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Can We Dodge the Fiscal Bullet?
Submitted by Leo Kolivakis, publisher of Pension Pulse.
My
boss emailed me this afternoon telling me the former governor of the
Bank of Canada, David Dodge, was in Montreal. He asked me whether I
would like to go listen to his speech and I immediately jumped at the
opportunity.
David Dodge is one of the smartest people in
finance and listening to him speak was a real treat. If I were running
a big global macro hedge fund, I'd hire him as a senior advisor. His
knowledge of economics and global economic issues is deep and
comprehensive.
Mr. Dodge was the guest speaker at CIRANO. His presentation was entitled "Emerging from the Crisis: the Fiscal and Monetary Policy Challenges Ahead".
He
began by going over the origins of the crisis, paying close attention
to global imbalances, financial market innovation and underpricing of
risk.
He then discussed how central banks and governments dealt
with the crisis through liquidity provisions and government bailouts.
He emphasized that automatic fiscal stabilizers accounted for over 50%
of the fiscal deficits and that it wrong to think that the bailouts
were the only driving force behind mushrooming fiscal deficits.
Mr. Dodge then listed four factors driving the economic rebound (he did not call it a recovery but a rebound):
1) reversal of inventory cycle
2) huge fiscal stimulus
3) extraordinary low interest rates
4) house price stabilization
And he listed two factors driving the financial rebound:
1) pessimism of last winter was overshot
2) extraordinary liquidity provision by central banks
According
to Mr. Dodge, the rebound has come one or two quarters earlier than
predicted last winter because of the size and speed of coordinated
monetary and fiscal policy. The global economic contraction in 2009 now
seems likely to be only 1% 9versus 2% last winter). Growth in 2010 now
likely to be 3% (versus 2% last winter). Inflation is well contained.
But
Mr. Dodge warned that private demand is still weak, household balance
sheets in OECD remain problematic, and unemployment still to peak in
2010.
As far as the global financial system, Mr. Dodge said catastrophe was averted in 2009 but a substantial "hangover" remains:
- government ownership of financial institutions
- huge government deficits and high debt
- central banks expanded balance sheets
- securitization very weak and bank credit tight
- And rebuilding of the system still to come
On
the last point, Mr. Dodge notes that banks starting to rebuild capital
with steep yield curve, substantial investment banking profits and
equity issues. Risk management models are being recalibrated and
"derisking" process underway. But he noted that little progress yet on
reform of financial instruments and markets.
In particular, he noted the following key issues for market regulators:
- standardization of instruments
- building of continuous markets
- regulating credit default swaps
- need to develop a sustainable private mortgage market
- need to harmonize accounting standards
Mr. Dodge then got to the core of his presentation, the fiscal outlook, noting the following:
- In 2007, Canadian federal and provincial bugets show a small surplus (1.3% of GDP)
- Big reduction in net debt to to about 52% of GDP
- Favorable terms of trade led to stronger nominal income growth (2002-2007)
But the global financial crisis dealt a severe blow to government
revenues and automatically increased some expenditures. Moreover,
governments undertook stimulus spending. The combined Canadian federal
and provincial deficit in 2009-10 rose to about 6% of GDP, with
slightly more than half of this increase due to automatic stabilizers.
The comparable deficit in the US was over 10% of GDP.
In his fiscal outlook, Mr. Dodge went over several factors affecting future spending:
- Assume temporary programs expire more or less as scheduled in 2011/12
- Spending programs then largely driven by changing demographics
- Health care costs continue to increase driven by aging (6%+)
- Elderly benefit costs set to increase
To
restore fiscal balance, Mr. Dodge says it would require discretionary
fiscal action of roughly 3% of GDP (federal plus provincial). If all is
done on spending side, program spending growth would have to be
constrained to below 3% (nominal) and all temporary spending eliminated.
Restraint of this magnitude is very difficult and disruptive so some tax increases will be necessary.
To cut spending by 1 1/2% (1/2% of GDP per year), Mr. Dodge said you need to:
- hold real capita spending to 1% growth p.a.
- cut other real spending on other programs by 2% p.a.
To raise revenues by 1 1/2% of GDP by 2014-15, Mr. Dodge noted that you need to:
- raise the harmonized sales tax (HST) by 2%
- some form of carbon tax
- raise user charges (eg. student fees)
Mr. Dodge ended with the implications for monetary policy:
- Hold interest rates at zero 'til mid 2010 but reduce non-conventional initiatives
- With
credible fiscal plan, policy can remain accomodative through 2015, i.e.
slow increase in policy rates to 2% (zero real) in 2010-2011 and hold
below "neutral" through remainder of period to compensate for fiscal
drag and continuing (small) output gap
And finally the implications for global policy coordination:
- Canada is not an island
- USA must reduce net absorption and Asia (especially China) increase net
absorption (he also mentioned that other EM can start to run current
account deficits) - Canada will have to adjust for global policy changes and unforeseen events
- Adjustments
can best be accomplished if baseline fiscal plan is credibly set to
achieve balance (less than 1% deficit) by 2015 and monetary policy set
to keep inflation at 2%
During the discussion period, Mr.
Dodge said that risks of deflation and inflation remain. On the
elusive issue of productivity, he repeated several times that Canada
has not found a way to increase total factor productivity, something
which he also recently lectured on to Laurentian University graduates.
»
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Leo... (As above) Any thoughts here?
There is no question that things are getting bubbly in some segments of Canadian real estate. When I was in Toronto earlier last week, it really struck me how many million dollar+ homes were being fetched above asking prices (classic sign of a mania). This is a year after the credit crisis roiled that city's financial services industry.
Last week, I read this interesting article in the National Post:
Canada's (Sub-Prime) Mortgage Market - Causing Concern for the Bank of Canada?One thing I have to stress though, Canadian banks are much more prudent in lending for mortgages. In most cases, you have to put 10-20% down and you have to show an income that supports your mortgage payments. Also, sub-prime is simply nowhere near as big here in Canada compared to the US.
But things are getting toppy in some Canadian real estate markets. Problem is that it can last for a while because historic low rates are spurring all this activity.
Leo
Thanks Leo... we just have to build until that $600B limit is hit... or rates go up and the froth comes off.
BTW did you hear about that company in Toronto that bought the Silverdome? Deal or No deal?
It looks like a deal:
http://www.thestar.com/sports/article/729769--toronto-developer-snaps-up-vacant-pontiac-silverdome
Quite amazing if you think about it and shows you the extent of the carnage of US commercial real estate.
Cheers,
Leo
That's what I was hoping to hear... we think so too ;-) The comments were running 50/50... half thinking this was nuts... time will tell.
The kicker was the enhanced rezoning the City of Pontiac placed on it a couple of months prior to increase the sale value... you can do anything with this land... $5,000 dollars an acre...
See you on the Danforth for some souvlaki sometime Leo...
Later.
Sure just email me, my contact details are on my blog under about me.
Cheers,
Leo
Easy fix then. I'm so glad. I can now stop reading Tylers depressing doomsday messages and go surf me some porn, watch me some Idol and maybe crack me a Bud. How about those Nicks hey!
I love the term " need to harmonize accounting standards ".
The entire financial orchestra is so out of tune on reporting standards, they cant even remember the name of the song anymore.
Next headlines: US adopts EUROPEAN tax levels at 55%!
Higher taxes. Less services. Got it.
Can we dodge the fiscal bullet?
No.
DavidC
Very interesting. His fame comes from sitting in meetings with the finance minister and saying 'bullshit' to every cockamamie idea that was spouted.
What I don't see is mention of housing prices increasing by 20% this year (limited to very small markets) and the increase in household indebtedness. If interest rates are increased there will be consequences.
He is right about governments cutting spending. I don't think they will be able to grow out of this mess. Nor tax.
Derek
Whatever they adjust, however they tinker, whether or not they move rates, they cannot create additional wealth.
I'm staying in gold...
No mention of the CMHC and the Canadian housing bubble?
http://www.financialpost.com/opinion/columnists/story.html?id=734ff73e-1...
http://www.theglobeandmail.com/globe-investor/easy-credit-soaring-prices...
http://network.nationalpost.com/np/blogs/francis/archive/2009/10/21/cmhc...
08/
http://www.marketoracle.co.uk/Article15223.html
Ironic isn't it... I was expecting something along that line as well.
$600 B in federally backed mortgage insurance with 5% down and 1.7% (yup) variable rate financing to create the hottest housing market (bubble) in a recessionary period I've ever seen. As a result we ourselves find ourselves extremely conflicted yet commencing with a new residential development in the GTA.
It's cheaper to buy a $300,000 house than it is to rent a two bedroom apartment in Toronto right now. This will not end well I'm afraid.
I have no major issues with Dodge per se but what was with Flaherty putting Carney (GS remember) at the helm of the Bank of Canada? He was clearly NOT the most qualified candidate. And let's not forget the May 2006 budget shall we? (0% down... and 'infinite' amortization).
What were these clowns thinking... or am I being too critical?
Leo? Any thoughts here?