Response to Krugman on My Canada Study By David Henderson

UPDATE BELOW

I think this qualifies as a cockroach idea (zombies just keep shambling along, whereas sometimes you think you’ve gotten rid of cockroaches, but they keep coming back.) I thought we had disposed of all this four years ago. But nooooo.

This is from Paul Krugman’s post today, “Conservative Canadian Cockroach.” The link he provides is not to a post by him, but to a short critique of my study of the Canadian government’s budget cuts from the mid-1990s to the mid-2000s. The critique is by Stephen Gordon, an economics professor at Universite Laval in Quebec.

The “this” that Krugman thinks qualifies as a cockroach idea is the idea that “austerity is expansionary.” Krugman doesn’t define austerity, but a random look at his past posts on austerity suggests that he doesn’t carefully distinguish between austerity brought about through cuts in government spending and austerity brought about through increases in taxes. I think there’s a huge difference. The Canadian case that I dealt with here is one in which the government cut spending by about $6 for every $1 of tax increases.

For those of you who don’t read Krugman regularly, cockroach ideas are bad ideas that “you think you’ve gotten rid of” “but they keep coming back.”

First to set the record straight, although I think austerity with government budget cuts can be expansionary, my goal with my study of Canada’s budget was more modest: to show that one could cut government budgets substantially even during a period of slow growth of GDP without slowing the economy. Here’s how I put it in the study:

The second big lesson is that the Keynesian argument that big cuts in government spending will slow an economy receives no support from Canada’s experience.

In his critique, Professor Gordon makes two points. I’ll respond to both.

Gordon writes:

Henderson suggests that “the Canadian experience does not support the Keynesian view that policymakers should not cut government spending during an economic slowdown.” In point of fact – and it remains an open question in my mind whether this was by luck or by design – Paul Martin’s famous austerity budget of 1995 was brought down at a point when private-sector employment had reached its pre-recession levels.

Notice that Professor Gordon doesn’t take on my point that there was an economic slowdown. Rather, he shows, correctly,that “private-sector employment had reached its pre-recession levels.” Well, as any good macroeconomist knows, private-sector employment can often reach its pre-recession level during a period of slow growth. As Gary Burtless of the Brookings Institution pointed out, in March of this year private-sector employment finally exceeded its pre-recession level. Does anyone care to disagree that this happened during a time of slow growth?

Indeed, the time that Professor Gordon refers to was a period of slow growth. Here are the World Bank data on Canada’s growth rate of real GDP during the period at issue:

1994: 4.6

1995: 2.7

1996: 1.7

1997: 4.3

So 1994 was a year of high growth, but 1995, when the big budget cuts began, and 1996, were years of low growth.

Gordon writes:

Monetary policy could and did offset the fiscal contraction. Henderson hardly mentions monetary policy, except to note that inflation was low and stable, and that by February 1995, the CAD had depreciated to USD 0.71. But there’s much more to the story than that:

[He follows with a graph of interest rates and exchange rates.]

In the two years following the 1995 budget, the Bank of Canada reduced interest rates by more than 500 basis points. And by 1999, the Canadian dollar had depreciated by 10% in USD terms, fueling the export-led expansion.

He’s right that I hardly mentioned monetary policy. I do believe, as he seems to also, that monetary policy can offset fiscal policy. Great! I have no problem with that. Co-blogger Scott Sumner has written extensively about how monetary policy can offset fiscal policy.

I will point out, though, that Gordon hardly mentions monetary policy either. At best, Gordon looks at the effects of monetary policy. That’s at best. But his claim that “the Bank of Canada reduced interest rates by more than 500 basis points” is probably false. Central banks have only small effects on interest rates.

Final note: I do thank Professor Gordon for his tone (hey–he’s a fellow Canadian–what do you expect?) and for his statement:

Much of the paper sets out the political context that made this possible, and is very useful in that respect.

UPDATE: David Beckworth argues that, indeed, Canada’s central bank did offset fiscal policy with monetary policy.