Tuesday, February 23, 2016

Budget deficits are OK - it's the debt ratio that really matters

With Canada's budget deficit looking to be closer to $30 billion than the promised $10 billion this next year, the question arises is: this a big deal? And the answer: probably not.
More details will be available in the upcoming budget, and in the pre-budget fiscal and economic update due early next week, which are being speculated upon even now. With a worse-than-expected (and still deteriorating) inherited economy, over which they had little or no influence, Justin Trudeau's Liberals are now anticipating an $18.4 billion deficit based on slumping economic growth alone, before taking into account the $10 billion or so they are looking to pump into the economy as stimulus spending on infrastructure and other projects.
Is this important? Doubtless the Conservative opposition will be full of righteous indignation about it, and there will be much tooth-gnashing and many "sky-is-falling" predictions of economic catastrophe. A considered analysis in today's paper, though, suggests otherwise.
The point is that the magnitude of individual budget deficits are not as important in the scheme of things as the debt-to-GDP ratio, a measure of the country's ability to pay its interest, and ultimately to repay its debt. Every budget deficit increases the national debt, but by relatively small amounts and, as GDP continues to rise each year, the overall debt ratio may not change much, if at all. Even a series of small budget deficits can actually result in a declining debt-to-GDP ratio, which is ideally what we should be aiming for in the long term.
Canada's federal debt is currently around 31% of its GDP, only slightly higher than in 2008-09 (before the financial crisis of that year) and broadly comparable to what is was some thirty years ago. That might sound like a lot, but consider that this is the lowest dent-to-GDP ratio among the Group of Seven industrialized countries, and by a long chalk: the ratio for Germany is 48.4%, USA 79.9%, Britain 80.0%, France 89.4%, Italy 113.5%, and Japan a whopping 126.0% (these figures are from 2015). And we think we have it bad!
Now, granted, a comparison with some other smaller countries with which Canada is commonly compared paints a less rosy picture - Australia's ratio is 17.5%, New Zealand's 8.8% and Denmark's 6.3%, and Sweden's and Norway's are actually negative (-18.4% and -161.7% respectively), indicating a surplus in their coffers rather than a national debt.
But I think the point is that Canada's debt-to-GDP ratio is actually at a very reasonable and sustainable level, and there is no compelling need to reduce it to an arbitrary smaller number like 25% (as the Tories counsel). Indeed, it could easily to go up to 35% or even 40% without setting off too many economic alarms, although politically this is probably not advisable for a new government.
All of this then begs the question of what effect an individual year's deficit would have on the overall debt-to-GDP ratio. This obviously depends on the increase in GDP, which in Canada's case is probably in the region of 1.4% for 2016-17 (substantially lower than the original prediction of 2%), and little more than that should be relied on for the next few years. But this still means that a budget deficit of around $22 billion for 2016-17 (and up to $30 billion for each of the next few years) would have no impact at all on the debt ratio, and a higher deficit of, say, $30 billion this year would only have a slight, but far from dramatic, effect.
At a time of low growth and market retrenchment, we should be grateful that Canada's national finances are not still in the hands of cutting, slashing, Conservative politicians. Now is not the time to be pursuing goals like a reduced debt-to-GDP ratio, however admirable such a goal may be in the long-term. Most economists seem agreed that the economy needs a serious boost of stimulus spending, and it is to be hoped that this is what the Liberals will provide, notwithstanding traditional scared cows like balanced budgets and even declining debt-ratios.

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