How to spend your way out of a deficit

TheStar.com – Insight – How to spend your way out of a deficit
October 17, 2009.   Thomas Walkom

Canada’s $56 billion federal deficit is a non-issue. Still, everyone frets. The media harp on about it, as does the Liberal opposition. The Conservative government hints that, should it remain in power after the next election, it will use the deficit as an excuse to cut spending it doesn’t like.

They should all get a grip. Relative to the size of the economy (which is the only measure that counts) the shortfall between what Ottawa spends and what it takes in is small beer. Once employment recovers fully, it will be even smaller.

To be more precise, this year’s federal deficit is expected to represent just 3.7 per cent of Canada’s gross domestic product. The equivalent figure for the United States is 12.9 per cent.

Nor is Canada’s total national debt (the sum of past government deficits) dangerously out of whack. At just under 30 per cent, it’s about half the average of those wealthy industrial nations that make up the so-called G7. In practical terms, this means that the cost of servicing this debt is easily doable – even if, as is almost certain, deficits continue for a few years.

So why the fuss? The answer has to do both with a misreading of recent history and an analytical confusion. Deficits do matter for big countries like the United States. America’s $1.8 trillion deficit is so large relative to the size of the world economy that it has the potential to affect international interest rates.

This is the famous crowding-out principle, in which one big borrower muscles out all others. Indeed, some development economists worry – with justice – that America’s government financing needs will effectively starve needier nations of the capital they desperately need.

But compared with the elephant of Washington’s annual borrowing needs, Canada’s federal deficit is a gnat. We can raise all the money we need without causing a hiccup in world financial markets.

True, deficits also matter when lenders start worrying about being repaid. These lenders don’t foreclose (even at the worst of times, financial markets have never refused loans to sovereign governments able to tax their populations).

But if a borrower’s credit rating is reduced, lenders may charge higher rates of interest.

It’s worth noting that Canada’s triple-A credit rating has slipped only once since World War II. That was during the 1990s when Ottawa’s debt-to-GDP ratio was 70 per cent, more than double its current level.

It’s also worth noting that this event was so unusual that it led otherwise sober editorialists to write that Canada was on the brink of bankruptcy – a scenario that was manifestly false.

But probably the greatest analytical confusion surrounds the cause of persistent government deficits. In Canada, excessive government spending is usually blamed.

In fact, most deficits are the result of massive unemployment, which in turn causes tax revenues to fall sharply.

In the recessions of the 1980s and ’90s, these cyclical deficits were compounded by the Bank of Canada, whose high interest rate policy substantially raised the cost of government debt servicing.

However, then – as now – the political right found it convenient to blame social programs.

In the mid-’90s, Prime Minister Jean Chrétien’s Liberal government – spooked by the censure of the New York rating agencies – embraced this right-of-centre critique. He and his finance minister, Paul Martin, slashed employment insurance, welfare and health spending.

Faced with declining financial support from Ottawa as well as their own deficit worries, provinces like Ontario cut spending even more.

And the public, softened up by media scare stories of Canada’s looming descent to Third World status, applauded.

For the Liberals, the Chrétien-Martin spending cuts became their proudest moment. A party that had historically been known for innovative spending revelled in its new image as a fiscal tough.

But as Doug Peters (a junior finance minister in the Chrétien government) and economist Arthur Donner recently pointed out, Martin’s spending cuts probably did more harm than good.

“The successful budget deficit reduction program from 1993 to 1997 was largely the result of reducing the unemployment rate from almost 12 per cent in 1993 to about 9 per cent in 1997,” the pair wrote in the Star last week.

“The spending cuts introduced in 1995 actually may have retarded budget deficit reduction as they substantially reduced employment (and thus tax revenues) in the total public sector.”

So where are we now?

Finance Minister Jim Flaherty predicts that federal shortfalls will persist for at least five years. Mike McCracken of the economic forecasting firm Informetrica Ltd. calculates the federal budget could be in surplus within two years.

Whoever is right, the problem is far from terminal. The Paris-based Organization for Economic Co-operation and Development estimates that Canada’s structural deficit for all levels of government (that’s the estimated shortfall remaining once cyclical effects of recession are filtered out) represents about 3 per cent of GDP – far less than that of France, Japan, Britain or the U.S.

Donner and Peters argue that even this could be virtually eliminated if the Bank of Canada keeps interest rates low.

However, in political terms, the great deficit debate still won’t go away.

The Liberals, anxious to relive their glory days and desperate to stand for something, accuse Prime Minister Stephen Harper’s Conservatives of squandering surpluses that Martin and Chrétien so painfully built up.

(In fact, both the Harper Conservatives and the Chrétien-Martin Liberals spent most of those surpluses on either tax cuts or debt repayment. Nor were the Liberals particularly frugal with what was left. As a percentage of GDP, Liberal program spending in 2004-05, the last full year of their government, was higher than Conservative spending in any year to date.)

Meanwhile, the Conservatives argue that the deficit-fighting methods of Chrétien and Martin unduly penalized the poor and unemployed – oddly enough echoing a critique levelled by Bob Rae, then Ontario’s New Democratic premier and now a high-ranking Liberal MP.

At the time, he called the Liberal deficit-fighting measures an example of “compounded unfairness.”

Flaherty says his Conservatives won’t be so unfair when they get around to tackling Ottawa’s shortfall. Rather, he says, they will exercise “spending growth restraint on direct program spending” – whatever that means.

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