Thank you, Mr. Chairman, members.
Dr. Donner and I are pleased to be asked for our views on the very important subjects under review by your committee at this time. We do not need to emphasize the extremely fragile world economic situation, about which all are aware. That world situation impinges on the lives of all Canadians, as I'm sure all of you hear daily from your constituents and from the media.
Dr. Donner and I have recently published two papers, which were accepted for publication by the Canadian Centre for Policy Alternatives. We're not here representing them but rather as two individual economists.
Our first paper concerns the effect of monetary policies when the central bank interest rate is zero or close to zero. Our second paper, which we have made available to you today and which will be published later this week, concerns the effect of central bank zero interest rate policy on fiscal policy. The fiscal policy paper particularly analyzes the different effects on the economy of programs of government spending as compared to tax cuts.
The recent central bank situation in both the United States and Canada is unique to North America. Both countries have serious recessions, price deflation, and central bank interest rates at or near zero. In these circumstances, both monetary and fiscal policy must work under very different parameters. It is the objective of our papers to examine those new relationships.
Our paper begins with the simple idea that in this deep recession both monetary and fiscal policies are needed to stimulate the economy out of this recession and to prevent the deflation from getting worse. The U.S. Federal Reserve has not only taken interest rates to zero but instituted a policy of quantitative easing. That means the purchase of large quantities of assets from financial institutions in order to maintain and improve the working of financial markets. In Canada the central bank has now reached the limit, largely, of its policy, with the rate at almost zero, and as the bank has recently stated, it must now consider other policy moves such as quantitative easing.
In our second paper we examine the effect on GDP of the two major types of stimulus proposals. The recent budget supplies the expected results of budget measures, as does the U.S. Congressional Budget Office. Both indicate a clear preference for expenditure measures over tax cuts as the best way to spur the economy to recovery.
A recent and provocative discussion paper from a New York Federal Reserve economist states that with central bank rates at zero, we are in a very different ball game. The paper analyzes the new conditions in the United States and poses the clear possibility that tax cuts may cause a contraction in the economy; that is, they might actually reduce GDP and worsen a recession. The reason is that in a deflationary environment, tax cuts may reduce inflationary expectations, thus raising real interest rates. Higher real interest rates would tend to postpone spending and reduce GDP. The much greater effectiveness of infrastructure spending will likely be the key to a rapid shift out of this deep recession. If new initiatives are needed, as is likely, then they should be in the area of federal spending on infrastructure programs.
Our papers conclude that both quantitative easing and substantial fiscal stimuli are absolutely necessary in current circumstances. The depth and duration of the global recession combined with the financial credit crisis mean that governments and central banks should risk providing too much stimulus rather than risk providing too little stimulus.
Despite the fact that Canada's financial system, especially the major banks, is in better condition than many around the world, our system is inextricably linked to the world financial system, and Canada cannot risk being less concerned about our financial institutions than are other countries. Credit interest rate spreads in Canada are unhealthily wide, suggesting that our financial system is also under strain. These are difficult times for policy-makers, and their decisions need to be made with great care.
We would be glad to answer any questions you have.