We are not heading to fiscal crisis

The 2016 federal budget does not put us on the road to 1995-style budget crisis. Here’s why.

Finance Minister Bill Morneau makes his way to hold a news conference before the release of his federal budget in Ottawa, Tuesday March 22, 2016. (Fred Chartrand/CP)

Finance Minister Bill Morneau makes his way to hold a news conference before the release of his federal budget in Ottawa, Tuesday March 22, 2016. (Fred Chartrand/CP)

The 2016 budget generated a lot of commentary on fiscal anchors and fiscal sustainability. Many commentators draw on the harsh 1995 federal budget as the example we need to avoid. For example, former Finance officials Scott Clark and Peter Devries argue that we must raise the GST immediately to avoid a nightmare 1990s situation. NDP Leader Thomas Mulcair warns that social program cuts may be coming again soon, also drawing on the 1995 scenario. Economist Jack Mintz decorates his warnings about debt with images of a bomb, hinting that federal fiscal mismanagement is at risk of blowing up the economy.

I have some good news for these commentators: the 1995 debt crisis is not very relevant to our current circumstance, so they can stop worrying. There are lots of solid ways to criticize the 2016 budget and the spending plan of the Trudeau Liberals. But the 1995 crisis example should be sealed in concrete and dropped into the deepest part of the Atlantic Ocean. Let me show you why.

The ultimate measure of the sustainability of fiscal policy is the debt-to-GDP ratio. This ratio compares the size of the debt to our collective ability to pay for it. When this ratio rises, we can get into a spiral where interest costs drive the debt higher, which then leads to more interest costs and we end up in a crisis. Back in 1995, Canada was very close to such a crisis. We had annual deficits around five per cent of GDP, which drove the debt-to-GDP ratio over 65 per cent. With the yield on long-term government bonds then exceeding eight per cent, debt servicing cost grew to a very large six per cent of GDP. The infamous 1995 budget turned the corner by chopping billions from federal spending and raising taxes until budget balance was reached in 1997.

The current scenario is very different. The 2016 budget projects a deficit of 1.5 per cent of GDP, which will push our debt to GDP ratio up to 32.5 per cent. With today’s long bonds yielding less than two per cent, public debt charges are only 1.3 per cent of GDP. If the Liberal government is able to hold to their plan, the deficit will fall to 0.6 per cent of GDP by 2021 and the debt to GDP ratio will recede to 30.9 per cent. As Stephen Gordon points out, that’s a big “if.” Meeting these Budget 2016 targets will require the Liberal government to have a steely spine and keep tight control of spending.

Maybe the resolve of the Liberal government will fail. Will that put us at risk of a 1995 crisis? No, not even close.

Related: Maclean’s annotates the federal budget

Let’s work through the situation in detail. What if growth stays low and the Liberals allow the deficit to stay at 1.5 per cent of GDP instead of shrinking it in the years to come. How long would it take to get back to the nightmare 1995 scenario?

Here’s the answer. I’ve graphed some scenarios below out to the year 2099. I assume the deficit stays constant at the 2016 level of 1.5 per cent of GDP out into the future. I’ve chosen three growth scenarios, with nominal annual growth of 2.5 per cent, four per cent, and five per cent. If you factor in expected inflation, these correspond to real growth of about 0.5 per cent, two per cent, and three per cent. As a benchmark, the average nominal GDP growth in the 2000-14 era was 4.25 per cent. I’ve also put in the 2016 Budget plan and the 1995-96 debt-to-GDP ratio as reference points. The data can be found here.

Debt to GDP ratios under three alternative growth scenarios

Debt to GDP ratios under three alternative growth scenarios

If nominal growth hits five per cent—which is ambitious—we’d see almost no increase in the debt-to-GDP ratio at all. In the very pessimistic 2.5 per cent low-growth scenario the debt-to-GDP ratio is still below 60 per cent by 2099. It wouldn’t exceed 60 per cent until 2137—that’s 121 years from now. The modest growth scenario has the debt-to-GDP settling in just under 40 per cent long into the future.

If you went one step further into fiscal profligacy and assumed that the extra interest costs generated by the extra debt were on top of the 1.5 per cent deficits, would things change? In the low-growth case you would hit the 1995 level of debt in 2049—33 years from now. In the four per cent growth case it would be in the 2070s, more than 50 years from now. Of course, to generate a 1995-style crisis you don’t just need the high debt-to-GDP ratio you also need eight per cent bond yields—and long-bond yields are currently under two per cent.

So, the 2016 budget does not put us on the road to 1995. We are not on the road. We are not in the car. We have not even put on our shoes, had breakfast, or gotten out of bed. In order to make the 1995 crisis happen again, we would need to see sustained deficits on the order of $100 billion for a decade. If deficits approach those levels, I will have my debt-crisis bomb decorations ready for my future Maclean’s posts.

Does this mean the federal government should spend without bound? No. There are three solid reasons why I think the debt-to-GDP ratio should not be allowed to rise much above current levels. First, we need to preserve the ability to act with fiscal policy in the case of a future recession. Second, the stress of health spending on provincial governments over the next generation will put pressure on taxpayers’ wallets, and the federal take from those wallets should not grow. Third, I worry about private debt accumulation in Canada and the explicit backing of mortgage bonds by the Canadian government. If the housing market should falter, the federal government needs the capacity to act. These are all good reasons to limit the growth of the federal debt-to-GDP ratio and to pay close attention to changes in the Liberal fiscal plan.

Beyond the debt-to-GDP ratio, we also need to stay very attentive to the quality of government spending. Are spending decisions wise? Is money being wasted? Is there really a return on the investment of hard-earned tax dollars for the extra things the government is spending on? The Liberal government should be challenged vigorously for each of its spending decisions. However, it is much more work to analyze each new government initiative to see if it meets a cost-benefit test. It’s easier to simply say that a debt crisis awaits if more is spent. I think we need more of the hard cost-benefit work and less of the lazy debt crisis talk.

Canada has many economic challenges it needs to address right now—weak growth, too much private debt, rapid technological and industrial change. I don’t know the current government has the best answers to these challenges. But I do know that a federal public debt crisis isn’t going to be what stops them from acting.

Kevin Milligan’s disclosure statement is here. Read Maclean’s comprehensive coverage of the 2016 federal budget here.



We are not heading to fiscal crisis

  1. Another economist who neglects the accumulated debt of the provinces which puts Canada’s net debt to GDP at around 60%, not 30%. This was not true 20 years ago.

    There is only one economy and one taxpayer.

  2. There are many problems with this budget, including its failure to over-spend purely for infrastructure and to triple the over-spending promised.

    But a central one revolves around that famous Liberal clarion call for fairness. In the election, the Liberals told us that henceforth child benefits would be “income tested” so the rich wouldn’t receive them (despite the fact they’d have to pay them back in taxes). Well, it turns out that there’s no real ‘income testing’ just a red line at $190,000. Above that, no child benefits. Below that, MORE child benefits and ALL tax-free. And this new social spending is now structural and not constrained by taxation or anything short of a subsequent budget’s common sense re-think. So the deficit is now not so optional, it’s built-in. The Liberals are simply hoping the incredible GDP growth under Harper continues at a similar rate so that revenues will catch up to expenditures in 5 years. No plan, just hope.

    Of course, they lied about the economy so they could sell their infrastructure-building deficit. Now they’re not spending it on infrastructure. Indeed, they will likely spend less on infrastructure this year and next year than Harper spent last year. Harper had raised annual infrastructure spending by a factor of 10 over what Martin spent, to $5 billion a year. Doubling that was no doubt where the Liberals conjured $10 billion, because it bears no resemblance to what they’ve actually done.

    The sideshow of daily rejecting their own Fiscal Monitor’s real numbers from being put in Hansard shows the depths of their deception. We were still in surplus months after the election, and quite possibly until Budget Day. Which brings up a final point: they’ve built so much wriggle room into their projections that they can fail as spectacularly as Allan McEachern and still come close. But it’s more to ensure they say overshot their targets and boy, are they great fiscal managers. Ignore that man behind the curtain…

    • “the incredible GDP growth under Harper”!? They actually had a recession with negative GDP growth for the first and second time since Mulroney – let’s hope we don’t see that again.

  3. Another Liberal justifier using a totally different situation and then saying see it is not as bad as that because it is different.
    The budget is a string of stupid ideas resulting in billions being spend and nothing at best achieved. This is a kindergarten government playing at leading a country. Unfortunately it is no game. Thinking the middle class will all of a sudden grow and magically solve all idiot boy’s financial problems. Talking about infrastructure spending when he does not even know what has been done and what supposedly needs to be done.
    Opposition parties stop playing politics and get us out of this mess. Media stop making believe we have a new rock star and do some real analysis what this group of neophytes is up to, start by analyzing what this sorry group’s qualifications are.

    • Sure, as Rona Ambrose points out this is a ‘nightmare budget’ for those in the top 2% of income.

  4. Recently $5.8B in 2008-09, $55.6B 2009-10; $33.4B in 2010-11; $26.3B in 2011-12; $18.4B in 2012-13; $5.2B in 2013-14 – a total of $144.7B. Nobody died although the conservatives scored negative GDP growth a second time which should make us at least question what all that deficit spending was in aid of. Hopefully, the condition of Quebec highways is not an indicator of the effectiveness of infrastructure spending; certainly Lac Megantic – 21st century freight traffic on a 19th century right-of-way – suggests basic deficiencies. One of the problems is that development and even maintenance of infrastructure is so far behind what is needed that actual advance is unlikely at any conceivable rate of spending.

  5. I think the obsessive focus on deficits is largely about 1) lack of trust that government will do the right thing and needs to be put in a straightjacket (I put Jack Mintz in this box), 2) the lessons from the past (the debt crisis of the 90s) have been well-learned and the commentators are like generals – always fighting the last war, and 3) a simplistic aversion to deficits and focus on taxcuts that has been successfully used by the Harper government and other copycats of the winning narrative in American politics for the past 40 years.

    I question whether government spending should be held to its current share of the economy for several reasons – 1) the investments to pivot to a carbon-neutral economy will be so massive that the federal government will need to get heavily involved (hello to those 50-year bonds), – 2) lifting up the poor and middle-class means massive investments in early childhood education, housing, transit and everything else that is needed to make our cities worthwhile places to live, and only the federal government has the fiscal room to make this happen on anything more than a token scale, 3) if Canadians want a government that has the capacity to actually do some things, like monitoring air and water quality, and policing food safety, then federal spending needs to be “rebalanced” and cuts made by the Harper government reversed. This will cost.

    Just one small example – this budget gives Stats Can $500 thousand to develop information about the impact of foreign investment and ownership on Vancouver real estate prices. This, quite frankly, is a joke. It’s 2016 and $500 thousand will go only a small distance towards developing and conducting a survey that produces useful information about an area of economic activity where Stats Can has to start from scratch.

    Finally, increasing taxes very much needs to be part of this national discussion. The federal government needs to get more involved in buttressing health care and education, the twin pillars of the middle class, and Canadians need to decide on how much they are willing to pay to receive first-rate services. Taxes are not evil. They are necessary and deserve public support because they will be put to good use.

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