Are deficits the solution to low growth?

The Liberals are betting that deficits will boost growth. The low cost of borrowing means it won’t cost us too much to see if they’re right.

Minister of Finance Bill Morneau participates in a town hall meeting ahead of pre-budget consultations in Ottawa, Monday February 22, 2016. (Adrian Wyld/CP)

Minister of Finance Bill Morneau participates in a town hall meeting ahead of pre-budget consultations in Ottawa, Monday February 22, 2016. (Adrian Wyld/CP)

Finance Minister Bill Morneau revealed an update on the country’s finances on Monday morning at a community centre in the Ottawa suburb of Vanier. The numbers showed that new deficit projections have deteriorated compared to the last official projection in the fall update in November of last year. What does this deficit announcement mean, and what should we do?

What’s in the announcement

First, let’s dig into the numbers in the backgrounder provided with the announcement. The backgrounder informs us the deterioration of economic forecasts accounts for a $12.2-billion increase in the projected 2016-17 deficit. In addition, new spending on programs accounts for $2.6 billion. When you add it all up with the previously forecast small deficit, you get to a total projected deficit for 2016-17 of $18.4 billion. With this deficit, the debt-to-GDP ratio will rise from 31 per cent to 31.8 per cent before declining to 31.1 per cent in 2017-18.

One caveat is in order, though. The numbers released today were based on the average of private sector forecasts for economic growth in 2016-17. Minister Morneau did not just take this average forecast as his baseline, however. Instead, he lopped off an extra $40 billion (two per cent of GDP) from projected growth, which had the effect of increasing the projected deficit by around $6 billion. In other words, if you just went with the private sector forecast the projected deficit would only be around $12 billion. This gives the government a large buffer to ensure they hit their new deficit target.

What the announcement means

The Liberals have offered three anchors to their fiscal policy from the election through to recent days. First was the commitment to a $10-billion limit on the deficit for 2016-17. Second was the commitment to reach a zero deficit by 2019. Third was a debt-to-GDP ratio that declined every year. Morneau’s announcement on Monday means the government will likely miss on all three commitments. Does this matter?

In the long run, stable public finances require a stable debt-to-GDP ratio. The GDP measures the size of the economy, so our finances are stable so long as the debt is not growing more quickly than our ability to pay it. Allowing the debt-to-GDP ratio to rise when there is still growth (albeit small) in the economy should set off some warning bells. What if we were to fall into a recession because of some unforeseen shock hitting the economy in 2016 or 2017? If we are already allowing rising debt-to-GDP now, we will be less well-equipped to handle negative events in the future. So, we are off the ideal long-run path for debt-to-GDP.

But we need to ask: what does this deviation from the optimal path for debt-to-GDP actually cost us? Many commentators turn to anecdotes from the 1980s or 1990s, when deficits led us into a corrosive spiral of debt. The relevance of those anecdotes to today’s situation is hard to see. We are now in a world where the government of Canada can borrow using 30-year bonds that pay only 1.92 per cent interest. That means if we run up $100 billion in debt, it only costs us $1.92 billion to finance that new debt. We are in no danger of a public-finance-driven deficit-debt spiral, and we should simply dispense with anecdotes from previous eras as solid guides for policy today. Our problems today are different.

Another important factor is the long-run outlook for federal finances. According to the Parliamentary Budget Office, the long-run fiscal position of the federal government is not bad at all. Future fiscal problems lie in provincial capitals (because of health spending, mostly), not in Ottawa. So a slightly higher debt-to-GDP ratio should be less of a concern federally than provincially.


Watch Evan Solomon and Frank Graves discuss the political implications of the Liberals’ budget plans:


What should we do?

This fiscal situation announced by Morneau is approximately where we would sit no matter what government was formed after the Oct. 19 election. The deficit is largely driven by factors outside the current government’s control. Politicians in question period may work themselves into a lather assigning blame, but the truth of the matter is that today’s situation was a result of a decline in economic growth outside any federal finance minister’s ability to manipulate the situation.

In sharp contrast, what happens in the coming March 22 budget is very much for the Liberals to decide. If they continue with the plans outlined in their 2015 election platform, they will add at least $10 billion more to today’s $18-billion deficit, taking us close to $30 billion. That’s still only 1.5 per cent of GDP, but $30 billion is real money. And there will be no mistaking who is responsible from this point forward.

It’s worth considering for a moment if there are other choices we could make instead of the Liberals’ preferred path. The best way to see the choices we confront is to consider the top and bottom of the debt-to-GDP ratio. Should we focus on the debt part on top, or the GDP part on the bottom of the ratio?

Some commentators, like economist Stephen Gordon, see today’s low growth as something beyond our control; we more or less have to accept that we are in a low-growth era.  Gordon points to Canada’s labour market which already has fairly high national employment rates and he asks where the growth is going to come from, especially without big increases in labour productivity.

This “end of growth” idea appears outside Canada as well—American economist Robert J. Gordon (no relation to Canada’s Stephen) argues in a new book that the life-changing growth of the 20th century won’t be repeated in the 21st century.

If the professors Gordon are right, the only way to return to a stable debt-to-GDP ratio for Canada is to focus on the top part of the ratio—attack the deficit through spending cuts or tax increases.

On the other hand, economist Larry Summers argues in Foreign Affairs that running deficits can stimulate the economy—like giving a car battery a boost to get it going. Moreover, if these deficits are spent on things that expand the potential of the future economy, we can escape the low-growth scenarios. This would increase the bottom of the debt-to-GDP ratio through economic growth, and return us to stable public finances.

Myself, I’m not sure which side has the better argument. But, all indications from Monday’s announcement are that the Liberal government is going all in for the Summers solution. It will take a couple of years to observe if the Liberals are making the right call, but we’ll certainly know in time for the scheduled 2019 federal election. And with the low cost of borrowing it won’t cost us too much to see if the Liberals are right. For now, I don’t expect the Liberals to give up on their plans before they even give them a try—even if that means bigger deficits.



Are deficits the solution to low growth?

  1. I will say it again like I said it before, the conservatives ran this country with 2 sets of books, the ones they wanted Canadians to see, and the ones they didn’t want Canadians to see. I don’t care what they spend and don’t think outside the bubble cares, as long as I don’t see anymore of them Economic Action Plan adds.

    • CB,
      I don’t recall the Federal Auditor General EVER finding that the Conservatives to have two sets of books. If you have any proof of such an idiotic statement I’d sure like to see it.
      You should care what they spend. Old man Trudeau damn near bankrupted Canada and gave us the highest mortgage rates in Canadian history. His less smart son will likely do even worse.

    • So because you say something beyond idiotic, that makes it so. Wow you sound like a liberal.

    • No deficits aren’t the solution,diapers are….why you ask ? So which human government can you name that has solved even the basic issue’s including, poverty, crime, justice, etc. Yuuup none…so where do you think this game is going ? Laugh till you poop big boy diapers… Canada it will be the hair war between Justin and Rona, in the U.S. it will still be hair, but we know who wins that…..haaaaa

  2. With constant references to middle CLASS….does that mean there is a lower CLASS and a higher CLASS? Regardless of what the government may spend and incur debt I personally do not intend to run into debt. No debt benefits me to the max….so why does a government want to accrue debts? It IS true they can influence growth….but then so do MY personal savings!

  3. Is there really any significant demand for 30 year bonds providing rates of 1.92%? You can get 5 year GIC rates that meet or exceed that, and given that it’s MUCH more likely that rates will increase rather than decrease during that 5 year term, it makes more sense to go short term with GICs or something similar. Yes, the federal government likely has the highest credit rating possible for a debt issuer, but still, that can only take it so far.

    And, doesn’t borrowing more because of current low rates put the government in something of a conflict of interest should later on the correct or prudent course of action be to raise rates? I.e., in the future it may be best for the economy to raise rates, but doing so would leave the government with significantly higher debt financing costs, so it possibly doesn’t do what’s best for the country. I imagine this possibly ties into how much of this new debt could be financed with long term (30 year) low rate (1.92%) bonds.

    Finally, the US seems to be poised to raise rates. This will decrease demand for Canada bonds should Canada not do the same. And this decreased demand will result in an even lower loonie. So, tying Canada to a low rate future, seems to have a possible result of a further devalued loonie (and a corresponding increase in costs for such things as food, and an increase in demand by foreigners for Vancouver and Toronto real estate). So again I wonder, would significant borrowing be likely to result in the government failing to increase rates when the time comes?

  4. Keynes lives!!!!

    • The modern media don’t mention the name Keynes anymore. They don’t have a clue who he is. They don’t know he represents a legitimate economic viewpoint and proven solution to economic cycles.
      The American and Harper supply side, deficit phobia propaganda is unchallenged in the Ottawa media pundit class.
      So looking down the right hand column of National Newswatch today, it’s all deficit hysteria.

  5. 1) Japan and Abenomics disproved the notion that even more stimulative monetary (lower and now negative interest rates and massive QE) and fiscal policy (large budget deficits0leads to economic growth. After three years of Abenomics, wages are down and the economy has barely had any economic growth, and is slipping back into recession.

    2) Ditto the United States. Interest rates have been near zero for 7 years with massive QE, and deficits averaging a trillion dollars per year for the last seven years, and the economy is stuck at 2% growth.

    3) Ditto Europe.

    Why should Canada be any different. Canada had no QE and interest rates between 0.5-1% for seven years. Moderate fiscal austerity at the federal level and moderate fiscal stimulus (i.e. large deficits) at the provincial level, and Canada did as well, are arguably better than everyone else, without the unconventional monetary policy and massive deficits.

    Plus, Canada has tried Trudeau’s policy before when Bob Rae got elected in Ontario. It didn’t work then, and it won’t work now. And the massive deficits and spending haven’t worked for McGuinty and Wynne either.

    • Truer words were never spoken. The free and loose spending Ontario Liberals have made Ontario look like Canada’s home grown Greece!!

    • Also tried by Trudeau 1 followed up by Mulroney, and that didn’t end well either. It took Chretien & Martin (as finance minister) to clean up that mess.

      We’ll just have to wait and see if Trudeau 2 is a repeat of this, but initial signs are that this government isn’t (yet?) willing to do anything that doesn’t involve throwing money at a problem.

  6. “Are deficits the solution to low growth?” I was hoping the article would actually attempt to answer the question – it didn’t. We always hear two things: 1) reduced taxation and business friendly policy will stimulate economic activity 2) investment in infrastructure will stimulate economic growth. The math is 1) reduction in government revenue 2) increase in government spending, consequently deficits.

    ‘spent on things that expand the potential of the future economy’ – that at least seems like a rational for government spending, positioning it as an investment. Of course, spending on gazebo projects are just as likely when politics is involved while pressure to throw money at non-competitive and failing enterprise seems contrary to spending on potential and in is spending on the past economy. One can only wish that government spending meets the objective stated – not most likely, so deficit spending may be less likely to boost the economy. The frequent talk of ‘shovel ready’ projects, which create short term bursts of economic activity, smacks of throwing money against a wall to see if it sticks rather than a well thought out investment in economic productivity; this is at least one reason why ‘deficit spending’ could be ineffective. Already there is a lot of chirping looking for bailouts for companies and provinces – money pits rather than investments.

    • Massive spending on infrastructure will create some near term jobs as well as a deficit adding to our debt However, in order to keep those people employed, you need to continue spending at that level and then the deficit becomes structural with our debt continually rising. The only way government near term plus spending can have any long term financial benefit to the government is if those things which are built generate some revenue directly or federal tax revenue-i.e.true investments that generate a return. I haven’t heard of anything planned that will generate either plus revenue or plus Federal taxes. A more effective way to not increase our debt and to stimulate the economy is to clear the bureaucratic crap around private sector capital spending which generates taxable income. One notable example would be strong government support for pipelines to get Canada’s crude oil to market which would result in higher government revenue through higher royalties collected as well as increased taxes collected on the earnings those projects make.

      • you nailed it …. very foolish plans come from governments who want to be seen as fixing the problem they themselves created. I have never seen spending more than one can take in solve a debt problem.

  7. The majority of Canadians voted for promised debt by Mr Trudeau in the last election.
    Canadians who did so really don’t care about debt as if it is a neutral economic situation.(I won’t even mention the provinces).
    Now $10 billion debt will turn into $18 or $20 billion this year.
    I guess the majority of voters got what they wished for by voting for Mr Trudeau and the majority Liberal government. All’s good!!

    • and sadly most of the voters who put Liberals in power are paid by taxpaying hard working people in private sector because govt. jobs never add to the GDP or GNP. so their fat and happy union run loaders.

  8. i wish i could run my family finances the way Liberals run the country. spend millions more than I earn, and then ask others to pay back the loan. and believe that “debt money” somehow stimulates profits and growth. FOOLISHNESS. stop the debt drain Turdeau.

    • If governments run deficits it stimulates growth. That increases revenue. It’s foolish to compare government and family finances.
      Of course all families know wise debts like mortgages are the foundation of family success. But continued deficits must be accompanied by increased revenue, your salary has to to keep going up!
      Nobody has apparently heard of him, but the greatest of them all, John Maynard Keynes is back.

      • No. At the end of the debt supercycle, which is where the world is at right now, where most governments are nearly 100% debt to GDP ratios or higher (and all debt government, personal, and financial, nearly 300% debt to GDP) deficit spending doesn’t stimulate growth.

        The amount of debt to produce a dollar of economic growth is reaching the exponential blowoff phase.

        The United States has had ZIRP for 7 years, with nearly $4 trillion in quantitative easing, with an average federal deficit of a trillion dollars per year, and the US economy has been stuck at 2% GDP growth.

        Japan has been deficit spending for two decades, with massive QE, and doubled and tripled down over the last 3 years with Abenomics, and the economy is slipping back into recession.

        At the end of a debt supercycle, more debt doesn’t work.