Federal finances vulnerable to economic slowdown due to deficits

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Appeared in the Vancouver Sun, February 1, 2018
Federal finances vulnerable to economic slowdown due to deficits

An end-of-year poll by the Angus Reid Institute showed increased concern among Canadians about government spending and deficits, which is now (along with the economy) the number one issue of concern. And for good reason—federal finances remain in the red despite a growing economy.

A key risk of running deficits during times of economic growth is that the budget cannot be balanced regardless of economic conditions because a permanent imbalance develops between how much the government spends and the amount it raises from taxes. This is exactly the situation Canada experienced throughout the 1970s, ’80s and early ’90s. It didn’t matter if the economy was growing, slowing or in recession. The federal government could not balance its budget.

Prior to the Trudeau Liberals taking office in late 2015, the budget plan of the previous government called for a small surplus in 2018-19 of $2.6 billion. Upon assuming power, the new Trudeau government immediately increased budgeted federal program spending by $8.1 billion over 2015-16 to 2019-20.

Less than six months later, in its first full budget (2016), the federal government increased budgeted program spending by an additional $65.9 billion over the same five-year period (2015-16 to 2019-20). The most recent update indicates a deficit of $15.7 billion for 2018-19.

But what would happen to the federal deficit if a recession or economic slowdown were to occur? In our recent history, a recession, or at a minimum an economic slowdown, occurred roughly every eight years. Given that the last recession was 2008-09, Canada is due for a slowdown in 2018 or perhaps 2019 if this historical pattern persists.

Understanding the implications of an economic slowdown or recession on federal finances better illustrates why it’s bad policy to purposefully operate in deficits during times of positive economic growth.

Slowdowns or recession automatically increase the government’s deficit without any action on the part of government. The explanation lies in programs that are referred to as “automatic stabilizers.” These programs automatically take in less revenues and spend more money without any change in policy when the economy slows (and vice versa when it’s growing). For example, in the most recent 2008-09 recession, spending on employment insurance increased from $14.1 billion in 2006-07 to $21.6 billion in 2009-10, an increase of 53.3 per cent.

Often times, governments will also enact discretionary measures that further reduce revenues and/or increase program spending in response to recessions. The Harper government, for instance, introduced large stimulus spending in the 2009 budget in response to the 2008-09 recession. The result of both the automatic revenue declines and spending increases, coupled with potential discretionary policy changes, is larger deficits.

To further illustrate the point, let’s assume that the conditions of the economic slowdown of 2000-01 were repeated in 2019-20. In other words, let’s assume the economy repeats what happened in 2000-01 and the government responds exactly the same way. Revenues would decline by $14.3 billion while spending would increase by $14.0 billion, resulting in a deficit of $42.7 billion rather than the currently planned $14.4 billion. And the federal government would accumulate $75.7 billion in extra debt compared to its current plan over the 2019-20 to 2022-23 period.

The numbers are significantly worse if a more serious recession like 2008-09 happened again.

Clearly, running deficits in times of economic growth, even periods of slow economic growth, risks much larger deficits when the inevitable recession occurs. Given the current level of deficits, the risks to federal finances from even a mild recession, let alone a more severe recession, are substantial and should be addressed as the Trudeau government needs to more purposefully move towards a balanced budget within its mandate.