Chrystia Freeland, Canada’s Deputy Prime Minister and Minister of Finance speaks with the provincial finance ministers during the Finance Ministers' Meeting in Toronto, on Feb. 3.Nathan Denette/The Canadian Press
Munir Sheikh is a research professor at Carleton University. He has served as chief statistician of Canada and as an associate deputy minister of finance.
Look across the world, and you will see governments piling up debt. Canada is no exception, with the figure at $1.1-trillion.
Those who are uncomfortable with this situation want governments to follow a fiscal anchor: a commitment to follow certain accounting guidelines. But some of these anchors come in a variety of shades, like shades of lipstick – which, if followed, would only temporarily make things look pretty until reality takes over.
For example, former prime minister Stephen Harper’s commitment to balanced budgets flew out the window when the 2008-09 recession struck. Meanwhile, Prime Minister Justin Trudeau’s commitment to a declining debt-to-GDP ratio took a beating with the onset of the COVID-19 pandemic.
The buzzword behind such anchors is “fiscal sustainability.” But what exactly does that entail, and how do you know when things have become unsustainable?
A look at the Canadian and international experience highlights the problem with focusing on such a vague buzzword. Canada’s net debt-to-GDP ratio is the lowest among G7 countries according to the 2022 federal budget and can rise fourfold to be in the same league as Japan, which is presumably still sustainable. Our debt-to-GDP ratio rose 50 per cent from about 30 per cent before the pandemic to more than 45 per cent in 2021-22. If such an increase does not make it unsustainable, what would?
Rather than wait for us to hit an imaginary wall one day, we should substitute concepts of fiscal anchor that rely on arbitrary numbers – such as balanced budgets and declining debt-to-GDP – with ones that are grounded in hard economic theory. The benefit of such an alternative approach would be that fiscal policy would be linked to economic performance – both short- and long-term – rather than floating about without a direction, waiting for an uncertain crash. Such a crash did not occur even during a 30-year period of fiscal irresponsibility that ended with then-finance minister Paul Martin’s 1995 budget.
Where does economic theory take us in conducting fiscal policy?
It provides two fundamental principles. First, a government should follow a countercyclical discretionary fiscal policy. Note the word is countercyclical, not counter-recession. The distinction is that a discretionary fiscal policy – explicit actions taken by the government, in contrast to automatic stabilizers – that is countercyclical would be restrictive to slow down the economy in a period of above-average growth. Second, productive investments that generate increased income flows over time should be financed with borrowed money. The objective here is that a generation that benefits from public spending must also be the one that pays for it.
Put the two principles together and you find that, over a business cycle, the net accumulation of debt should be equal to the value of income-generating investments. This anchor would carry over to the long term.
How does our current fiscal policy stack up against these economic principles?
Budget 2022 shows explicitly that our discretionary fiscal policy after the pandemic-driven recession is pro-cyclical, violating the first principle. Further, it is hard to find in the document, or most budgets for that matter, the size of income-generating public investments so one could compare them with the buildup of public debt to comment on the second principle.
Why is linking fiscal policy to economic principles important? Canada, according to the 2022 budget document, has a serious productivity problem. Against that backdrop, rising public debt levels, without a buildup of income-generating public capital, could mean a rise in tax rates in the future (the more they are postponed, the bigger the rate increases) that could negatively affect saving, investment and labour-supply decisions. The net outcome of these effects could be a further hit on productivity, living standards and economic growth.
We need a fiscal anchor that relates the change in the size of public debt to the change in the size of income-generating public capital over the long term. This would fluctuate with changes in business conditions but would guide policy makers to maintain the tight relationship between its two parts over time.
The anchor would not focus on when we could hit an imaginary wall, but rather tell us on a continuing basis whether fiscal policy is contributing to making our long-term productivity problem better or worse.