Looming Fiscal Crisis? Why the Latest Finance Report is Neither a Harbinger of Doom Nor Cause for Complacency
Last week the Toronto Sun published article with the alarming, but not out of character headline Buried government report reveals looming fiscal crisis about the Update of Long-Term Economic and Fiscal Projections report from the Department of Finance Canada, which was released just prior to Christmas. The Department of Finance’s report projects the federal budget will remain in deficit until the year 2055. In a reaction that will surprise no one, the Conservatives and right of center pundits worked themselves up into a frenzy over the news. I got fundraising emails railing against Trudeau’s reckless spending from more or less the entire slate of Conservative leadership candidates. They do have a point. When the previous conservative government left office the budget deficit was around $5 billion and projected to be balanced in the upcoming fiscal year. And even when Trudeau promised deficits they were to be small and end by 2019. Even with the new spending the debt to GDP ratio would decline every year. Going from a 4 year deficit to a 30 year deficit is understandably a cause for concern.
Fortunately politics is ever the lover of hyperbole and the damage to Canada’s fiscal health falls far short of “crisis”. Projected federal debt to GDP peaks at 31.9% in 2018-2019 FY. The trend line goes in the wrong direction but does not cross into the Danger Zone. Furthermore as Yogi Berra is alleged to have said “predictions are hard, especially about the future”. The projections are based on extrapolating current spending forward and applying demographic and economic forecasts to those extrapolations. The probability of no change in government spending beyond merely adjusting to changing demand over the next 29 years is low, its very low. Even Justin Trudeau doesn’t hope he is PM in 2055. Long run governments do keep the same policies in place year after year, they change as circumstances and the political winds change. This is the scenario where the budget is left to balance itself, as Trudeau famously quipped. In all likelihood some Prime Minister between now and 2055 will endeavor to balance the budget.
Whether those efforts will be successful is another question. A lot can happen on the time span of decades . There is too much uncertainty to brush off the concerns with a “don’t worry everything will be alright”. As Chart 4 in the report shows there are a wide range of possible outcomes just from moderately adjusting the variables in the model. We could pay off the whole $636 billion federal debt or have a spiraling debt that pushes debt:GDP up by more than 20 percentage points. By far the biggest factor is labour productivity. With sufficient productivity growth the deficit gets overwhelmed by economic growth. Unfortunately Canada generally has lower productivity growth than many other developed nations. Although this has been a long running concern the current government has placed little emphasis on addressing the country’s anemic productivity growth.
As with all projections the quality is only as good as the assumptions and scope. While the demographic assumptions appear to be reasonable (any demographers out there; feel free to correct me), the fiscal assumptions are less solid. Notably the Canada Health Transfer (CHT) only growing in line with nominal GDP. As the recent circus around renegotiating the CHT attests there is constant political pressure from the provinces to increase the rate well above nominal GDP growth. A factor that will only grow more pronounced as the population ages and the strain on provincial health budgets magnifies. It is well within the range of possibilities that a future government will acquiesce to the provinces’ demands and grow the CHT well above NGDP growth. The projections also fail to account for unforeseen negative economic events. And while that is quite reasonable within the context of this document, as the economics profession has yet to develop a reliable method of predicting recessions, it never the less presents a more rosy picture than actually exists. A deep recession with a resulting large deficit could blow these projections apart and leave the country in much worse fiscal shape.
Perhaps the biggest limitation of the Department of Finance’s projection is the projection is of Federal not national fiscal situation. The federal debt to GDP ratio is a healthy 31.8% thanks to multi-decade and multi-partisan governing philosophy of fiscal resistant. But the federal government is not the only government with debt in Canada. The provinces have considerable debt putting the total government debt to GDP ratio at 91.5%; up from 66.5% in 2007. While there is no hard and fast rule regarding when a country’s debt load becomes too great, the rule of thumb is that ratios over 100% are cause for concern. While most of the 25 percentage point growth in debt to GDP can be laid at the feet the recession it highlights the vulnerability of the debt to recessions. With the recession over and the economy experiencing slow but positive growth now is the time to bring the deficit and debt to GDP ratio down so we have fiscal maneuvering room should another recession hit. The many provinces, including the two largest, Ontario and Quebec, have large debts and are facing increasing budgetary pressure from bearing the brunt of the demographic related rising healthcare costs. There is precious little room to absorb another economic shock without adversely impairing the fiscal health of the country. Should a provincial bail out become necessary or a future Prime Minister decide to take on more of the load from an aging population at the federal level the health federal balance sheet could rapidly deteriorate.
There no guarantee such a scenario does happen. I certainly hope it does not. The projection gives an overall positive outlook for the federal government’s fiscal situation. However it would be prudent to prepare for the possible negative scenarios not outlined in the report. With an uncertain global economy and a looming demographic bomb on the horizon now is the time to strengthen our fiscal position at all levels of government. Unfortunately the short term trend lines are moving in the opposite direction. Fiscal discipline and policy of only incurring debt for productivity enhancing infrastructure investments would be an excellent first step. I will be eagerly watching the course this government lays in the 2017 Budget.