Finance Minister Morneau and Prime Minister Trudeau have finally admitted that the upcoming deficit will exceed $10 billion and that the deficit will not be eliminated over the next four years. Deficit elimination is no longer a short-term fiscal target for the Liberal government, but a “long term” issue.

 

Thank God the government has finally got the obvious out of the way. The Finance Minister is facing a very precarious global economy as he plans his budget. Financial markets are in a state of uncertainty not seen since 2009. The global economy is slowing. Bond markets are signaling the possibility of a global recession in the next twelve to eighteen months.

 

Given this extremely fragile economic and financial outlook, deficit elimination in four years would have been a major policy mistake.

 

What is the right fiscal policy anchor in these circumstances? The Finance Minister still remains committed to implementing a medium-term fiscal policy that will maintain a stable or declining debt/GDP ratio over the next four years. That is his fiscal anchor. Currently the federal debt is around 31 per cent of GDP, slightly higher than in 2008-09 before the financial crisis and not much higher than it was over thirty years ago.

 

Few people appear to understand what this means.

 

In order to maintain a stable debt ratio over the next four years, the growth of the debt must be the same as the growth in the economy.   Based on the November 2015 Update, this means that the deficit must be no higher than $22 billion in 2016-17 and around $30 billion for each of the next four years (about 1.5% of GDP). Higher deficits would result in the debt growing faster than the economy and a rising debt burden.

 

Adopting a “stable” debt to GDP ratio as a medium-term fiscal anchor gives the government more needed flexibility in implementing its policy agenda, but there is a sill an upward bound which cannot be broken if fiscal and indeed political credibility are to be maintained. In a previous article we suggested that a deficit between 1.5 and 2 per cent ($40 billion) of GDP would violate the government’s commitment to a stable debt burden.

 

There are no economic reasons why a “stable” debt burden around 30 per cent is better than a “stable” debt burden around 35 per cent or even 40 per cent. Similarly there are no economic reasons to justify a lower debt ratio of 25 per cent (the Conservative goal).

 

It just happens that the Liberal government inherited a debt ratio of around 30 per cent and it might be politically difficult to set a higher debt target. A lower debt target would also be problematic, since it would mean rejecting much of the policy platform on which the government got elected.

 

The experience of other counties also provides no help in determining an “acceptable” debt level for Canada. For example, consider total government debt burdens (using 2015 IMF Statistics) of the G-7 countries: U.S. (79.9%); Japan (126.0%); U.K (80.3%); Germany (48.4%); France (89.4%); and, Italy (113.5%). Canada recorded the lowest debt burden at 37.8%, roughly the same as in 1988.

 

Among other countries: Australia (17.5%); New Zealand (8.8%); Norway (-161.7); Sweden (-18.4%); Denmark (6.3%); Netherlands (34.8%). Countries with small open economies have debt ratios much lower than those in the G-7.

 

EURO countries are required to follow policies that would ”eventually” lead to a deficit of 3% of GDP and net debt of 60% of GDP. Few EURO countries have ever achieved these goals, and few are likely to achieve them in the future. Some countries (Japan and Italy) don’t care about their debt levels because their government debt is mostly held internally, and the U.S doesn’t care about its debt level because it is so large and important it doesn’t need to care.

 

A key question for policy makers is whether there is a level of debt beyond which growth will suffer. An important study by Rogoff and Rheinhart in 2013 came to the conclusion that when debt levels reached 90 per cent of GDP growth indeed would suffer. Despite some criticism of their work, their original analysis has been supported by IMF research.  However, in Canada’s case, there was a significant interest rate premium placed on its debt in the late 1980s and early 1990s, when its debt ratio approached 70%. However, the fiscal situation then was totally different than it is today. Nevertheless, the exact relationship between growth and debt remains an open issue for economists and of little use to policy makers.

 

So where does this leave the Finance Minister in planning his first budget? In fact, it leaves him pretty much on his own. He must decide how prudent, risk adverse, and credible he wants to be. In our view, there are two “guiding fiscal principles” that he should adopt in his first budget and in subsequent budgets. 

 

First, make sure in budget planning that the debt level averages around 30 per cent of GDP (roughly where it is now) over the next four years. This would be consistent with running a structural deficit of up to $30 billion, or just under 1.5 per cent of GDP and should be more than enough to implement a carefully managed political agenda. This would be acceptable to financial markets and help fiscal credibility.

 

Our second guiding principle is that if there is a political desire for a larger political agenda and higher spending, it should be financed through revenue increases and/or program cuts, not larger deficits and higher debt. Do not repeat what happened in the 1980s. Some political promises should be financed by current taxpayers and not by future taxpayers.

 

Having rejected (correctly) deficit elimination as a fiscal planning target, now the government must reaffirm its commitment to a fiscal anchor of a stable debt burden of around 30 per cent of GDP over the next four years.

 

The government should stick to this anchor “come hell or high water”.