The economy is in a downfall.  Federal and provincial governments have shut down the economy to contain a deadly virus.  Businesses have closed, jobs have been lost and unemployment has soared.

This year, real GDP could fall by 10 to 15%, or even more, which is larger than the decline in output during the Great Depression. Although some social isolation restrictions are being lifted, at this time, given all the uncertainty, no one really knows how large the decline in output will actually be.

The federal government has responded by implementing programs to provide massive income support to individuals, families, and private companies. So far, this direct support amounts to over $150 billion, with most of it scheduled to end in mid-June. This total could easily rise to $300 billion if these ‘temporary’ programs are extended to the end of the year.  Taking into account the possible decline in GDP, we could see the deficit rising to $400 billion or 20% of GDP in 2020-21.  If no vaccine is found, the same could be true for 2021-22.  The debt ratio could rise to over 50 percent of GDP.

The federal government has quite correctly said that its immediate priority is to curtail the growth of the virus before beginning to open up the economy.  No one knows how the economy will behave over the coming months, or even years. There is simply too much uncertainty about health outcomes, economic behavior, financial market stability, and day-to-day consumption, investment and employment decisions.

However, the fiscal situation we are in is not unique. During WWII, the federal government incurred very large deficits because of military spending. The debt ratio rose to over 100% of GDP.  When the war ended and military spending stopped, deficits fell significantly.  By 1946-47, the government was running a surplus, which continued for the next five years. The debt ratio also began to decline and continued declining until 1974-75, when it reached 18.7% of GDP.

Does the federal government face a looming financial crisis in 2020-21, or in subsequent years? Already some commentators are saying the government will have to slash spending because this is what happened after earlier periods of rising deficits and debt.

During the 2008-09 financial crisis, the Conservative government implemented a major ‘temporary’ stimulus package as part of a G20-coordinated global strategy.  Once the economic recovery was underway, the government began withdrawing the economic stimulus.  At the same time, the Conservative government decided to pursue a fiscal strategy of expenditure cuts to eliminate the deficit. Although the deficit did fall dramatically, the goal of deficit elimination was never achieved.

In 1993, the government faced a financial crisis that had been developing since the late 1970s.  The deficit, as measured then, was just under 8% of GDP and the debt ratio was close to 70% of GDP.  Although the government was running a surplus on its operating balance, the surplus was not increasing fast enough to offset the rising impact of high interest rates on public debt charges.  As a result, the government was borrowing to pay the interest on its debt and every year this borrowing was getting greater. Ten-year bond rates were close to 12% and over one-third of every revenue dollar was used to pay interest on debt. This was a financial crisis.

Fortunately, the situation in 2020-21 is very different. Interest rates on government bonds are virtually zero.

What happens to the deficit in 2020-21 or 2021-22 will depend entirely on political decisions regarding the ‘temporary’ programs introduced to assist individuals and businesses facing financial struggles due the pandemic.  If all the ‘temporary’ assistance programs were ended or allowed to wind down, then there would be an automatic decline in program spending and a deficit in the range of $150-$300 billion. The debt ratio would also decline significantly. The government will need to resist making all those ‘temporary’ programs permanent.

If this does not happen then yields on government bonds might increase if bond markets perceive the government as being unwilling to take the difficult political decisions to restore a sustainable fiscal structure. This would be true for other countries as well.

The Prime Minister has said this is not the time for a budget. He is probably right. There is still far too much uncertainty to prepare a full budget. Until a vaccine is discovered, any economic forecast will be a shot in the dark.  However, this does not preclude the Minister of Finance from presenting an economic and fiscal update to parliament by September, when second quarter economic results become available.

The Parliamentary Budget Officer has already presented three possible economic and fiscal updates, each one significantly worse than the last one. The government’s update should present alternative scenarios, with alternative policy responses. This kind of analysis would be needed to determine if a new stimulus program might be necessary to help the economy get restarted.

Originally published on May 6 on “Canada Newswatch”