Doug Peters and Arthur Donner (names I remember from the 1970s debate over inflation in Canada) have an opinion piece in the Toronto Star on the role of the Bank of Canada in reducing the budget deficit. It starts out fine, but ends in a non-sequitur.

It really does start out fine. They give numbers for the deficit as a percentage of GDP, both for the Federal deficit and for the total (Federal, provincial, plus municipal) government deficit. They note that Canada's deficit/GDP ratio looks good compared to other countries.

They note that lower unemployment would reduce spending and increase tax revenues and automatically lower the deficit. They note that lower interest rates would reduce interest payments on the existing debt, and also lower the deficit. Fine. And they ask the right question:

"The real public policy question is whether Canada can grow out of its deficit or whether massive spending cuts or new tax revenues will be needed – or all three: economic growth, spending cuts and new tax revenues?"

The trouble starts when they try to answer a more specific question:

"And to date, there has been relatively little discussion about the role the Bank of Canada will play in any process of deficit reduction."

That's when the flashbacks to the early 1970's begin. They keep switching back and forth between one vision of reality and an earlier alternate vision of reality.

Before Friedman, Phelps, and Lucas changed our vision of the Phillips Curve (which happened sometime in the mid 1970's), the mainstream Keynesian perspective was that monetary and fiscal policies, through their influence on aggregate demand, could target the unemployment rate. The following statements make perfect sense from that earlier perspective:

"If the bank continues to target a 6.5 per cent to 7 per cent unemployment rate, then surely Canada has a structural budget deficit. In that case, both spending cuts and new tax revenues would be essential.

If, however, the bank were to take its full employment "target" to a much lower level, say 5 per cent, and also raise its comfort zone for acceptable capacity utilization for the economy, then it would be easier to bring the federal budget into balance or to a very low deficit level by supporting economic growth and job creation."

But note how they put the scare quotes around "target" the second time. A true early 1970's Keynesian would not have used scare quotes to talk about the "target" rate of employment or unemployment. They know they are having a flashback. They know the Bank of Canada has a 2% inflation target, and only uses unemployment as an indicator of whether it is likely to hit its inflation target.

And in the very next sentence, they indeed come out of their flashback, and ask:

"The key for the bank is going to be whether a 2 per cent inflation rate is consistent with the objective of lower unemployment."

Exactly! That is indeed the key question.

But immediately following that sentence we get the total non-sequitur:

"Thus, whether Canadians have new taxes or huge spending cuts to federal programs to cure the fiscal deficit is to some extent up to the Bank of Canada."

There's no "Thus" about it. It is not to some (or any) extent up to the Bank of Canada; it is to some extent (and to a very great extent) up to whether or not a 2% inflation target (or any long-run equilibrium rate of inflation) is consistent with 5% unemployment.

The final paragraph I can only interpret as an attempt to reconcile their two visions of reality: to make sense of the flashbacks.

"We believe the recent deep recession provides Canadian policy-makers with more scope to achieve low inflation and low unemployment simultaneously. But have the central bank and other policy-makers also recognized that the structure of the economy has changed?"

Now if the long run Phillips Curve has indeed shifted left as a result of the recent deep recession, we would indeed want the Bank of Canada to recognise that fact. It would mean that unemployment as an indicator had indeed changed its meaning, in the same way that a thermometer would if the scale slipped. And if the Bank of Canada missed seeing the fact, the result would be a temporary bout of inflation below target and higher unemployment.

But Doug Peters and Arthur Donner give no reason to support their belief that the recent deep recession has caused the Phillips Curve to shift favourably. They just assert their belief.

Let me assert my belief to the contrary: I believe that the recent deep recession has probably caused the Phillips Curve to shift unfavourably, at least temporarily. And the reason I believe that is that there has probably been a shift in relative demand for the different sorts of goods that Canada produces. Demand from the US will probably be lower, and demand from China will probably be higher, for example. And these sorts of shifts in relative demand will cause a temporary increase in structural unemployment. It's not all structural unemployment, but some of it is. I wish it weren't so, but it is. And the Bank of Canada can't wish it away either.

Why stop at 5%? Why can't the Bank of Canada target 0% unemployment? Sorry, just a quick flashback to my youth.