One of the more popular tales of 'expansionary austerity' was Canada in the mid-to-late 1990s. During this time Canada slashed government spending and brought down its debt-to-GDP ratio. Despite this fiscal stringency, the economy grew steadily and the unemployment rate fell. How was this possible?
Ramesh Ponnuru and I have argued this outcome occurred because the Bank of Canada (BoC) provided a monetary policy offset to the fiscal policy tightening. The evidence we point to in support of this view was the BoC cutting its target interest rate more than 500 basis points between 1995 and 1997. Some folks like David Henderson and Bob Murphy did not find this evidence compelling. It did not help our case that we shared the same view as Paul Krugman. Apparently, we were taking the "Keynesian view". Guilt by intellectual association?
Nonetheless, I laid out further evidence for the monetary offset view in a later post. Bob Murphy has now replied to me in a new post and concedes that at least one of my points, the permanent increase in the monetary base, does lend some support to our view. (However, he correctly points out there are timing issues with the increase in the monetary base.) So he does concede the story is more complicated than he originally envisioned.
In my view, however, the strongest evidence for the monetary policy offset view is not to be found in the monetary base. It is found is the divergence between the BoC's and the Fed's target interest rates. I made this point before and reiterated it in the comment sections of his new post. Below is an edited and extended version of the comment I left there.
Bob, the monetary base data does raise some questions for both sides as you note. But let me share what I think is the most compelling evidence for the monetary offset view by making a set of observations.
First, Canada is a small open economy. During the period in question, Canada’s GDP was about 7% of US GDP on average. Canada, in other words, is very susceptible to external economic shocks, particularly ones coming from the US.
Second, Canada’s financial markets are highly integrated with US markets. This is especially true with short-term money markets which means there should be over the long run very little arbitrage opportunities between the two countries interest rates once one controls for risk and other country specific-factors.
Third, given the points above it should be the case that when the Fed (large economy) sets its short-term interest rate target in the US it also influencing short-term interest rates in Canada (small economy). This understanding would imply that the BoC generally follows what is happening to US monetary policy. That seems to be the case as seen here:
But now take a closer look at the period in question:
The figure shows that Canada’s central bank interest rate differed as much as 250 basis points for a sustained period from the federal funds rate during the period in question.
How can this be possible given the observations above? Are not Canadian financial conditions tied closely to US financial conditions? The answer is yes, but they can deviate if the BoC exogenously intervenes and tinkers with interest rates. Put differently, had the BoC not intervened Canadian short-term interest rates probably would have more closely tracked the Federal Reserve’s target rate. As shown above, they typically do. But this time the BoC defied external money market pressures coming from the United States and struck its own interest rate path.
As a robustness check on this understanding I estimated the relationship between the BoC's target interest rate against the federal funds rate as well against the core inflation rate and the output gap in Canada. I estimated the model from 1980:Q1 to 1994:Q4, the period right before the BoC eases. This way we can ask the following question: given how the BoC adjusted interest rates in the past, how would one have expected it to do so going forward into the 1995-2000 period as new realizations of the federal funds, core inflation, and the output gap occurred?
If there were a deviation between the actual path and predicted path of the BoC's interest rate target during the 1995-2000 period, then this would constitute an exogenous movement or 'shock' to monetary policy. The figure below shows the results of this exercise.
The actual easing, then, was not something one could have easily predicted based on past BoC behavior. What is nice about this is that it provides a kind of a natural experiment for the monetary offset view. It provides (1) an exogenous easing of monetary policy (2) in a period of fiscal tightening and (3) results in stable aggregate demand growth. In my view the evidence provided by this natural experiment is very clear.
Nick Rowe rightly notes in the comments, though, that one should also look at the exchange rate. It depreciated during this time indicating monetary easing was at work. So it is hard for me to understand how one could view this experience as anything but strong evidence for the monetary offset view.