian economy is not operating below potential; it is instead operating at close to full capacity given the decline in our potential growth rate.

Fiscal stimulus can do nothing to change this reality. Instead, it will only serve to further misallocate scarce resources.

This is not to say that there is nothing the government can do to improve our economic prospects.  It instead implies that supply side reforms rather than demand side stimulus are key to reviving economic growth in Canada.

To boost our long-term growth potential, the federal government should instead focus on spurring productivity growth by making Canada a better place to invest.  This could entail policies such as lower marginal tax rates on labour and capital, scaling back interprovincial barriers to trade, and deregulating industries with artificial, government imposed, barriers to entry such as transportation.

Fiscal stimulus will fail to improve an economy wrought with difficulties that are supply side in orientation.

This blog is part of our AIMS on Campus Fellows program. Please visit http://www.aimsoncampus.com for more information.

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