The ending of the Bush tax cuts is equal to 2% of the US GDP. What is the impact of the non-renewal on Canada’s economy?

As a strict monetarist I believe that deficits do matter, that has always been my position, government should, like everyone else, live within their means.  That means that borrowings are OK, as long as they are repaid out of the revenues they have created (eg a new bridge or power station -- these thing generate economic activity). It’s not OK to use deficits to pay for healthcare or teachers salary; these are general expenses and as such should come out of tax revenues.  Government will operate in deficit during recession, but it should be a rule that as the economy recovers, the government seek to reduce these deficit (yes I know that this is recessionary).  

Over the past few days I have spoke to 4 bank economists in three institutions (don’t ask) and they all came across as optimists on the Bush tax cuts!  All their base models assumed that the Obama administration will “continue” to Bush tax cuts for another 3-4 years.   At first, I wondered if there was something that I missed, but then it dawned on me, these guys are all equity bulls… every one of them looks at the economy and sees a return to the “normal” of the Bush years.Rose tinted glass in my opinion. 

A bit of realpolitiks should be included here.  First the Republicans are speaking for their master – these are the ultra wealthy and right wingers who believe that less taxes is always better – cutting entitlements is the solution (medicare and Social security).  The Tea Partiers now being selected – and probable winners in November will never strike a deal with Obama’s White House, who they consider as traitors anyway.  You can bet that a witch hunts will ensue following the November elections:  Black Panther party, Birther, Appointment, Accorn.  Everything under the sun will be used to stop and destroy Obama’s legislative “successes”. 

There is almost no way for the Obama White House to agree to the Bush tax cuts if they remain as drafted today, and there is no way for the Republican who will probably control both the House and Senate to agree to substantive changes (see Tea Party reference above) that would focus tax cuts to the “middle class” and away from the very wealthy.  Since the WH and Congress will not agree to change the tax cuts these will naturally expire.  In a revenge move Congress will slow/stop the financial reform, health care, and will stall the WH agenda (a reprise of the mid 90’s “Contract with America efforts) -- thereby reducing the Federal government's deficit (and increasing the hardship for millions of Americans).

Now the meat:  $250 billion, which is equivalent to about 1/3 of the current federal budget’s deficit and about 2% of the US total GDP will disappear in 2011 as taxation takes revenues out of the system.  This will generate further economic contraction – it’s simple math!  The results:

(1)               Anemic GDP growth – in the 1.5% to 2.0% for 2011 and 2012

(2)               Stronger U.S. dollar as the Feds will need to borrow less (impact on U.S. exports)

(3)               Further job losses as local, state and Federal government has to lay-off staff because of budget constraints.

For Canada the impact of low U.S. growth in 2011 and 2012 is mixed.  Already in 2009, OECD and emerging economy each consumed 45bbl/day.  OECD oil demand growth was near zero, rest of the world growth rate around 20%, producing a blended increase in oil of about 10%.  In 2011, global oil demand is expected to rise to 89.3 bbl/d [above the 2007 peak demand of 87.6  bbl/day (oil prices had risen to $147 at that time).  An American recession would in the past have lead to a fall in oil prices, but the changing dynamic of oil demand maybe permanently changing the pricing picture.

Currently, 70% of all Canadian exports are destined to the U.S.  About 1/3 of this total is energy (mostly synthetic oil and gas).  Canada is extremely dependent for its export markets on the U.S.

Our second largest exported goods are vehicles – the North American car industry is fully integrated and has been for decades.  It is expected that even in a weak U.S. recovery demand for vehicles is unlikely to drop substantially below the current 10 million units per annum (which is about 20% below the “replacement” level).  As such Canada’s two core U.S. exports are considered largely safe.

Further weakness in the U.S economy will affect the Canadian economy, especially since many of the internal growth factors in Canada have peaked (housing and infrastructure spending).  Canada’s growth rate is therefore likely to suffer slightly form continued U.S weakness caused by the removal of the bush tax cuts, but is unlikely to hamper the Canadian dollar or the broader Canadian economy.  At most further U.S. weakness will trim between 0.5% and 0.75% to Canada's growth prospects.  We still anticipate that Canada's 2011 GDP growth will exceed 3% -- forecast for 2010 is still around 3.2%.

Two caveats, a weak U.S. economy will have no room to maneuver in the event of an exogenous chock; Iran/Israel conflict, failure of one or more European state or some other unknown event could be a tipping point for the U.S. economy from stagnation to recession. 

Second should the U.S. economy face a depression like scenario all bets are off on Canada.  Our economies are closely related, an American depression would severely damage Canada’s economy.  A continuation of the U.S, recession will reduce Canadian growth, but our position as a large exporter of materials and energy will endure with the rest of the world keeping up demand.