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Time to Accept a Fiscal Deficit

| Oct 16, 2008
Glen Hodgson
Senior Vice-President and Chief Economist
Forecasting and Analysis
The global financial crisis has demanded extraordinary measures from governments around the world. Most of the action has been through monetary intervention by central banks and treasuries, but an active fiscal policy is also an option. After spending more than a decade putting Canada’s fiscal house in order, a strong economic case can be made for accepting short-term fiscal deficits in these exceptional times. But can political support be built for deficit spending?

Let’s start with a bit of history on how fiscal surpluses came to have such a hold on us. From the mid-1970s to the mid-1990s, Canada went through two decades of unguided fiscal policy where deficits were run as a matter of course, largely unrelated to the state of the economy. A series of governments at the federal and provincial levels – with parties of all stripes in office – ran deficits year after year, piling up mountains of fiscal debt as a result. These deficits were not part of any larger economic strategy. Many governments planned to reduce their deficit, but the plans were always for next year. The deficits symbolized the inability of our governments to set fiscal priorities and be frank with the voting public.

The rules changed in 1994-95, when Canada was confronted with a loss in investor confidence – as had just happened to Mexico. Without firm fiscal action, this loss of confidence would have increased the difficulty of accessing credit, increased borrowing rates, and resulted in a plunging currency. The federal government led the shift from chronic deficits to fiscal balance, and then to surplus. It was not easy. Spending was slashed; transfers to the provinces for health and social spending were cut by 24 per cent from fiscal year 1993-94 to 1997-98. Programs were down-loaded, many landing on municipal governments, and taxes were increased.
For over a decade now, our federal and provincial governments have been paying down debt and taking great pains to avoid deficits. At the federal level, the ratio of debt to GDP has been more than cut in half, from nearly 70 per cent of GDP in 1995-96 to below 30 per cent in 2008-09. The level of federal debt has dropped by $100 billion over the same period, and annual debt service payments are down from $50 billion to $32 billion. Similar progress has been made at the provincial level.

But getting the mountain of fiscal debt under control is not the only reason to generate fiscal surpluses, as it was over the past decade. Running fiscal surpluses during good economic times gives governments the capacity to offer fiscal stimulus when it is sorely needed, like now.

The economic case for accepting short-term fiscal deficits today is not hard to make. The Canadian economy has been side-swiped by events in the United States that have spread around the globe. Canadian monetary policy is already accommodative; the Bank of Canada has cut interest rates as part of a concerted global effort to restore confidence by adding liquidity to the financial system. And rates may need to be cut again.

Short-term deficit spending by Canadian governments (federal and where warranted, provincial) could provide needed stimulus through explicit action – one-time immediate income tax cuts, or a sharp acceleration in infrastructure spending. We could also accept a short-term fiscal deficit if there is a shortfall in revenues due to much slower economic growth. It would be wrong-headed economically to slash program spending during an economic slowdown in order to attain a pre-determined fiscal surplus or balance target. That action would only make a difficult situation worse.
Yet building the political case for accepting deficits is another matter. Few governments around the world have demonstrated the management capacity to provide short-term fiscal stimulus when required, and then shift back into balance or surplus when the economy recovers. The Bush administration has run up huge fiscal deficits and debt for its entire term, the consequences of cutting taxes on the wealthy and going to war simultaneously. Governments in Europe and Japan have been in chronic deficit for years.

Most Canadian governments are in much better fiscal shape than those elsewhere, and therefore have more scope for short-term fiscal action. It must be noted, however, that government spending in Canada has grown considerably in recent years. At the federal level, rapid spending growth, coupled with cuts to the GST and other taxes, has shrunk the projected federal surplus for 2008-09 from $20 billion to a planned $3 billion.

If Canadians are to accept fiscal deficits in times of economic stress, our governments will need a credible plan to return to fiscal balance as quickly as practical. The specific actions to restore fiscal balance must be crystal clear, and a credible timetable offered.

The bottom line? There is a strong economic case for permitting fiscal deficits to occur when needed -- like now. A fiscal deficit would give our economy a bit of breathing space during times of slow or even negative growth. However, the political evidence from our recent past, and from elsewhere in the world, is that governments do not quickly move back into fiscal balance or surplus when the economy recovers. The political and the economic justifications for deficits will only converge when our political leaders convince the public that the fiscal breathing space will be short-lived and used responsibly.

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