Pandemic debts leave fiscal planning exposed to icy chill of economic misses

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We tend to think of government debt in terms of weight on public shoulders – something that we either have the strength to carry comfortably, or that will crush us if it gets too heavy. But perhaps a better way of considering Canada’s fiscal health is in terms that anyone who has lived through a Canadian winter can understand.

It’s more of a parka.

Shedding your fiscal capacity by taking on much more debt, as governments were forced to do during the pandemic, is like losing that warm coat. You might be okay as long as the weather’s nice. But even a few degrees of cooling can leave you much more exposed to the elements.

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A new paper to be published Thursday by the C.D. Howe Institute makes that very point. Authors Alexandre Laurin (C.D. Howe’s director of research) and Don Drummond (the veteran economist from Queen’s University) have run the federal and provincial deficit numbers through several scenarios, and they conclude that it wouldn’t take much at all for the public debt situation to be much worse in the next few decades than our governments have predicted.

What’s more, they argue, the assumptions for long-term economic growth that are baked into the last federal budget are too rosy. The authors’ base case projects that we’re headed for a federal debt-to-GDP ratio of a problematic 60 per cent by 2055 – not the benign 30 per cent that the budget predicts, which would be in line with prepandemic levels. Toss in provincial debt, and you’re looking a national debt-to-GDP of 140 per cent by that time, they estimate.

“Recent federal and provincial budgets amount to ‘rolling the dice’ on Canada’s future,” they write.

The discrepancy between the C.D. Howe paper’s debt outlook and that of the federal budget lies in the economic growth and interest rates that each uses in its calculations. Ottawa has assumed long-term nominal gross domestic product growth (that’s real GDP plus the impact of inflation) of about 4 per cent annually, with the effective interest rate on government debt running about one percentage point below nominal GDP growth. On both fronts, Mr. Laurin and Mr. Drummond believe the government is being optimistic. Their baseline estimate for both nominal GDP growth and the effective interest rate is about 3.5 per cent.

In the grander scheme of things, the differences in those numbers aren’t huge. But the impact on the debt trajectory is profound. If nothing else, the calculations are evidence of just how risky fiscal planning has become as a result of the roughly $500-billion of additional debt Ottawa has taken on since the pandemic began.

“The 2021 federal budget demonstrates the sensitivity and fragility of Canada’s fiscal prospects,” the report says.

It’s not a huge surprise that the C.D. Howe Institute would be the source of this report. The Toronto-based economic think tank has long been a champion of fiscal responsibility, and it includes “ensuring fiscal and financial stability” as one of its primary policy-research objectives. It has made a mission of holding governments to account for debt excesses, rose-tinted forecasting and missed budget estimates.

It’s a position that was solidly in the mainstream for most of the past two decades, when modest deficits, balanced-budget targeting and debt reduction were widely accepted as gospel across the Canadian political spectrum. Until recently, C.D. Howe was preaching mom and maple syrup to the country’s public policy cognoscenti.

The budget foibles with which the think tank took issue just a couple of years ago were remarkably small potatoes compared with the fiscal rubble left behind by the pandemic. And Mr. Laurin and Mr. Drummond express some despair that, as federal and provincial governments emerge from the COVID-19 crisis, policy makers look willing to move only very slowly and modestly toward reversing course and cleaning up the mess – a pace, the authors warn, that will leave the country’s finances exposed to the whims of the economic cycle.

But despite arguing that “policy can, and we would say should, change to mitigate risks,” the paper does not advocate austerity as the means to reverse this potential debt spiral. Rather, the authors suggest that the key may lie in addressing the critical variable that feeds that heightened risk: economic growth.

They argue that governments need to direct their spending priorities increasingly to investments that will boost productivity and expand the economy’s growth capacity. If public policy can raise the average annual growth, the math will begin to work in governments’ favour – reining in the debt burden, restoring fiscal capacity and reducing that risk exposure.

“No matter the answers to policy choices about taxes and spending, one thing is clear: this exercise draws out the imperative of raising Canada’s long-term economic growth rate,” they write.

“Above all, fiscal decisions today must be geared towards increasing Canada’s sustainable productive capacity.”

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