More deficit spending not the answer for Ottawa

The 2007/08 recession knocked many Canadian governments off the sound policy footing of balanced budgets, falling debt levels, and tax relief. After a sustained period of deficit spending, the federal government now seems poised to balance the budget. Yet a well-regarded institution recently promoted the idea that the federal government should prolong the deficit for three more years and accumulate further debt in order to stimulate economic activity. This is not the right fiscal prescription for Ottawa.

The federal government will have run consecutive deficits for seven years if it delivers on its current plan to balance the budget in 2015/16. This has led to the accumulation of over $170 billion in debt since 2008/09, erasing past progress made to pay down debt.

The argument for extending and growing the federal deficit is based on an economic concept that assumes government spending produces a multiplier effect, whereby a dollar increase in government spending increases overall economic output by more than a dollar.

Specifically, the claim is that ongoing deficit spending of roughly $10 billion per year would increase real GDP by $15 billion and lower the unemployment rate by 0.4 percentage points. This assumes that deficit spending of $10 billion, representing 0.5% of the approximately $1.8 trillion Canadian economy, can stimulate economic activity in a meaningful way and that there would be no negative consequences from delaying the deficit’s elimination or the additional debt accumulated.

The analysis does not prescribe a particular type of deficit spending but simply assumes higher overall program spending will produce these economic benefits. The assumption is that every dollar the government borrows and spends in the economy (regardless of form or purpose) generates an extra $1.50 in economic activity.

If it were only that easy.

The presumption that deficit-financed spending will lead to a greater value of economic activity relies on a number of highly debatable assumptions: that borrowed money could not better be used by the private sector, that the government will spend the money effectively and wisely, that it will not be captured by special interests, and that government can anticipate an economic downturn and enact fiscal stimulus on a timely basis. On that last point, it is a bit odd to be calling for fiscal stimulus nearly five years after the recession.

We have seen the results of such Keynesian thinking before. Similar rationales were made for delaying balanced budgets in the 1970s, 1980s, and early 1990s. The argument was that the economy was too weak and unemployment too high to reduce government spending. When is there a good time to consolidate spending?  Waiting for the right time could mean waiting forever, leading to a never-ending cycle of persistent deficits, growing debt, and rising interest costs. The end result could mean much deeper cuts and reforms than would have necessary had the changes been made early.

A growing number of empirical studies have examined the economic effects of actual cases (not simulations) of government stimulus spending. The body of research casts serious doubt on the ability of government stimulus spending to boost economic activity.

For instance, in their study Large Changes in Fiscal Policy: Taxes versus Spending, leading fiscal policy expert and Harvard University professor Alberto Alesina conducted a comprehensive analysis of stimulus initiatives in industrialized countries from 1970 to 2007 (including Canada). He identified 91 instances where governments tried to stimulate the economy and found that “a one percentage point higher increase in the current [government] spending to GDP ratio is associated with a 0.75 percentage point lower growth.” In plain language, increased government spending based on deficits reduces, not increases, economic growth.

The response from proponents of stimulus is that it’s different this time because current circumstances are not “normal” with interest rates at historic lows. But a review of the most rigorous research on fiscal stimulus by noted expert and University of California professor Valerie Ramey shows there is not a general consensus among economists regarding the presence of an economic multiplier of greater than one.

As for the assumption that deficit reduction will harm Canada’s economy, we only need to look at the federal government’s own experience in the late 1990s to find contrasting evidence.

The government enacted ambitious reforms in the mid-1990s that led to a reduction in program spending of almost 10% and eliminated a $38.5 billion deficit (5.2% of GDP) which is considerably higher than the current deficit of $2.9 billion (0.1% of GDP). These reforms reduced the size and scope of government, created room for important tax reductions, and ultimately helped to usher in a period of sustained economic growth and job creation.

The federal government now appears once again poised to balance its budget after several years of deficit spending. This is an opportunity to use future surpluses to improve Canada’s tax competitiveness, particularly on personal income taxes, and set the stage for long-term economic growth. A step backwards in the direction of borrowing and spending more would be a huge loss with little economic reward.