Scott Sumner has a follow-up post on Nick Rowe’s post about whether a supply shock or a demand shock caused the Canadian recession in 2008-9. Both Nick and Scott seem to think that the recession in some way was caused by a supply shock.
I must admit that I really don’t understand what Scott and Nick are saying. It is pretty clear to me that the shock in 2008-9 was negative aggregate demand shock.
Lets start with the textbook version of a negative aggregate demand (AD) shock). Here is how a negative demand shock looks in AS/AD model (the growth rate version):
So what happened in Canada? Here is a look at inflation measured by headline CPI and by the price deflator for final domestic sales.
Both measures of inflation were running higher than the Bank of Canada’s official 2% inflation target when the crisis hit in the autumn of 2008.
However, it is pretty clear that inflation slowed sharply and dropped well-below the 2% inflation target in 2009 as the Canadian economy went into recession (real GDP contracted). It is hard to say that this is anything other than a rather large negative AD shock.
Obvioulsy inflation increased above 2% in 2011, but we all know that a major negative supply shock hit in 2011 as global oil prices spiked. In the case of Canada this in fact is both a negative supply shock and a positive demand shock (remember Canada is an oil exporter). That said, the rise in inflation was certainly not dramatic and since 2012 inflation has once again dropped well-below 2% indicating that monetary policy in Canada has become overly tight given the BoC’s 2% inflation target.
I might add that different measures of inflation expectations (both survey and market data) are telling the exact same story. Inflation and inflation expectations eased significantly in 2008-9 and once again in 2012.
And we can tell the same story if we look at the price level. The graph below compares the two measures of prices (CPI and the final domestic demand deflator) with an 2% price path starting in Q3 2008.
Again the picture is clear. The price level – for both measures – are lower than a hypothetical 2% price level path – indicating that Mark Carney and his colleagues in the Bank of Canada have kept monetary conditions too tight over the past 4-5 years – maybe because of a preoccupation with the risk of “bubbles”. Mark Carney might be talking about NGDP level targeting, but he is certainly also speaking quite a bit about “macroprudential indicators” (modern central bank lingo for bubble risk).
Concluding, it is very clear that the Canadian economy was hit by a large negative demand shock in 2008 and initially the BoC has kept monetary policy overly tight and the recent tightening of monetary conditions certainly also looks problematic.
Once again it is monetary policy failure and it is certainly not a negative supply shock, which is to blame for the Canadian recession and sub-trend growth since 2008. Needless to say NGDP tells the exact same story. I should add that the size of this “monetary policy failure” is fairly small compared to for example for example what we have seen in the euro zone.
Reminding Scott about the Sumner Critique
Given the very clear evidence of a negative demand shock I find this comment from Scott somewhat puzzling:
Let’s suppose that the BOC had been targeting NGDP in 2008, when global trade fell off a cliff. How would the Canadian economy have been affected? Many would see the drop in global trade as a demand shock hitting Canada, as there would have been less demand for Canadian exports. In fact, it would be an adverse supply shock. Even if the BOC had been targeting NGDP, output would have probably fallen. Factories in Ontario making transmissions for cars assembled in Ohio would have seen a drop in orders for transmissions. That’s a real shock. No (plausible) amount of price flexibility would move those transmissions during a recession. If the assembly plant in Ohio stopped building cars, then they don’t want Canadian transmissions. If the US stops building houses, then we don’t want Canadian lumber. That’s a real shock to Canada, i.e. an AS shock.
I simply don’t understand Scott’s argument. A negative shock to exports obviously is a negative demand shock. From the perspective of nominal spending a negative shock to exports is a negative shock to money-velocity in the exact same way as a tightening of fiscal policy. Therefore, if the BoC had been targeting NGDP (it actually also goes for inflation targeting) the Sumner Critique would apply – the BoC would offset any negative shock to exports by easing monetary policy (increasing M to offset the drop in V). As a consequence domestic demand would rise and offset the drop in exports. And this obviously applies even if prices are sticky. Yes, the production of transmissions in Ontario drops, but that is offset by an increase in construction of apartments in Vancouver.
However, the point is that the BoC failed to offset the shock to exports and as a consequence prices have been growing slower than implied by BoC’s official inflation target.
There is absolutly nothing special about Canada – its monetary policy failure – the failure is just (a lot) smaller than in the euro zone or the US.
PS I could also have used the GDP deflator as well in my examples above. The story is the same. In fact it is worse! The GDP deflator dropped by more than 4% during 2009. The primary reason for the massive drop in the GDP deflator is that the price of oil measured in Canadian dollars dropped sharply in 2008-9. As drop in the oil price obviously is a negative demand shock as Canada is a oil exporter. The story in that sense is completely the same as what happened to the Russian economy in 2008-9. Had the BoC had followed a variation of an “Export Price Norm” as the Reserve Bank of Australia is doing then the negative shock would likely have been much smaller as was the case in Australia.
PPS JP Irving also comments on the Canadian story.