Governments and the Economy

If there is one thing that pollsters and politicians declare often, it is that "it is about the economy". There are good reasons to believe that (not least because the biggest threat to an incumbent in a democracy seems to be an under-active economy, ask George H.W. Bush!). I think there's more to it than just the economy (as the voters of Alberta from a few months ago).  But let's have a look at the economic angle anyway. One of the axes of security I think we should consider from our government is "economic security". But what do we mean by that?

Well first and foremost, most individuals don't seem to like the ups and downs of an economy much. I don't mean the thrill seekers or entrepreneurs who consider that a downturn is a buying opportunity, or who want to grab as much "cheddar" as they can in the boom times - and in Calgary we see a lot of both.

Day in and day out though, most people seem to prefer a "stable" and "strong" economy. Newspapers typically report on the unemployment rate (which is not as straightforward a concept as it sounds), Gross Domestic Product (GDP) and inflation. GDP is the total value of good and services we produce as a country. Inflation is the average rate at which prices for goods and services rise; usually measured by regularly pricing out a "basket of goods and services" which is called the CPI or "Consumer Price Index". The unemployment rate is a measure of the number of people looking for work - which is not actually the same as the number of people who don't have a job. In fact, we don't expect everyone to have a job (stay at home parents, retired people, children, etc.)

For some reason we hold our governments accountable for unemployment (which is fair, when it's low they like to claim credit as well), but why? Governments DO employ a lot of people, but usually not enough to dent the employment rate significantly. Well the answer is we use the unemployment rate as a metric for how healthy our economy is - but how can the government influence this?

Some ways are: the rate of corporate income tax (which can attract businesses from other jurisdictions, or vice versa, incentives (such as low interest financing for companies that buy from Canadian companies - the aerospace industry gets some of this), environmental legislation, permitting for projects, local or industry specific subsidies, or lower tax rates, and so on. What do we get in return for these expenses (and many of them are, one way or another)? Well, we get employment, investment opportunities, lower prices, etc.

Unemployment since 1971 looks like this:

If we put in the governments who were in power...(red for Liberal, Blue for Progressive Conservative, and Light Blue for Conservative Party of Canada), we see this:

The highest and lowest unemployment rates have been under Liberal governments, but all have had their share of ups and downs - and of course, the government only has a limited effect, lets add another measure and see...

The stock market index seems to correlate much better with the unemployment rate that the government - but not completely. So can you draw a conclusion? Well, correlation is not causation. We could also overlay business tax rates (all this data is from the Statistics Canada website by the way. It's not free, our tax dollars paid for it. So you should help yourself! - I did punch up the colours in paint, and I overlaid the governments)

So what can we conclude? Well correlation is not causation, but when I look at graphs like this, I think there are a lot more factors than just the government in play. This makes sense, we have trading partners who have good and bad years, and lots of things influence the economy. I believe that the "Government is in complete control of the economy" (one way or the other) idea was soundly disproved by the former Soviet Union.

Some tax expenses (whether they are actual money spent, or just taxes forgone by a lower rate) can be offset by gains. For example, a tax break for a company on payroll taxes might create more employment, which means more people paying income tax and more total revenue for the government, in effect, a smaller size of a larger pie. There is a concept that one can *optimize* the amount of revenue by finding a tax rate that yields the highest total revenue. This is called the Laffer Curve (although Laffer didn't come up with it). The idea is that a tax rate of 0% yields zero tax revenue. At the other end of the curve, if one taxed every bit of profit from individuals and companies, they would lose any incentive to earn, and so tax revenue would also drop to zero. Nice theory, and it seems sensible, but very few economists agree on where this optimum point is (for any given market) and worse, they don't even agree on the shape of the curve! So much so that George H.W. Bush once referred to this as "voodoo economics"...which led to a memorable scene in the movie Ferris Bueller's Day Off - and a movie career for Ben Stein.

If economics cannot agree on the rates and shapes, can we expect our government to get this right? (or blame them if they don't?) Well - maybe a little. They have a lot of empirical data and history, but they are not usually prone to experimenting much, very few people get blamed for being conservative in economics.

What about inflation? The oil shocks of the 70s led to massive inflation in the West, what's wrong with inflation anyway? Well if prices are rising faster than wages appear to, people feel poorer and spend less. If they spend on less goods, less goods need to be made, and then more people lose their jobs, who then don't spend as much. Other people see this and get nervous, and spend less as well, and so high inflation can lead to a recession. Well that's bad - why don't we just work to get inflation to zero? Turns out that's not so hot either. If people think prices are going to fall in the future, why spend now? Why buy a car for $25000, if you think it will be $23000 in 6 months? Once again, spending falls, jobs are lost, spending falls further.

Economists (and Central Bank Governors) seem to agree that a target or 1-3% inflation is desirable. So much so that most western Central Banks target this, and adjust their interest rates accordingly. They seem to feel that setting this "lever" in this spot is safest to keep the inflation rate from oscillating wildly. This doesn't actually prevent recessions cause by other reasons, but we have not had high inflation in the West since the mid 1980s, so there is some reason to believe this works.

But can we credit the government for this? Well not really. The target is now so universal, and it is not directly controlled by the government, but rather the Bank of Canada (BoC), which is an arms length organization. The BoC doesn't lend to individuals or companies, but it lends to banks, to keep them liquid through day to day variations (which means they can lend out more money, instead of having it sitting around). The BoC discount rate is (mostly) directly reflected in the Prime Rates that the Banks then lend out at to business and consumers. When the economy slows down, and inflation starts to fall, the BoC lowers the interest rate, making it more attractive for business to borrow and invest, and when things heat up, it can raise the rate to try and slow things down. But the BoC doesn't take direction from the PM.

So much for the direct influence of the government on the economy..except...taxation. What do we do with taxes anyway? Well taxes are a way for all of us to share in the expense of government itself. Nothing is free, courts cost money, so do prisons, diplomats, economic negotiators, Transport Canada Inspectors, Legislators - and their staffs, roads, the Army, Jet fighters, Search and Rescue Helicopters and so on. By spending our tax dollars the government provides services and infrastructure - but it also provides jobs. Many of our fellow citizens serve our country and get paid for it. In turn they spend in the private sector (as well as paying taxes themselves) which keeps the whole economy going.

Of course, that's the whole thing about the economy, it is people spending money that keeps everything going. When people stop spending, and just park their money - well that's where we get into trouble! If no one bought (insert the service or good you yourself produce here> what would you live off of?

There is another way the government can influence the economy - with taxation rates. Taxes can be placed on activities and behaviours it wishes to discourage. Cigarette taxes are an example. In the 1990s, governments discovered that raising taxes correlated with a decrease in cigarette sales, and in the smoking rate. There are limits to this, when the government raised taxes past a certain point, a large amount of smuggling started taking place, culminating with running gun battles on the Saint Lawrence River!

So if we think about economic security, and what we expect from the government, we need to think, not only about what we want them to do, but how they are to do it. Is it better to give out a subsidy? Tax a poor behaviour? Give a tax break for a desired behaviour? Should the government provide a service by hiring people and setting up a department? Or should it specify the service and hire a company in the private sector to provide the service?

Regulate emissions? Carbon Tax? Cap and Trade? Do nothing?

All these techniques are currently in use at some level of government in Canada. When you think about what you expect the government to accomplish, remember their tools are diverse, but also limited.

There is also another thing all politicians must worry about. With an election every four to five years, the window for accomplishing economic change *and getting the credit for it* is limited. Many times when you pull an economic lever, even if you do get a result, it can take years to become obvious, by that time, your successor may be in government, and you can just bet they will take the credit for it.