Opinion: Canada’s Biggest Source of Inflation: The Government Has Borrowed Over $700 Billion
John H. Cochrane is a senior fellow at Stanford University’s Hoover Institution and author of The tax theory of the price levelavailable January 2023. Jon Hartley is a PhD student in economics at Stanford University and a research fellow at the Foundation for Research on Equal Opportunity.
The most important source of inflation in Canada is simple: starting in 2020, the the government borrowed more than 700 billion dollars, and especially distributed. People spent it, driving up prices.
It was of course normal for the government to help people and businesses severely affected by the COVID-19 pandemic. And debts and deficits do not automatically cause inflation – Canada can borrow an immense amount without impacting the price level if the government has a credible repayment plan.
But the government had gone too far in borrowing and spending without such a plan. People are trying to get rid of government debt, driving up the price until its real value returns to what people think the government will repay.
Fiscal and monetary policies are linked. The key to unraveling the current mess is recognizing that the government cannot borrow more without causing more inflation.
The Bank of Canada bears part of the responsibility for the problem. He waited a full year for inflation to burst, eventually raising interest rates from 0.25% to 0.5% last March. Whether the bank’s slow action made inflation worse is a matter of debate, but it certainly didn’t help.
Other popular arguments don’t work. Supply chain shocks increase one price relative to another, not all prices and wages together. Energy prices have gone up and down several times without triggering inflation. Greed has always been with us.
Part of the inflation is imported from the United States. When that country experiences inflation, Canada must follow or adjust to a higher exchange rate. He chose inflation.
Fortunately, the deficits are fading and inflation has gone from 8.1% in June to 6.9% in September. But the situation remains dangerous: Canada is now struggling with a debt that exceeds 100% of GDP. And the economy is clearly running at full speed.
Every one percentage point rise in the interest rate now raises interest charges on the debt by 1% of GDP, worsening the deficit and driving up inflation. Rising interest rates may not reduce inflation at all, and Canada is also vulnerable to a rise in global rates.
The government to plan providing billions of dollars in cost-of-living inflation relief is almost comical. He sent people money and caused inflation. In response, he sends even more money to people. We go around.
In the next recession, the government will want to respond with more bailouts, stimulus and transfers. But these are now likely to trigger more inflation.
And if a major crisis such as war or a larger pandemic were to arise, Canada would somehow need to borrow large sums. Then what ?
Economic stagnation is the deeper problem. from Canada Real GDP per capita only increased from $53,834 in 2007 to $56,197 in 2021. In US dollars, it barely increased from $42,097 to $43,945. Even the dysfunctional US did better, dropping from $54,300 to $61,280. American incomes are now a shocking 40% higher than Canadians.
Inflation teaches us that Canada cannot borrow and spend its way to growth. So what can be done?
A strong program of supply-side, growth-oriented policies is the only answer. This is the surest way to fight debt and inflation: higher incomes produce more government revenue for the same tax rate and reduce the need to spend. By contrast, tackling fiscal problems with higher taxes is like walking on a sand dune.
Canada recovered from debt, inflation and stagnation in the early 1990s, without a painful recession. The same ingredients can work again. Start by taking the central bank’s inflation mandate seriously. An inflation target means inflation, not jobs, climate change or other goals properly left to elected politicians.
Fiscal policy must commit to fighting inflation – to paying down rather than increasing debt. In addition, the government needs an economic package focused on spending and regulatory reforms, and supply-side growth. For example, boost energy, remove housing restrictions, and fix business licenses. Remove the sand from the gears.
Every successful disinflation in the past has included monetary, fiscal and microeconomic reforms. Attempts to stop inflation without all three have generally failed.