Canada has been down this fiscal path before. Back in the 1980s, under a succession of deservedly forgotten Conservative Finance Ministers, it was never quite the right time to rein in the budget deficit. That task eventually fell to the Chretien/Martin Liberal governments of the 1990s. How they did it is not well recalled and is relevant to what the present government and its successors may find themselves facing in the next few years. We shall come back to that.
When Justin Trudeau came to power in 2015 he inherited a minute budget surplus from the Harper Conservatives. Trudeau had campaigned on a promise to run small deficits for a short period of time in order to boost growth. It quickly became apparent that the deficits would be neither as small nor as temporary as Trudeau promised -- and then came COVID. The government correctly boosted spending sharply to cushion the pandemic's impact on the economy, and as revenues fell, the deficit skyrocketed to unprecedented levels.
Tabling her Fall Economic Statement on Tuesday afternoon, Finance Minister Chrystia Freeland alluded to the impact of COVID on the fiscal situation, citing the most severe economic slowdown since the Depression. Here's the thing though: the downturn in the economy in the first half of 2020, severe though it was, lasted barely long enough to meet the "official" definition of a recession, i.e. two quarters of declining output. By the second half of that year the economy was rebounding sharply, and a solid rate of growth was maintained through 2022.
The temporary spending schemes hastily put in place in 2020 were gradually unwound as the pandemic waned. However, instead of bringing the deficit back under control, Trudeau and Freeland decided that the funds should largely be redeployed into new spending initiatives, so deficits remained far larger than originally projected. The Bank of Canada, and increasingly the business economics crowd, have been arguing ever louder that this fiscal stimulus directly contributed to the persistence of an above-target level of inflation, which in turn forced the Bank of Canada to raise interest rates substantially.
Thus we arrive at the economic background to yesterday's economic statement: a slowing economy, sluggish growth in revenues, a raft of post-COVID spending commitments, urgent new spending needs (especially for housing) and the rapidly rising cost of servicing the soaring government debt. Courtesy of higher interest rates that may well be in large measure the government's fault, debt service costs are set to rise so quickly that even if the government were prepared to contemplate meaningful spending cuts -- which it emphatically is not -- the deficit would still be an almost intractable problem.
The actual content of the economic statement itself is pretty flimsy stuff. The Government's economic projections, as is usual these days, reflect those of non-Ottawa economists. In the base case, the economy is expected to avoid a recession by the skin of its teeth, with growth of just 0.4 percent next year. Inflation is expected to keep moving lower, which is of course not positive for the revenue growth outlook. Unemployment, which has already been moving higher in recent months, is expected to rise by almost another full percentage point next year, to 6.5 percent.
Under these assumptions, the base case forecast for the deficit in fiscal 2023/24 (ending in early April) is C$ 40 billion, just about identical to what was tabled in last Spring's budget. Beyond this year, however, the situation looks markedly worse. In the budget, the deficit was projected to narrow fairly steadily over the five-year forecasting horizon, reaching C$ 14 billion by FY 2027/28. The new projection shows essentially no narrowing of the deficit in either of the next two fiscal years, and the deficit at the end of the planning horizon is now projected at C$ 18.4 billion. "Downside scenario" numbers are of course considerably worse.
The Government can try to portray itself as being helpless in the face of adverse developments here, but that is not the whole story. The fiscal outlook table reveals that "policy actions" since the Spring budget have already added about $ 6 billion to the cumulative deficit over the first three fiscal years of the planning horizon. Adding in the new measures announced by Freeland yesterday, the Government is now planning to boost spending by a cumulative C$ 20 billion over the full five-year horizon. Presenting this as "fiscal prudence" is unlikely to convince many voters, let alone opposition politicians.
That new spending is mainly focused on the housing sector, which faces something of a perfect storm as a result of rising mortgage rates and rapid population growth. Provinces and municipalities are crying out for immediate help, but Trudeau and Freeland have perversely chosen to back-end-load the new funds. Much of the money will not be available until FY 2025/26 when, surely by pure coincidence, the next election is likely to be called. One measure that will take effect sooner is an attempt to crack down on the likes of Airbnb, but given the wiliness of buy-to-rent investors, it remains to be seen how much that can achieve.
It's a problem largely of the Government's own making. Suggestions that Canada will soon hit some kind of a "debt wall" are off the mark -- that need never happen to a sovereign currency issuer -- but the way out of the mess is hard to discern. How did Chretien and Martin pull it off back in the 1990s, and can the current hapless pair do the same?
The big innovation made by Paul Martin as Finance Minister was to shorten the planning horizon. His Conservative predecessors had always promised lower deficits in the "out years", but as budget succeeded budget, the reductions kept getting pushed into the future. Martin cut the horizon to two years but insisted that the spending ministries actually obeyed the targets that were set in each budget, with no backsliding. What had seemed an intractable problem was largely eliminated in less than a decade.
Ever since that time, Liberals have taken the occasional victory lap to remind people of how they cut spending in the 1990s. One former minister even pitched up in London when I was living there, offering his deficit-slaying expertise to the Cameron government. The problem with that is that it is not entirely true. There were some spending cuts in the mid-1990s, but by the decade's end almost all categories of spending were as high or higher than they had been when Martin took on the job. What really closed the fiscal gap was a startling rise in revenues, which soared by more than 60 percent over the course of the decade. For that, thank a strongly-growing US economy fueled by the low interest rate policies of the Greenspan Fed.
That lesson from history is not an encouraging one for the Trudeau government. The US economy has been outperforming Canada's and interest rates, though higher than they were two years ago, are still not high by historical standards. Despite this relatively helpful background, Canada's fiscal situation has deteriorated sharply, mainly thanks to spending decisions consciously taken by the current economic team. The next Finance Minister, be they Liberal or Conservative, is going to face a truly tough task.
Apologies for the unusually long post, but it's depressing to see such a complete failure to learn the lessons of the past.
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