Fraser Forum

Federal government will likely violate fiscal anchor during economic downturns

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Federal government will likely violate fiscal anchor during economic downturns

Prior to the pandemic, the federal government’s fiscal anchor was maintaining its debt-to-GDP ratio (a common way of comparing government debt to the economy’s ability to support it) at 30 per cent. But then, with the massive increase in pandemic-related spending, the debt ratio shot up to 47.5 per cent in 2021.

Rather than adopting the fiscal restraint necessary to return the debt ratio to its previous target, the federal government, which will table its next budget on March 28, has embraced a new fiscal anchor—gradually reducing the federal debt-to-GDP ratio over the medium term—with no explicit target ratio or timetable. Although the government has adopted a much less ambitious fiscal goal, it still argues that a declining debt ratio will provide the “fiscal room” to deal with future fiscal challenges arising from recessions, new pandemics and geopolitical risks.

To demonstrate its commitment to its new fiscal anchor, the government has projected a steadily declining debt ratio over the next 45 years, assuming the economy grows annually by 1.6 per cent. However, the assumption that the economy will grow at a constant rate ignores our historical experience—the Canadian economy will likely experience one or more recessions in the coming decades.

In evaluating the federal government’s new fiscal anchor, it’s important to consider how major economic downturns could affect the public debt, rather than assuming them away. Downturns in the economy increase public debt directly because government revenues decline and some public expenditures may increase, leading to larger budget deficits, higher inflation-adjusted interest rates, and slower economic growth as public-sector debt increases. The effects of a recession could set off a debt “doom loop” with the debt ratio spiralling upward if the government does not quickly respond by reducing its post-recession budget deficits.

Our recent study provides a more realistic assessment of the federal government’s multi-year fiscal plan. We investigate how the federal government’s debt ratio could evolve over a 20-year time horizon if the Canadian economy is subject to recessions similar to those experienced over the last 40 years. On average, recessions have occurred once every 10 years.

The results indicate there’s a 30 per cent chance that the federal debt-to-GDP ratio will increase over a 10-year time horizon and a 53 per cent chance it will increase over a 20-year time horizon. The likelihood of no recessions occurring over a 20-year time horizon is only 15 per cent. Thus, it’s very unlikely the federal government will achieve its stated goal of reducing its debt ratio. In other words, the federal fiscal anchor will most likely be violated.

The probabilities of one, two and three or more recessions over a 20-year time horizon are 32 per cent, 28 per cent and 25 per cent respectively. When two recessions occur, there’s a 60 per cent chance the debt ratio will increase.

A realistic assessment of the federal fiscal position is important because some have argued, based on the federal government’s optimistic debt projections, that Ottawa could spend an additional $20 billion per year and keep the net debt-to-GDP ratio below 45.5 per cent. But failing to recognize the near certainty of future economic downturns means overestimating the federal government’s ability to increase spending.

While the federal government’s fiscal policies should not be so restrictive that it entirely eliminates the possibility of an increase in debt relative to the size of the economy, it should adopt a more restrictive fiscal policy. If, for instance, the government ran surpluses (excluding interest costs) equivalent to 2 per cent of GDP, the probability of an increasing debt ratio would drop to around 20 per cent. The best way to accomplish this is through spending restraint.

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