In the July 8, 2020 “Economic and Fiscal Snapshot”, the Government presented revised fiscal projections for 2019-20 and 2020-21 only.  It stated that “given the unprecedented degree of uncertainty clouding the economic outlook, providing an economic and fiscal forecast beyond 2021 with an appropriate degree of confidence is not possible at this time and would potentially be misleading”.

The government, nevertheless, promised to provide an economic and fiscal update with a longer-term time horizon sometime in the fall. In proroguing Parliament, the Prime Minister promised that the Speech from the Throne would present a “detailed vision for the future”.

Prior to COVID-19, the Government had used a declining debt-to-GDP ratio as its fiscal anchor in budget planning. The debt ratio declined from 32.1% in 2016-17 to 30.9% in 2018-19. In the July “Snapshot” however, that ratio increased slightly to 31.1% in 2019-20, but then jumped to 49.1% in 2020-21.

As a point of comparison, in 1995-96, the debt-to-GDP ratio reached a post-war high of 66.8%.  By 2007-08, the ratio had been wrestled down to 29.0%.  The situation today, however, is much different than in the 1990’s, when the elimination of the deficit during the Chretien/Martin era was the result of many factors, most notably the dramatic decline in interest rates and a strong recovery in global economic growth.

There are three important fiscal questions that Finance Minister Chrystia Freeland needs to answer in planning her post COVID-19 budget strategy.

• First, how much fiscal flexibility should she build into the fiscal framework in the short term to manage a potential second COVID-19 wave and the required costs of structural changes generated by the virus?
• Second, once the COVID-19 crisis is behind us (end 2021?) what fiscal anchor should the government use in its post COVID budget plan?
• And third, what will it take for the government to achieve that anchor?

Based on the COVID support initiatives announced to August 26th and the forecast for nominal GDP in the “Snapshot” for 2021, we have extended the economic forecast to 2024 by extrapolating the projected growth rates for nominal GDP in the December 2019 Economic and Fiscal Statement for 2022 to 2024. This provided us with the base for forecasting the fiscal framework for the period 2021-22 to 2024-25.

Since the July “Snapshot”, new support measures have been introduced amounting to $36.8 billion. This has increased the deficit for 2020-21 from $343.2 billion in the “Snapshot” to $380.0 billion and the debt ratio to 50.9%.  For 2021-22, the carry-over from stimulus measures announced to date is estimated at only $13.9 billion.  This dramatic reduction primarily results from the ending of the COVID-19 measures impacting on 2020-21 and the replacement of the Canada Emergency Response Benefit (CERB) by changes to the Employment Insurance program and the introduction of the Canada Recovery Benefit, the Canada Recovery Caregiver Benefit, and the Canada Recovery SicknessBenefit.

Until a vaccine is developed and available to the majority of the population, it is likely that new support measures will be required for both 2020-21 and 2021-22. Our deficit forecast for 2021-22 and beyond does not make any allowance for any new spending beyond that already announced. It is therefore the “best case” scenario and probably an unrealistic scenario.

In our Update, the deficit outlook for 2021-22 will largely be determined by the nominal economic growth assumption in the “Snapshot” (increase of 7.9% in 2021).  The deficit is projected to fall from $380.0 billion in 2020-21 to $86 billion in 2021-22, reflecting the significant decline in the COVID-19 stimulus measures.  It is forecast to decline continuously to about $27 billion in 2024-25.  However, the debt-to-GDP ratio remains virtually stuck at 50% over the 2020-21 to 2024-25 period. To achieve a pre-COVID debt ratio of about 30% would require surpluses averaging about $150 billion per year over the 2022-23 to 2024-25 period. This is clearly not attainable.

The government is confronted with a major fiscal dilemma. The increase in the federal debt is primarily influenced by the temporary COVD-19 support measures implemented in 2020-21. A key consideration is how fast should this impact be offset, if at all.  To make any significant reduction in the debt ratio, annual budgetary surpluses would be required. This would preclude the introduction of any new policy initiatives, such as those being considered by the Prime Minister for the upcoming Speech from the Throne, without raising taxes and/or finding significant reductions in existing programs. Given the nature of federal spending, the scope for such savings is limited. As such, it is unlikely that the current increase in the federal debt will ever be significantly addressed.

To implement a new Speech from the Throne policy agenda, a new credible and publicly accepted fiscal anchor will be required.  Without it the fiscal credibility of the Finance Minister and the government will be completely undercut.
Prior to 2015, the fiscal anchor was a declining annual deficit, leading to a balanced budget. The Chretien Government in 1993 initially established a deficit-to-GDP target of 3% by 1996-97.  Over time, the deficit target was reduced by one percentage point per year until a balanced budget was achieved. The Harper Government committed to balancing the budget over the medium term, following the 2008-2009 financial crisis.

Most Canadians are probably more familiar with a deficit target than a declining debt ratio. Assuming that a vaccine will be discovered relatively quickly, the deficit should continue to decline from its present peak over time. By 2024-25, the deficit, at $27.0 billion based on our calculations, is expected to amount to 1% of GDP. 

Fiscal anchors are viewed as a mechanism to hold governments to account – to impose a degree of fiscal discipline.  Adoption of any fiscal anchor is not without its risks. There are many events over which governments have little or no control. As such, committing to a single point target at a particular moment in time is extremely risky and often without credibility. Legislative targets have proved not to be successful, as witnessed by the experience in the EU.  In Canada, legislative targets are usually eliminated by a change in government.  Furthermore, any target set should be limited to the election cycle.

The government might adopt a deficit target track averaging around two to three percent of GDP. Even in this situation the government will have to establish policy priorities when it comes to implementing its Speech from the Throne agenda. Nor can the government adopt the unproven strategy of simply borrowing “whatever is required” from the Bank of Canada” - the Modern Monetary Theory. Whether it might work in the U.S. (and it is uncertain that it will), it is too risky to apply it in Canada. It would affectively mean the end of the Bank of Canada as an independent central bank responsible for monetary policy. There are longer-term inflation and interest rate risks surrounding a trillion dollars of debt that cannot be ignored. Rising interest rates can impose a major cost on the budget even if the Bank of Canada holds the debt.

The upcoming Economic and Fiscal Update followed by the budget will be critical for the Finance Minister’s fiscal credibility. She will need to convince financial markets, stakeholders, the media and, most importantly, Canadians that she will act in a fiscally responsible, fiscally prudent and fiscally transparent way. To do so, she will need the support of the Prime Minister.