Right now, the primary focus of the Opposition parties and the media is on the second Budget Omnibus Bill and rightly so. Like the first Omnibus Bill, it is very large - 443 pages. We can now finally discover what those vague and obtuse references in the budget actually mean. Once again the credibility of the budget process is being eroded and the authority of Parliament undermined.

But we should not loose sight of some other things that are happening that could have very serious consequences for the Canadian economy, not just in 2012 and 2013, but in the medium term as well.

The fall meeting of the International Monetary Fund (IMF) was recently held in Tokyo. It didn’t receive much attention in the Canadian media. There were a few articles mostly repeating government “speaking points” that Canada, despite a reduction in forecast global economic growth (the second since April), was, nevertheless, still the leader in the G-7. Apparently, it is not that difficult to be the best in the G-7 these days.

The IMF’s October, 2012 World Economic Outlook (WEO), “Coping with High Debt and Sluggish Growth” is a must read for anyone who wants a realistic and independent assessment of global economic prospects, the challenges confronting policymakers, and the risks to global economic growth that are increasing by the month. And if that were not enough to make a reader seriously concerned, if not alarmed, this could be followed by a reading of the IMF’s Global Financial Stability Report (GFSR), “Restoring Confidence and Progressing on Reforms”.

The IMF Reports have some sobering messages.

In the WEO the report begins: “The recovery has suffered new setbacks, and uncertainty weighs heavily on the outlook. A key reason is that policies in the major advanced economies have not rebuilt confidence in medium-term prospects”.

“Projected global growth, ….in 2012 and 2013 is weaker than in the July WEO Update, which was in turn lower than in the April 2012 WEO.”

The GFSR begins with the observation that “Risks to financial stability have increased since the April 2012 GFSR, as confidence in the global financial system have become very fragile.”

The WEO concludes “that there is now a 1 in 6 chance of global growth falling below 2 percent, which would be consistent with a recession in advanced economies, and low growth in emerging market and developing economies.” This is a substantial increase in the probabilities of a global recession since July.

However, as bleak as this sounds, it is not be the end of the story.

The current IMF global economic outlook is based on two critical, and quite frankly, unrealistic assumptions. “The first is that European policy makers will adopt policies that gradually ease financial conditions further in periphery economies.”

This would mean activating the European Stability Mechanism (ESM), which requires agreement on a EURO bank supervisor, under the direction of the European Central Bank (ECB). Non-Euro countries would have the option of joining. Germany is less than enthusiastic and the European Commission’s own legal advisers have said that this might require a change in EU treaties and country ratification.

It would also require a clear plan to establish a banking union (including a bank supervisor) and greater fiscal integration. Germany is reluctant to proceed rapidly on either since it would mean that Germany would have to absorb the financial and sovereign risk of the weaker EURO countries. For Germany to agree to this, there would have to be greater political integration. At a minimum Germany would want a central fiscal authority which would have the power to approve or reject the budgets of EURO countries. This would require a treaty change and the French are adamantly opposed. In 2005 French voters rejected the proposed EU Constitution.

The second critical assumption, underlying the IMF forecast, is equally improbable.

It is that “U.S. policymakers will prevent the drastic automatic tax increases and spending cutbacks (the fiscal cliff) implied by existing budget law, raise the federal debt ceiling in a timely manner, and make good progress toward a comprehensive plan to restore fiscal sustainability.”

In other words Democrats and Republicans will need to get together after a fiercely fought presidential election and do what they have failed to do for years - that is to work in a bi-partisan way to make sensible policy. The IMF concludes “if they fail to do so, the U.S. economy could fall back into recession, with deleterious spillovers to the rest of the world”.

The IMF forecasts for GDP growth for the advanced economies make for grim reading. The U.S. economy is forecast to grow by only 1.3 percent in 2012 and 1.5 percent in 2013. For the EURO area as a whole, output is forecast to decline by 0.4 percent in 2012 and then to increase by only 0.2 percent in 2013. Italy and Spain are forecast to be in recession for both years, while France is verging on recession. Output in Germany is forecast to grow by less than 1 percent in both years. The U.K. is currently in recession, but growth is forecast to “recover” to about 1 percent in 2013.

These are rather grim forecasts, but what makes them even more disconcerting is that they assume that the two assumptions will turn out to be valid. Good luck to that.

The IMF made another very important recommendation. The IMF is now recommending that the Greek government be given more time to achieve its fiscal targets. This is based on new research that shows that austerity without economic growth will be self-defeating. This would also be true for Spain, Portugal, and Italy. This may sound like an obvious recommendation given what has been happening in Greece, but it represents a major change to IMF policy thinking.

What it means is that the EURO area needs a growth strategy, not simply an austerity strategy.

Germany has completely rejected this recommendation, since it has been preaching for years that the only way out of the EURO crisis is austerity. The result has been ever-deepening recession and ever-increasing debt followed by more austerity. The same is now happening in Spain, the U.K., Portugal, Italy and perhaps France.

The reality is that you can never solve a debt problem by austerity alone. This was true for Canada in the mid-1990s. The austerity program was necessary but not sufficient. The Canadian economy benefitted from a recovery in the US and the emergence of China as a major global economy

There is a lot at stake and Canada will not be immune to the consequences if policy makers in the EURO area and the U.S. fail to take decisive action. 

We can only hope that “ fear of failure” will make policy makers act in time.

Mr. Flaherty will soon be meeting with his private sector forecasters, as he prepares for his upcoming Economic and Fiscal Update.  The economic forecast he uses for this Update should be based on the “realistic” assumption that the two critical assumptions will not be fulfilled.  The prudence that he proposes to include in his budget forecast should be increased to a minimum of $4 billion in 2013-14 and growing over time.


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