Will there be a Great Inflation in the Wake of the 2008 Great Recession?

Abstract: The paper presents data on the level and composition of the actual and forecast debt of the US government. It argues that the real burden of this debt cannot be reduced significantly by inflation because the bulk of it is held by government agencies, is adjusted for inflation or is short-term. Inflation offers politicians low returns and high costs. The paper also presents data on the excess bank reserves that resulted from the efforts of the Federal Reserve to lower interest rates and that bring the potential of a future massive and very inflationary increase in the money supply. While the Fed can prevent the inflation technically, questions arise over its willingness to use the proper policies in time, given Congressional pressures to favour lower unemployment over inflation.

1. Introduction

The Great Recession of 2008 has left a legacy of deficits and debt that has created a widespread fear about the creation of a Great Inflation by the US government in order to reduce the real fiscal burden of the debt. The fear of inflation has been fed further through the purchase of unprecedented amounts of securities by the Federal Reserve and a correspondingly large expansion of commercial bank reserves that can lead to the expansion of the money supply.

History contains several important examples of countries that used inflation and monetization to deal with excessive debt loads, such as Germany and Hungary during the 1920s and most recently, Zimbabwe. Many pundits and investment advisers have called attention to this history and stoked the public’s fear that the US government will be tempted to follow these historic examples. One of the effects produced by this fear has been a large public demand for gold as an inflation hedge, which resulted in record prices for the metal.

This paper examines the likelihood that the fiscal condition of the US government will induce it to create a great inflation. The examination involves the analysis of the expected fiscal benefits relative to the economic and political costs from such policy. It furthermore examines the technical ability of the Fed to prevent the large stock of bond holdings from leading to inflation and assesses the strength of the political forces that could prevent it from engaging in the needed policies.

The first part of the paper presents the basic data that underlie the existing fear of inflation. The second part presents a benefit/cost analysis of using inflation to deal with the excessive debt. Part three deals with the likely Fed policies that determine the development of inflation.



2. Facts Stoking the Fear

Table 1 shows the actual size of the federal government deficit spending and debt for the years 1993-2009. The figures for 2010 and thereafter are the official estimates issued by the Office of Management and Budget that serves the White House and Congress in the evaluation of the effects of spending and taxation programs proposed by the administration in the context of projected economic developments.

To fully appreciate the magnitude of deficits and the debt in the future, it is useful to consider their levels in the recent past. Thus, as can be seen from the table, the imbalances during the four years 1993-97 produced $751 billion in deficits. During the four years 1998-2001 the imbalances turned into surpluses of $559 billion.

The deficits returned in 2002 and by 2007 had added up to $1.7 trillion. However, the public fear of future inflation is based mainly on the $4.7 trillion deficits recorded and forecast of for the four years 2008-2011, as well as the continued high levels expected to be recorded in the following four years.




Table 1

US Federal Budget Debt

(billions of dollars)
Year Outlays Receipts

Imbalance
Total Debt


1993 1,409 1,154 - 255 4,351
1994 1,462 1,259 - 203 4,643
1995 1,516 1,352 - 164 4,921
1996 1,560 1,453 - 107 5,181
1997 1,601 1,579 - 22 5,369
1998 1,652 1,722 69 5,478
1999 1,702 1,827 126 5,606
2000 1,789 2,025 236 5,629
2001 1,863 1,991 128 5,770
2002 2,011 1,853 - 158 6,198
2003 2,160 1,782 - 378 6,760
2004 2,293 1,880 - 413 7,355
2005 2,472 2,154 - 318 7,905
2006 2,655 2,407 - 248 8,451
2007 2,729 2,568 - 161 8,951
2008 2,983 2,524 - 459 9,986
2009 3,518 2,105 - 1,413 11,876
2010 3,721 2,165 - 1,556 13,787
2011 3,834 2,567 - 1,267 15,144
2012 3,755 2,926 - 828 16,336
2013 3,915 3,188 - 727 17,453
2014 4,161 3,455 - 706 18,532
2015 4,386 3,634 - 752 19,683

Source: Office of Management and Budget (2010)

Note: Figures for 2010-2015 are estimated


The last column of Table 1 shows the impact these deficits have had or will have on the size of the federal debt. Over the 15 years between 1993 and 2007 the debt more than doubled, in spite of the surpluses that occurred in 1998-2001. However, this growth in the debt pales in comparison with that forecast for the seven-year period 2009-2015. It is expected to double again from $10 trillion to $20 trillion, thus growing at twice the rate experienced during the preceding 15 years.

While the forecasts shown in Table 1 depend on expected economic growth and crucial assumptions about future spending and taxation policies and therefore they are highly uncertain, they provide a valid basis for public fears about the probability that the government will use inflation to reduce the real burden. Since the deficits may in fact turn out larger or smaller than forecast, the uncertainty about their size further feed public anxiety about future inflation.

However, the figures found in Table 1 need to be put into some perspective relevant to the assessment of their impact on inflation and other government policies. For this reason, it is useful to consider Table 2, which expresses the deficit and debt figures in relation to the actual and projected levels of nominal Gross Domestic Product, which is a function of the growth in population and productivity, as well as inflation and general business cycle developments. These percentage figures express more accurately than the absolute numbers the burden the debt imposes on the budget and individual Americans through the interest payments necessary to service it. This fact is evident if one considers that the burden of a given amount of mortgage payments on family budgets is smaller the greater is family income.

As can be seen, the level of the debt expressed as a percentage of GDP actually decreased from 66.1 percent to 64.4 between 1993 and 2007. However, again providing a basis for fears about inflation, the ratio is forecast to rise to 102.8 percent over the period 2008-2015.

This fact is especially significant since the projections contained in Table 2 are based on the use of assumptions about future economic growth and other variables determining revenues, which many economists consider to be excessively optimistic because the official estimates are made by the Office of Manpower and Budget (OMB) and assume that the full legislative spending and taxation proposals contained in the President’s budget are realized. Moreover, there is an institutional bias towards optimism about future growth that is inherent in the OMB acting as an agent of the President. It is therefore advisable to consider the estimates of future developments with some caution.

There is no agreement among experts on the optimum debt/GDP ratio. The academic debate over the consequences of zero debt levels suggests that the optimum is greater than that since the sovereign debt plays an important role in the management of private sector wealth portfolios.

On efficiency grounds, the debt level is proper if it is matched by the value of the legacy left by past generations in the form of economic infrastructure, the democratic and free society that was defended through war expenditures and the prosperity that was restored by Keynesian deficits during cyclical downturns. The proper valuation of this legacy is virtually impossible, especially in the light of the widely held view that a substantial part of the debt was incurred by politicians buying votes from special interest groups.



Table 2

US Federal Budget Debt
(as a percent of GDP)

Year Outlays Receipts
Imbalance
Total Debt

1993 21.4 17.5 -3.9 66.1
1994 21.0 18.0 -2.9 66.6
1995 20.6 18.4 -2.2 67
1996 20.2 18.8 -1.4 67.1
1997 19.5 19.2 -0.3 65.4
1998 19.1 19.9 0.8 63.2
1999 18.5 19.8 1.4 60.9
2000 18.2 20.6 2.4 57.3
2001 18.2 19.5 1.3 56.4
2002 19.1 17.6 -1.5 58.8
2003 19.7 16.2 -3.4 61.6
2004 19.6 16.1 -3.5 62.9
2005 19.9 17.3 -2.6 63.5
2006 20.1 18.2 -1.9 63.9
2007 19.6 18.5 -1.2 64.4
2008 20.7 17.5 -3.2 69.2
2009 24.7 14.8 -9.9 83.4
2010 25.4 14.8 -10.6 94.3
2011 25.1 16.8 -8.3 99
2012 23.2 18.1 -5.1 100.8
2013 22.8 18.6 -4.2 101.6
2014 22.9 19.0 -3.9 101.9
2015 22.9 18.9 -3.9 102.6

Source: Office of Management and Budget (2010)

Note: Figures for 2010-2015 are estimated

However, it is interesting to note that the European Economic Community Treaty specified that one criterion for admission to the economic union is a level of government debt at or below 60 percent and annual deficits below three percent of GDP. By these criteria, the US record before 2007 was acceptable, but has failed to pass thereafter and may be expected to do so into the indefinite future.

In the end, American voters will determine what level of deficits and debt are acceptable. During the Congressional election campaign in 2010 the issues were discussed widely and voters strongly supported candidates that promised to reduce the deficits and debt. Strong and vocal political movements at the grass-roots level are likely to further increase the number of politicians with these views in future elections. At the time of writing in early 2011, there are indications that the Obama administration’s legislative agenda will be modified in ways that will reduce future deficits.

In the meantime, Americans face the facts found in the two tables presented above. Public discussions and the analysis of investment advisors, as well as the purchase of gold as a hedge against inflation among other actions suggest that Americans (and people in the rest of the world) continue to be concerned about a future great inflation caused by government efforts to reduce the burden of the debt. The discussion in part three below sheds further light on the validity of this concern taking account of the limits and costs faced by the potential government policies to use inflation as an effective instrument for the lowering of the burden.


Monetization of the Debt

The hyper-inflations of the past like those in Germany and Hungary in the twenties of the last century were caused by deficits and accumulated debt so large that the private market for bonds disappeared. Wealth-holders were unwilling to purchase any more bonds at any promised yield that they believed could and would not be serviced or repaid in the future. Under these conditions, these governments instructed their central banks to buy the bonds and pay for them by new issues of currency. As governments put this currency into circulation to meet their obligations, too much money began to chase too few goods and inflation developed. Eventually, the expectation of continued and accelerating inflation induced the public to spend any currency they had earned as quickly as possible on goods and services that would cost more a short time later.

The vicious cycle of deficits financed by the printing of money, growing deficits, unwillingness to hold currency and accelerating inflation caused by this new money led to the collapse of the German and Hungarian economies. The inflation had benefited borrowers who repaid their obligations with worthless funds and dramatically reduced the real wealth of lenders. The resultant inequities and prolonged unemployment resulted in deep economic, social and political scars that shaped national life in these countries for generations. Germany’s hyper-inflation has been identified as paving the way for the Hitler regime and the Second World War, though more positively, it also decisively influenced the political agenda in the postwar years when Germany’s inflation rate was much below the average of developed countries.

Figure 1

Source: The document was obtained through the courtesy of Ambassador William Middendorf, who is the Chairman of the Committee for Monetary Research and Education in Washington, DC.

The government of Zimbabwe offers a contemporary example of how the vicious cycle of deficit spending and the printing of money leads to hyper-inflation, economic disaster and political upheavals. Figure 1 shows the extent to which the inflation has required the government to print currency in ever increasing denominations needed to pay for the goods and
services it provides to the public at ever higher prices. The economic and social miseries that accompany this hyper-inflation are horrendous and well known.

It is not realistic to believe that conditions in the United States will become like those in Germany’s and Hungary’s past and present day Zimbabwe. Nevertheless, there has been a development that is ominously similar to that in these countries. As can be seen from Figure 2, from the beginning of the Great Recession in 2008 until early 2011, the Fed’s holdings of securities rose sharply from $500 billion to $2,200 billion. This increase compares badly with the one that took place during more normal times between 1990 and 2007, when the Fed increased its holdings of securities at a rate that was roughly in harmony with the growth of the economy.

Figure 2

Source: Federal Reserve Bank of St. Louis (2011a)


The dramatic increase in Fed holdings of securities is referred to officially as involving “quantitative easing”. In early in 2011 the Fed announced that it would engage in the further purchase of securities under the name “quantitative easing II”. Whatever these policies are called, they are historically unprecedented and resemble those undertaken by countries that subsequently experienced hyper-inflations.

The Fed justified quantitative easing on two grounds. First, it was needed to lower interest rates and to create liquidity sufficient to induce economic recovery from the Great Recession of 2008. Second, many of the securities purchased were “toxic assets”, that is securities whose value was uncertain for a number of reasons, that therefore traded at substantial discounts and that threatened the viability of important financial institutions that owned them. It was believed that the failure of these institutions threatened by defaults of these assets would severely deepen and lengthen the recession.

As a result of quantitative easing the federal funds rate at which banks can borrow from the Fed fell to near zero. Figure 3 shows that this level is unprecedented during the postwar years. As a result the entire structure of interest rates in the economy was lowered as the Fed had wanted.


Figure 3
Source: Federal Reserve Bank opf St. Louis (2011b)

However, the economic recovery expected to follow developed only very slowly. One reason has been that commercial banks did not behave as they did in the past. The Fed paid for the securities it bought by creating deposits owned by commercial banks, a process equivalent to the historic “printing of money”, which the Fed can do without legal or practical limit.

Under normal conditions, banks use the new liquid assets yielding nothing or only a very low rate of interest to make loans to private borrowers at the market rate of interest adjusted for risk, an activity which gives rise to most of the banks’ profits. These borrowers use the funds to buy goods, services and assets. The sellers of these goods, services and assets redeposit their proceeds with other banks, which then make more loans that lead to redeposits and new loans, in a process that is repeated until the banking system creates demand deposits that amount to a multiple of the amount of deposits created by the Fed. The only constraint on this process is the requirement that banks keep a certain percent of loans as reserves with the Fed.

Figure 4 shows that during the period under consideration, this normal use of bank deposits created by the Fed did not take place. The amount of excess reserves held before 2008 was near zero. Since then, the excess reserves have grown rapidly and have stayed high, except for a small decrease at the end of 2010 and beginning of 2011. The banks’ behaviour was conditioned by concerns about the general economic and financial outlook during the Great Recession that made loans riskier than acceptable at interest rates borrowers could afford to pay.



Figure 4

Source: Federal Reserve Bank opf St. Louis (2011c)

The public fear of inflation is based on two important facts just presented. First, the Fed’s purchase of securities resembles the policies that were used by the central banks of countries that in the past experienced hyper-inflations.

Second, the behaviour of commercial banks could result in a dramatic increase in the US money supply M1, which includes currency and commercial bank deposits once banks return to their normal lending practices, which is likely to happen as soon as recovery from the recession is evident and economic as well as political developments lead to lower deficits and debt. The existing bank reserves will allow the money supply to increase by a very large amount and do so quickly as the so-called money multiplier returns to more normal levels.

The validity of fears of inflation based on these facts will be discussed in Part 3 below, where they will be seen to depend crucially on both the ability of the Fed to reduce the excess reserves through the use of policy instruments at its disposal and, importantly, on the political restraints on the exercise of this ability in the light of the fact that any tightening of monetary policy increases the risk that economic recovery will be slowed or even lead to a second dip in the recession.


3. Inflation and the Reducing the Burden of the Debt

The process by which inflation reduces the real burden of the debt and lowers the needed level of taxation to service it may be illustrated with the help of the following example.

Consider the government issues a bond for $100 thousand that matures in thirty years. The existing rate of inflation is zero and the bond has attached to it 30 coupons that pay the holder of the bond $5,000 at the end of each year. To pay this interest, the government requires that same amount in revenue, which is equal to the reduction in spending on goods and services by taxpayers.

Now consider that at the end of the first year, inflation goes to ten percent per year. At the end of the second year, the coupon payment still requires $5,000, but the amount of goods and services that it represents is only $4,500, causing the tax that needs to be collected and the burden on the taxpayers to represent the same diminished amount. If the inflation continues after the second year, the real burden continues to fall by ten percent every year. After 30 years, the $5,000 coupon has a purchasing value of only $285, which represents a significant reduction from the original.

The main conclusion from this example is that the real return from holding long-term bonds with a nominally fixed yield is diminished by inflation and that the real burden on taxpayers is lowered correspondingly. Politicians like this outcome since tax rates can either be lowered or spending can be increased without explicit changes in tax rates.

However, inflation cannot be used to lower the real burden of debt with short maturities. Consider a short-term bill maturing in one year and yielding 2 percent, which was sold while inflation was expected to be zero. Now consider what happens to the interest rate on short-term bills if the inflation rate goes to ten percent. This rate of inflation will cause lenders to insist on a rate of interest of at least 12 percent, ten percent of which represents compensation for the depreciation of the invested funds and the 2 percent is the normal return from short-term investments. Investors could possibly insist on compensation in excess of 12 percent if they expect an acceleration of the inflation rate during the year or simply to be paid for the increased risk about the future development of inflation.

Under the assumptions above, at the end of the year when the original bill matures, refinancing requires the payment of at least 12 percent, a rate at which the real value of the debt is maintained for the buyers of the new obligation and the real burden for taxpayers remains unchanged. In the real world where one-year bills are sold virtually every day, the average interest rate on notes quickly approaches the rate that reflects the inflationary expectations.

The preceding analysis leads to the following important conclusion: The benefits from using inflation to reduce the real burden of debt depend on the length to maturity of the outstanding debt.

Before data on the maturity structure of the US federal debt are presented, it is important to note the facts found in Table 3. As can be seen, of the $13.3 trillion of US Treasury securities outstanding at the end of June 2010 (December data not yet available), 34.6 percent or $4.6 trillion are held by agencies of the government. The most important of these agencies is the Social Security Trust Fund, which holds funds that the US pension system collected in years when contributions exceeded expenditures.


Table 3
US Treasury Securities Outstanding
(trillions of dollars, June 2010)

Total Held by
Govt. Public

13.3 4.6 8.7

Percent

100 34.6 65.4

Source:
Treasury Bulletin (2010), Table FD1


Whatever happens to the surplus of this fund in the future, for the purposes of the present analysis it is important to realize that inflation will mean increased spending on inflation-indexed pensions while at the same time, taxpayers’ incomes increase at the same rate and so do the taxes disguised as insurance premiums flowing into the fund. This analysis implies that the burden of the debt held by the trust fund cannot be reduced by inflation.

Since other trust funds within the government operate under conditions very similar to those of the Social Security System, it is clear that inflation does not produce a lower real burden on the near 35 percent of the federal debt held by government.




Maturity Structure

Table 4 shows that in June 2010 the public held $8,079 billion in marketable federal debt. For the present analysis it is worth noting immediately that seven percent of the total of this debt, $564 billion, consists of TIPS securities (Treasury Inflation Protected Securities). The interest payments on these securities are automatically adjusted for the rate of inflation so that inflation does not lower the real burden of serving them.

Table 4 also shows that $1,777 billion or 22 percent of the total marketable debt held by the public are bills, which are defined as securities that mature within a year. These notes have almost the same characteristic as TIPS. Every time they are rolled over, the Treasury will have to pay interest at a rate that reflects the current and expected inflation. Therefore, the relatively large amount of bills held by the public offers virtually no opportunity to reduce the real burden of the debt. Moreover, the higher interest rate expenses caused by inflation would add to the deficit and the growth in the nominal level of the debt.

Notes, which are securities that mature within one to five years, show a value of $4,935 billion and represent 61 percent of the total. If one assumes that the average length maturity of notes is 2.5 years, they offer a moderate opportunity to reduce the burden of the debt. Bonds, maturing after 5 years, are worth $803 billion, representing about 10 percent of the total. They offer the greatest opportunity for reducing the burden of the debt through inflation.


Table 4
Marketable Debt Held by the Public

($ billions, June 2010)

Bills 1,777 22.00
Notes 4,935 61.08
Bonds 803 9.94
TIPS 564 6.98

Total 8,079 100

Source:
Treasury Bulletin (2010), Table FD2

Another way of showing the maturity profile of the US debt is presented in Figure 5, which is based on data published in the Treasury Bulletin, US Department of the Treasury, using detailed data on the maturity of all series of securities outstanding. These data change continuously as outstanding securities come closer to maturity and new ones are issued. The table reproduced here is based on data for March 2010.

As can be seen, about $2.5 trillion of the outstanding US debt matures within one year while the amounts over longer periods are comparatively small and less, the longer is the time to maturity. Thus, about $1 trillion matures within two years and another $.7 trillion within three years.




Figure 5

Source: Crazy Nut Job (2010); raw data found at: Treasury Monthly Statement of the Debt (2010)

Currency Notes and Coins

The preceding analysis does not consider the existence of currency in circulation, which is valued at $1.23 trillion on September 30, 2010. Almost all of this currency has been issued by the Federal Reserve. The Treasury Bulletin does not count this currency a part of the public debt, even though the notes promise to pay bearer this nominal amount printed on the note. In practice, this promise is an historic relic from the time when the Fed redeemed currency into gold but has since become meaningless.

However, the existence of currency also has implications for the ability of the government to use inflation to reduce the burden of the debt. The reason is that the public holding of currency increases with both income and inflation (and decreases with the development of substitute means of payment, like credit cards). When the Fed prints currency to meet the increased demand due to inflation, it enjoys corresponding increases in profit. This profit is transferred to the Treasury and has the same effect on total revenue as tax payments.

This profit is not negligible. A ten percent inflation and increased demand for currency on the $1.23 trillion stock comes to $123 billion. However, the government cannot rely on a constant relationship between nominal income and the holding of currency since inflation represents a tax on holding it and thus induces the public to hold less.

A large proportion of the circulating US currency is held abroad and used as a store of value and means of payments, especially in developing countries with unstable and inflation-prone currencies. If the value of the dollar is diminished through inflation, these foreign holders of that currency will exchange it for Euros or other currencies that are not subject to the loss of value from inflation. When this happens, the dollar notes will flow back into the vaults of the Fed and will reduce the need to print more for domestic circulation, reducing profits that accompany this process. Most basically, the so-called seigniorage earnings accruing to the United States from the use of dollar currency abroad are diminished and the US economy loses the value of the imports that were paid for with this seigniorage.

Since the Treasury data do not include currency as part of the debt, this paper disregards the potential but dubious benefits from the use of inflation to reduce the burden of the debt by the devaluation of the outstanding currency.


Summary and Conclusions

The preceding analysis leads to the conclusion that inflation offers only a very limited opportunity to reduce the burden of the US federal debt. The reasons for this conclusion are as follows:

First, only about 65 percent of the debt is held by the public and can be used for the reduction of the real burden. The other 35 percent is held by government agencies and represent obligations that are fixed in real terms.

Second, about 90 percent of the outstanding, publicly held debt consists of inflation protected securities, bills and notes that mature in a relatively short time after inflation begins. These securities can be refinanced upon maturity only at interest rates that compensate lenders for inflation so that it no longer allows the real burden of the debt to be reduced.

The implications of these facts are important for assessing the probability that the US government will use inflation to reduce the real burden of its debt to the extent that economic, financial and social benefits and costs of policies enter into decisions about government policies. One can be cynical about the weight such benefit-cost calculations have in government decisions, the weight almost certainly is not zero, as is evidenced by the efforts of governments to collect and analyze the kind of data presented in this paper.

Thus, as the data suggest, the financial benefits from inflation are very limited. At the same time, inflation results in serious economic and political costs.

The economic costs arise from the misallocation of resources that accompany the efforts of the public to escape the losses from holding assets whose value does not increase sufficiently with inflation. Additional costs arise from recessions and unemployment that accompany government anti-inflation policies that historically have always followed periods of inflation.

The political costs arise from the public’s dislike of inflation and the unemployment that arises from anti-inflation policies. The public usually votes out of office politicians responsible for these conditions.

The bottom line of the preceding analysis is that the economic and political costs far outweigh the benefits from using inflation to reduce the real burden of the debt and the political benefits that flow from this policy. This fact should be considered before the US government decides on methods for dealing with the deficits and debt that have arisen in the wake of the Great Recession. Whether or not these considerations in fact will carry the day remains to be seen, but the analysis suggests that historic examples that saw countries inflate away the burden of the debt are no longer relevant in today’s world of efficient capital markets.


3. Fed Policies and Inflation

Assuming that the US government is unlikely to use inflation to reduce the burden of the debt because the costs are greater than the benefits, there remain two other issues that feed the public’s concern over a possible future inflation.

The first of these involves the technical ability of the Fed to eliminate the potential expansion of the money supply that arises from the excess reserves held by the commercial banks, the magnitude of which is evident from Figure 4.

The second issue involves the Fed’s timing in the use of its tools to reduce excess reserves and generate a non-inflationary money supply in the face of uncertainties about the strength of the economic recovery and pressures from politicians to err on the side of reducing unemployment rather than fighting potential inflation.

Technical Capabilities

The Fed has available three basic instruments for bringing commercial bank reserves to a level consistent with a non-inflationary money supply.

First, the Fed can sell the securities it has bought when it engaged in quantitative easing during the height of the Great Recession. The sale of assets to reduce the money supply has been used routinely in the past and in principle nothing stands in the way to prevent its use again. The resultant absolute decrease in reserves would be unprecedented in the history of the Fed , but so is the magnitude of excess reserves in existence.

One concern with the use of this policy involves potential losses from the sale of these assets. Some will have decreased in value and some will have increased between the time they were bought and their sale as a result of changes in the economic fortunes of the issuers of the securities. It is impossible to know the magnitude of these gains or losses from the future asset sales, but it is worth noting that in the end they will simply affect the amount of profits that the Fed transfers to general revenue every year. These profits tend to be substantial in absolute terms but are small in relation to total federal tax revenues and will have only a marginal effect on the budget balance. Another concern is that the sale of assets like mortgage-backed securities will result in a lower market prices and therefore higher yields. Such a rise in interest rates on mortgage could endanger the recovery of the housing market and thus of the entire economy.

The second instrument the Fed can use to reduce the money supply potential involves increases in required reserves. This policy has been used sparingly in the past, but in principle, there are no obstacles to its use to eliminate the excess reserves shown in Figure 4 except that existing regulations contain an upper limit for such requirements. Of course, if this upper limit is ever reached, new regulations could be passed to increase it to preserve the Fed’s ability to pursue its monetary policy objectives.

The third instrument available to the Fed is raising the interest rate it pays on reserves held by commercial banks. In principle, the interest rate could be set at a level high enough so that the commercial banks earn less from using the funds to make loans to private borrowers than they can from holding on to the reserves, especially after taking account of differences in risk associated with the two alternative uses of the funds. In practice, the cost of paying high rates on reserves may be high, especially if interest rates on private borrowing rise rapidly in the wake of growing fears of inflation. Congress might object on political grounds to the payment of interest to banks by this method and it might create difficulties for the Fed’s chairman advocating this policy.

In sum, the technical instruments available to the Fed to deal with the inflationary potential stemming from the excess reserves in the hands of commercial banks on balance appear to be adequate. The public’s concerns over the threat to price stability coming from these excess reserves are not warranted on technical grounds.

Timing and Political Issues

However, in practice, the record of the Fed regarding the timely use of the available technical instruments to deal with inflation is not outstanding. Allan Meltzer has written a book about the history of the Fed. He recently noted that his study of past inflation-fighting policies convinced him that the Fed is unlikely to deal adequately and in a timely fashion with the threat to price stability existing in the wake of the Great Recession and quantitative easing.
The poor history of the Fed on this issue is due to the following facts.

Since monetary policy influences inflation and economic activity with unknown and variable lags, all decisions about the supply of money and interest rates have to be made in the light of highly uncertain forecasts of economic developments. Given this uncertainty, the Fed has to choose between two possible biases. It can err on the side of restoring economic activity and lowering unemployment through the maintenance of low interest rates or it can err in favour of preventing inflation by tightening raising rates.

The public, many economists and most politicians consider inflation to be a lesser evil than unemployment. In the light of this attitude, the Fed faces strong pressures to err on the side of expansionary policies to lower unemployment and to put less weight on the possible inflation that such policies will produce.

During the 1960s and into the 1970s, this bias in favour of inflation was even stronger than it is today because the dominant economic theory believed in a trade-off between lower unemployment and higher inflation. While this so-called Phillips-curve trade-off is now quite discredited, attempts of the Fed to deal with cyclical downturns are subject to policy biases that arise from the uncertainty of economic forecasts just discussed.

In sum, the preceding analysis implies that the risk of inflation is uncertain and depends on the strength of the bias in Fed policies that favours lower unemployment, even if it carries the risk of inflation. This bias is influenced strongly by political forces, for while the Fed is nominally independent from political influence, in fact it is subject to considerable pressures from Congress, which periodically offers advice on policy to the Chairman of the Board of the Fed at hearings before a congressional committee. The politicians on this committee have more to gain at the ballot box if the Fed reduces unemployment than they do from losses if the Fed policies produce inflation.

Therefore, there is some reason to fear inflation resulting from poor timing of anti-inflation policies of the Fed caused by the uncertainties surrounding the optimum timing when future conditions are uncertain and by political pressures that value the lowering of unemployment higher than inflation.


4. Summary and Conclusions

There is widespread fear over the development of a great inflation in the United States that could arise from the legacy of debt and monetary ease due to policies used to deal with the Great Inflation of 2008.

The size of recent and projected deficits and debt is unprecedented and supports fears that the government will attempt to reduce the real burden of this debt through inflation. However, it turns out that about one third of the debt is held by government agencies whose obligations are fixed in real terms so that inflation does not affect the real budgetary costs of this portion of the debt. The maturity structure of two thirds of the US debt held by the public allows for only a relatively small reduction in the real burden since modern capital markets would force the US Treasury to pay an inflation premium on all newly issued securities. Therefore, the benefits from the reduction in the real burden of the debt are much smaller than the economic and political costs of inflation. Assuming that the results of this benefit cost analysis will be considered by politicians and policy makers, it is unlikely that they will resort to inflation to reduce the real burden of the debt.

The Fed’s policies following the Great Recession have been very expansionary, as its acquisition of securities under the TARP programs provided the banking system with excess reserves that can form the basis of a very inflationary increase in the money supply. However, while the Fed has the technical tools to remove the potential for the inflationary expansion of the money supply, there remain grounds for fear because of the uncertainties surrounding the timing of the effects of monetary policies and of future economic developments. In the face of these uncertainties, politicians could well apply successfully pressures on the Fed to use policies that are biased in favour of reducing unemployment rather than maintaining price stability.


Endnotes:

Multiculturalism in Trouble

The elected members of anti-immigrant parties in the Netherlands and Sweden have recently joined government coalitions and as a result have important direct influence on immigration policies. More indirect influence on policies have been achieved by anti-immigrant parties, which have recently gained 29 percent of the votes cast in Switzerland, 22 percent in Norway, 17 percent in Austria and 14 percent in Denmark. (In the 2008 federal elections in Canada 6.9 percent of the vote went to the Green party and 18.2 percent to the NDP). In Germany Chancellor Angela Merkel caused a stir around the world when recently she said “Multiculturalism in Germany has failed”.

What is behind the growing public support of anti-immigrant parties and concern over multiculturalism in Europe? The ruling elites argue that the current economic crisis has activated the ever latent populist, extreme-right, racist and anti-Islam views held by a minority of the population. These elites expect that the anti-immigrant parties will lose support and the critics of multiculturalism will be silent once economic prosperity is returned. The validity of this assertion is doubtful in the light of the fact that anti-immigrant parties in Europe prospered well before the 2008 economic crisis.

A more plausible explanation of the growth in anti-immigrant sentiments in Europe is the public’s perceived threat to the very essence of their national identity and a sense of belonging, which are anchored in their cultural, social, religious and economic institutions. The threat is seen to emanate from immigrant communities that fail to integrate into the societies of their host countries and often challenge existing institutions, all encouraged by official policies of multiculturalism.

For example, the viability of Scandinavia’s generous social programs is threatened by practices of some immigrants who do not adhere to the traditional behavioural norms. Muslim minorities in several countries are demanding the selective application of Sharia laws, the acceptance of honour killings and head scarves for women. Practices of civil society, like queuing for services sometimes are disregarded by some immigrants. In Central and Western Canada, a number of criminal gangs dominated by members of immigrant communities engage in much publicized violence.

In several European countries the growth of anti-immigrant parties has prompted some changes in immigration and multicultural policies. In Canada, Jason Kenney, the Minister of Citizenship and Immigration released a new citizenship guide with very similar goals.

These new policies require immigrants to know or learn their host countries’ languages and to accept existing national laws, institutions and values rather than demand changes to accommodate their own cultural norms. The granting of citizenship will become conditional upon meeting these and other requirements.

These new policies basically represent a repudiation of multiculturalism, which had been created with the expectation that it would end strife and wars. I believe that this repudiation has a deep root. The need of human beings to belong to and unite behind a common culture, institutions and values is part of human nature. This need is hard-wired because of its survival value during evolutionary history. It cannot be overcome by government policies and coercion aimed at its elimination.

The world’s experience with policies designed to create socialist and communist utopias provides an interesting historic parallel. These policies were based on the notion that selfish behaviour of individuals operating in a capitalist free market system created income inequalities, economic crises, environmental degradation and other alleged pathologies. Policies to create these utopias ended in the face of persistent selfish behaviour that, like the need to unite behind a common culture is deeply embedded in human nature and is hard-wired because of its evolutionary survival value.

Canada has been spared the political turmoil that in Europe resulted from the creation and success of anti-immigrant parties. However, the public’s desire to preserve Canada’s culture, institutions and values has been growing and undoubtedly has played a role in the recent federal government’s issue of the citizenship guide for immigrants.

Some concerned Canadians are not satisfied with this guide and have created the organization Canadians for Immigration Policy Reform, which lobbies for more changes to current immigration policies and maintains a website to present facts and analysis of the issues. The government ignores at its own risk the public’s desire for the further modification of multicultural policies for the protection of Canada’s culture, institutions and values.


Herbert Grubel
Professor of Economics (Emeritus), Simon Fraser University
Senior Fellow, the Fraser Institute

Air Canada and Corporate Welfare

The regulation of the Canadian air industry is supposed to ensure that the public has access to safe, reliable flights at the lowest cost. This mandate has been perverted. The regulatory regime now subsidizes the employees and owners of Air Canada at the expense of the taxpayer and travelling public. Nothing drives home this point better than the current dispute with the United Arab Emirates over landing rights in Canada for its two national airlines, Emirates and Etihat.

These two airlines requested the right to service Toronto more often and to offer flights to Vancouver and Calgary. If these requests had been granted, Canadians would have saved money, benefited from greater convenience, or both.

These benefits are evident from the fact that the Emirates Airbus 380 (the largest passenger plane in existence) flying now twice a week between Toronto and Dubai is nearly always sold out. The large number of Canadians of Indian and Pakistani origin find Dubai a very convenient gate way, offering many daily flights from there to the Indian subcontinent.

Dubai also has good connections to other countries in the Mideast and Africa, which are the destination of many tourists and business travellers from Western Canada and especially oil experts from Alberta. All of these flyers would be able to avoid stopovers in Toronto and enjoy shorter travel times in the air.

The reason for the refusal by the government to grant these UAE airlines
more landing rights in Canada is that it would cause Air Canada to lose millions of dollars in revenues and profits because, to keep its current passengers from flying with these airlines, it would have to lower fares, improve service and offer schedules more convenient for customers. These costs reflect the value of the benefits, which Canadians would have enjoyed if regulators had decided to allow UAE airlines access to Canada. The value of these lost benefits represents a subsidy to Air Canada.

This subsidy is a clear case of corporate welfare, even if it does not show up in any government budgets. It violates the spirit of free trade and is equivalent to prohibiting the import of any good just because it would cause Canadian producers to lose money. It therefore is a violation of existing international free trade agreements.

International relations are a game of tit for tat. The government of the UAE has just done the tat. It has cancelled Canada’s privilege to use the Camp Mirage airport near Dubai as a staging area for the war in Afghanistan. The shift of these military flights to other locations will cost taxpayers millions, all because regulators protected the interest of Air Canada.

Air Canada is likely to have argued against the landing rights for the UAE airlines on the grounds that they benefit from unfair government subsidies. If this is true, Canadian consumers should rejoice in receiving these subsidies from the taxpayers of the UAE. However, since such subsidies are illegal under international agreements, a complaint lodged with the World Trade Organization would lead to their elimination.

But it is not clear that these airlines are subsidized. They may just be more efficient and less burdened than Air Canada with pensions, wages and work rules extracted by unionized labour in the past. Dealing with the financial problems caused by these conditions should not be the responsibility of Canada’s travelling public or taxpayers in general.

How can we explain the regulatory decisions that provide subsidies to Air Canada at the expense of the Canadian public? Research has shown that the design and operation of regulation often is hijacked by the regulated industry to serve its own interests rather than those of the public. One of the reasons for this result is that advice to the regulators predominantly comes from the people in the industry, who are the best experts available but who also know what the industry’s coveted interests are.

Politicians also influence regulatory rules and decisions since they know that any policies that affect adversely the interests of Air Canada result in the loss of votes from the employees and other beneficiaries of Air Canada while the public is either ignorant of or not interested in casting their votes in opposition to these policies.

It is high time that Ottawa stops corporate welfare going to Air Canada through its regulatory decisions, allows full international competition and limits the use of its powers to ensure the safety of passengers. Air Canada has an excellent brand name, management and staff. It can and will survive, if not prosper, without government protection.

Herbert Grubel
Professor of Economics (Emeritus), Simon Fraser University
Senior Fellow, The Fraser Institute

Cancel the Obituaries for the Euro

When Greece faced a serious financial crisis in 2010, many Euro-sceptics rubbed their hands in glee and wrote obituaries for the currency union. It now looks as if these obituaries have been premature. The Greek government adopted policies that are returning the country to economic stability. Domestic protests against these policies appear to have run their course.

The value of the Euro reflects the confidence the worlds’ investors have in the currency. While it was worth 1.51 US dollars before the crisis in December 2009 and had fallen to 1.19 at the height of the crisis in June 2010, it has since then climbed steadily and reached 1.40 in the middle of October.

The writers of the obituaries for the Euro based their views on the premise that the people of countries like Greece would suffer unnecessarily because its government could no longer use monetary, exchange rate and fiscal policies to deal with unemployment and other economic calamities. In response to these sufferings, they would flee the yoke of the Euro, adopt their own currencies and quickly eliminate these problems.

The main reason why the Euro-sceptics were wrong is that the problems of Greece and other countries like Italy and Spain have not been caused by the traditional business cycles and economic shocks. They have been caused by persistent economic mismanagement rooted in social-democratic ideology, which cannot be cured by Keynesian monetary and fiscal policies but require external pressures on politicians to mend their ways.

The driving force behind Greece’s economic mismanagement during the postwar years has been a belief in the idea that governments can do better than free markets and create a socialist utopia. It resulted in many unsustainable policies. One of these was that the government protected workers and firms from the impact of shifts in international comparative advantage. When Greek shipyards and the producers of textiles could no longer compete with foreign producers, the government bought the firms in trouble. It kept most of the workers or induced them into early retirement.

At the same time, Greece expanded public sector employment to deal with high levels of unemployment, which to a large extent were caused by its own misguided industrial policies. It used economic and financial regulation intensively to advance its ideological goals. It used tax and social spending policies to offer security from cradle to grave and equalize incomes.

The consequences of these policies were unavoidable. They resulted in large fiscal deficits due to bloated public sector employment and the fiscally irresponsible operation of public enterprises; low average retirement age for Greek workers; high levels of corruption and tax evasion; and most important for the longer run, slow productivity growth.

While most of these consequences worked slowly and were hidden from public scrutiny, the fiscal deficits were not. To finance them, Greek governments forced the Greek Central Bank into buying its bonds and paying for them by printing money. As a result, between 1971 and 1994 inflation averaged 17.7 percent annually. The inflation in turn caused the value of the drachma to fall to about 10 percent of its initial trade weighted average value between 1964 and 1999.

When Greece adopted the Euro in 1999, the inflationary financing of deficits through its central bank ended because the central bank lost its ability to print money. For some years, inexplicably, private sector investors continued to buy Greek bonds without asking for risk premiums commensurate with the unsustainable growth in the public debt. However, the global financial and economic crisis that started in 2008 changed all that. There were predictions that Greece would be unable to sell its bonds and declare bankruptcy.

That was the time when Euro sceptics had their day and the currency was under attack. But instead of resulting in a crumbling of the Euro, the attack produced international commitments to buy Greek bonds under the condition that the government adopt policies that would restore fiscal balance and modify the social democratic policies discussed above.

The beneficiaries of government programs demonstrated and rioted against the implementation of changes that would damage their interests. However, the Greek government had no choice but to make the needed changes and resisted their blandishments. Chances are that politicians welcomed the external pressures for policy changes that they knew were needed but which under normal conditions would have guaranteed electoral defeat. Doing so is perfectly consistent with publicly blaming outside forces for the problems suffered by interest groups.

There is no doubt that the newly adopted policies will benefit all Greeks. The ability to run fiscal deficits will be constrained more than ever before. The resources spent in the past by interest groups lobbying the government for more benefits and regulation will go into productive efforts in the private sector. Inflation will continue to be limited to rates in the rest of Europe.

The Euro system has proven sceptics wrong. Criteria for membership in an optimum currency have turned out to have been endogenous, just as some academics had predicted.

The real cost of the Canadian Long Gun Registry

In 1994, when Liberal Minister Allan Rock introduced legislation for the long gun registry, I sat a few feet from him in the House of Commons, serving as a member of the Reform Party caucus. Before question period one day I asked him privately for information that I required to assess the merit of the bill. He promised that he would provide it to me. He never did. Nor was it produced or considered in the public debates the preceded the vote in parliament that decided to continue the gun registry.

The information that I had requested of the Minister was: “What will be the cost per life saved as a result of the existence of the registry?” Knowing this cost does not imply a callous disregard for lives. To the contrary. It allows one to judge whether this cost is higher or lower than that of other ways in which lives could be saved through government spending programs.

The economic issue is clear. Resources used for one deserving cause are not available for other deserving causes. Economic benefit – cost calculations rationally should be used in the evaluation of all proposed government programs.

For example, if it costs $10 million to save one life through the registry but it costs only $5 million to save one life by improvements to road intersections or the provision of better medical equipment in hospitals, an enlightened government should spend that money of the improvement of roads and health services, not on the gun registry. More lives would be served through spending of a given sum of money, a result everyone would welcome.

With the resources available to the federal government, reasonably reliable estimates of such costs and benefits could be made by civil servants and academic specialists. In fact, after I had my conversation with Allan Rock, I asked a colleague in the Criminology Department of Simon Fraser University about the feasibility of such a study. He assured me that it would be possible to do one.

The arguments presented by gun owners on one side and by defenders of the registry like police chiefs on the other, basically are about costs and benefits presented with much emotion but virtually no empirical content.

Gun owners deplore the costs incurred by the government in setting up the registry, the fees they have to pay, the time lost completing registration forms and the inconvenience and cost of meeting the registry’s requirements for the storage and safe keeping of guns.

The police chiefs defend the registry on the grounds that it saves the lives of law enforcement officers, potential victims of crime and domestic violence and that it saves time in responding to emergency calls. Some Canadians argue that the registry prevents a repeat of massacres like the one at Montreal's École Polytechnique in December 1989 that lead to the death of 24 women.

In principle and in the final analysis, the costs borne by the gun owners and the general tax payer can be expressed in terms of dollars with relative ease. The benefits of the registry are more difficult, but not impossible to estimate. Needed is, for example the comparison of the number of police officers and private citizens killed before and after the registry, adjusted for the secular downward trend observed in recent years.

Similarly, it would be possible to estimate the number of innocent people killed by long guns used by emotionally disturbed persons and what effect the registry would have on this number. The needed calculation would be difficult since Montreal-style mass murders are very rare in Canada, but some estimates could be based on comparisons of such incidents in US states and other countries that have and do not have strict long-gun registration systems.

The recent vote in parliament will not make the issue of registry go away. It would be most helpful to all Canadians if future discussions would be based on the kind of information suggested above and lead to voting decisions based on real facts and much less on emotion.

COSTLY, NEW REGULATION WILL NOT PREVENT FUTURE FINANCIAL CRISES

The current push by national governments and international organizations for more financial regulation and mandated insurance schemes shows that politicians and bureaucrats have forgotten the dismal history of such policies.

Many studies found that regulation not only imposes high costs of compliance on governments and firms, it also all too often results in government failure that damages the interest of consumers more than did the market failures the regulation was designed to fix. These findings drove the recent, widespread deregulation of the airline, trucking and other industries in the US and around the world.

The most telling evidence concerning the cost of government failure involved a comparison of the prices of tickets for unregulated flights between Los Angeles and San Francisco with those for the equidistant but regulated flights between Boston and Washington. The unregulated, competitively determined ticket prices were one half of those that existed under regulation.

How and why did this happen? The answer is that the regulators were “captured” by the regulated and made decisions that served the regulated industries at the expense of consumers. The capture occurred because the people charged with administering the regulations were chosen on the basis of the specialized knowledge they had acquired as former employees of the regulated industries or because they were advised on current issues by experts in the pay of the regulated industries.

The recent oil-well disaster in the Gulf of Mexico is just another example of such a capture of the regulatory regime by the regulated. It has been blamed on the inadequate enforcement and the modification of regulation of the industry, the most important of which was economic. It limited liabilities of firms that caused the environmental damage, severely reducing the market incentives to take adequate measures to prevent the damages from taking place.

The second problem associated with all regulation is that it results in unintended consequences that often cause new problems. For instance, the punitive taxation of salaries for executives above one million dollars in the United States induced firms to compete for talent by the much increased use of bonuses, which in turn resulted in more policies focused on bonus-paying short-run profits that have been blamed for the misallocation of resources and contributing to the current financial problems.

Another example of unintended consequences of regulations involves banks’ capital requirements based on the riskiness of investments. Banks avoided this regulation by establishing separate corporate entities that housed the management of such risky assets, often just using the same personnel that had carried out the activity in house.

As a result, banks met the regulatory requirements but continued to earn profits from the risky investments through the dividends paid by the companies they owned. The unintended consequence for financial stability was that the operations of these new entities escaped the direct supervision by the banks’ boards of directors and the scrutiny of their stockholders and that their failure contributed much to the depth of the recent crisis.

One of the new types of organizations created by banks and independents were the so-called hedge funds. Their engaged in some highly innovative activities, increased the flow of capital to new ventures and raised the efficiency of capital markets in general. We have long had fire, accident, life and crop insurance. Now we also have bankruptcy insurance serving investors. But these funds and other issuers of new financial derivatives were not covered by regulation and have been seen by many to have contributed to the severity of the recent financial crisis.

The failure of governments to regulate the new hedge funds and derivatives is indicative of their inability to keep up with the development of new financial institutions and practices, which surely will occur again. And that is a good thing, because otherwise financial innovation would come to a halt to the detriment of economic efficiency and growth.

It is tragic that the protection of the public from the systemic problems accompanying the failure of financial institutions will rely on new regulations when there already exists a simple and proven method for dealing with the issues.

When a financial institution cannot meet its obligations, Chapter 11 procedures should be invoked so that it can continue with its normal business activities, while under the supervision of courts, attempts are made to restore fiscal health through refinancing and changes in business practices. If these measures fail, the firm has to declare bankruptcy and arrange for an orderly, legally specified settlement of debts out of remaining assets. This process worked well for firms in the airline business and other industries. There are no fundamental reasons why it would not work for financial institutions.

The second major policy initiative that has followed the recent crisis is the proposal to establish funds to be used for the bailout of failing financial institutions. The big problem with this measure is that it will induce moral hazard behaviour. Just like people with health insurance have increased doctor visits and restaurants that have fire insurance burn more often, so will financial institutions protected from bankruptcy require increased need for financial bailouts.

Mandated government insurance against the failure of financial institutions has the further undesirable consequences of making consumers less vigilant. Knowing that a bank deposit is insured results in less scrutiny of banks by rationally acting depositors. The same outcome is certain, but much more important for the economy once the more complex obligations of financial institutions, like derivatives, are guaranteed by the planned bailout systems.

Moral hazard behaviour can be limited by the use of deductibles and co-insurance. Not all but only a fraction of bank deposits should be insured. Shareholders in banks already bear the main risk of failure but their incentives are blunted by the knowledge that their institutions are “too big to fail” and therefore will be bailed out by governments.

There is one final serious problem with regulation, which stems from the fact that they have to be enforced by fallible humans. The problem is readily seen by considering the parallel between financial regulation and rules governing sports. If the past is any guide, fans at the upcoming World Cup of Soccer in South Africa will be protesting what they consider to be faulty interpretations of the rules of the game by the enforcers of existing rules. One can only hope that the protests will be limited to screaming and will not result in the sort of riots that have taken place in the past.

In this context it is worth noting that Canadian commercial banks have weathered the recent global financial crisis much better than US banks. At a recent conference on what US regulators could learn from this experience, experts agreed that the greater financial stability in Canada was due much more to proper enforcement of existing regulations than to differences in their design and scope.

Another illustration of the crucial role played by enforcers was revealed by the news that the US Security and Exchange Commission had agents on the premises regularly and for extended periods auditing the financial affairs of Bernard Madoff when his Ponzi scheme collapsed and caused untold hardships to many investors.

History is clear. Leaving in place or in many cases restoring the penalties that are dished out by free markets to those who go bankrupt and cause fluctuations will minimize the costs they impose on society much better than more regulations and controls.

Politicians eager to be seen as doing something to prevent future financial crises would be well advised to study the sordid record of regulation. They should learn that some financial and economic fluctuations are inevitable under capitalism, representing a cost that has been repaid many times by the dynamism of free markets and the rise in income and welfare they have produced.

Public Sector Unions and Fiscal Deficits

The Canadian Federation of Independent Business (CFIB) in 2008 published a study authored by Ted Mallett and Queenie Wong that compared the incomes of employees in the public and private sectors in Canada.

The results of this study have not been given the attention they deserve at the present time when governments are searching for ways to eliminate large deficits: If the incomes of public sector workers were equal to those in the private sector, fiscal deficits of governments would be lowered by at least $19 billion.

The income advantages enjoyed by public over private sector workers for different types of employers are:

Federal Government 17.3% 41.7%
Post Office 16.9% 40.5%
Urban Transit 12.9% 35.7%
Municipal Government 11.2% 35.9%
Educational Institutions 10.8% 17.6%
Healthcare Institutions 8.5% 19.0%

where the first figure shows the difference in wages and salaries only and the second shows total compensation (wages and salaries plus the value of other forms of compensation like pension contributions, length of work week, holiday and sick-leave provisions).

Source: CFIB analysis of Census 2006 custom tabulation, Wage Watch, December 2008, found at (www.cfib.ca).

It is important to note that these comparisons involve only occupations that have the same responsibilities in both sectors, such as office clerks, accountants, administrative officers and human resource specialists. Excluded are professors, urban transit drivers, fire-fighters, elected government officials and senior government employees such as deputy ministers, since they are not found in the private sector. The data are also adjusted for age to account for the fact the public sector employees on average are older than those in the private sector.

The data in the CFIB study show great variations in these percentages for different provinces and cities but the fact of greatest interest here is the authors’ conclusions that government deficits would have been $19 billion lower if the median wages and benefits in the public had been the same as in the private sector. The data are from the 2006 census, a year in which public sector employment was 20 percent of private sector employment. Because of the growth in public sector employment levels, compensation and general inflation since then, the excess in 2010 would be several billion dollars larger.

To justify any reduction in public sector compensation, it is essential to understand that the existing gap is due entirely to the higher levels of unionization of the public sector and to the disproportionate power the public sector unions have in raising the incomes of their members.

What explains this power of public sector unions? The answer is that public sector workers produce services that are free to the public and that face no competition from the private sector. At the same time, politicians face direct and grave consequences if strikes inconvenience the public while the consequences of covering higher labour costs through increased taxes are relatively minor, especially in a world of economic growth and automatically rising tax revenues.

The merit of policies to reduce public sector incomes must also take into consideration that they are unfair and inconsistent with Canada’s effort to ensure “equal pay for equal work”. Office clerks, accountants and others in occupations compared in this study should be paid the same whether they work in the public or private sector.

The blame for the existing income differences falls fully on politicians, who gave public sector employees the right to strike without making any provisions to prevent the observed, inefficient and unfair outcome. Unions and their members simply and understandably have been taking advantage of the opportunities offered them by the politicians.

What measures would help reduce the existing fiscal deficits and restore equity in the compensation of public and private sector workers? The most obvious measure would be the elimination of public sector unions, which would probably appeal to the vast majority of Canadians who are not members of unions and support the notion that no one has to work for the government if they do not like the absence of unions.

A second-best policy would permit public sector unions to exist but deprive them of the right to strike for higher compensation. Under these conditions, the main function of the unions would be to represent individual workers that have grievances against management. The existence of such an institution would improve the quality of the work environment raise productivity.

The elimination of public sector unions’ right to strike should be accompanied by the adoption of a formula that ties annual increases in public sector wages and compensation to those in the private sector. To eliminate the existing gap, the public sector increases should be a fraction, say 50 percent of private sector increases until the levels in the two sectors are equalized.

Politicians probably are reluctant to accept the preceding proposals because they would face fierce opposition from unionized workers in both sectors, endangering their electoral prospects. However, the effectiveness of such union opposition can be blunted significantly and can even raise electoral prospects if the vast majority of non-unionized Canadians are made aware of the consequences of not doing so: unjustifiable income advantages for a privileged group and higher deficits or taxes for the rest.