Ottawa must get the deficit under control

MARCH is often the cruellest month on the Canadian weather calendar and this March also promises a shift in fiscal climate as Ottawa moves to bring a $56-billion deficit under control.

To understand why Ottawa must move quickly to restore fiscal balance to its finances, one need only look back over the economic history of the last half-century. If we are to avoid a repeat of the fiscal crisis that engulfed Canada during the period 1973-1996, we need to take steps now to ensure that the recent deficit does not become the thin edge of a new debt wedge.

From 1961 to 1973, Canada enjoyed robust economic growth, rising tax revenues and rising expenditures, and put in place the last bricks of a comprehensive welfare state: namely, medi­care, unemployment insurance and the Canada Pension Plan. Real per capita revenues grew at an astounding seven per cent a year while real per capita spending grew at only a slightly less astounding rate of six per cent.

During this autumn period of the post-war boom, program spending accounted for nearly 90 per cent of total federal government spending, while the debt-to-GDP ratio fell to 20 per cent.

All of this came to an end with the oil price shock and the 1973-74 recession, which ushered in an era of slower economic growth, stagflation and budget deficits.

The slowdown of the 1970s at first seemed like a temporary phenomenon. The Keynesian prescription of fiscal stimulus combined with the regional development inclinations of the era resulted in seemingly modest deficits done with the good intentions of mitigating the downturn.

Unfortunately, the road to fiscal crisis runs parallel to the road to hell, which is also paved with good intentions.

What started out as deficits of $1 billion to $3 billion in the early 1970s reached $29 billion by 1982 and then continued to grow, peaking at nearly $40 billion by the early 1990s.

The early deficits rapidly took on a life of their own as the high interest rates of the 1980s compounded the accumulated deficits into a debt leviathan.

During the period from 1973 to 1996, real per capita revenue grew at about one per cent while real per capita expenditures grew at two per cent, resulting in a growing fiscal gap.

Debt service costs crowded out program spend­ing and the share of total expenditures devoted to government programs fell to 70 per cent by 1991. Whereas the accumulated federal deficit in 1961 was just under $15 billion, it had grown to $108 billion by 1982 and then soared to $563 bil­lion by 1996.

The concerted expenditure restraint of the mid-1990s, combined with a booming economy, brought the federal deficit and debt situation under control as deficits were converted to sur­pluses and both the absolute level of debt and the debt-to-GDP ratio fell. The fiscal pain felt in the area of federal health and education transfers to the provinces was substantial.

By 2007, the federal debt had fallen to well below $500 billion, the debt-to-GDP ratio had declined to 30 per cent and the budget had seen nearly a decade of consecutive surpluses.

In many respects the period from 2000 to 2007 had come to resemble the golden autumn of the post-war boom.

While the growth rates of real per capita revenues and expenditures were lower than the 1960s, the real fiscal driver became the dividend from falling debt service costs, which allowed program spending to rise faster than per capita tax revenues, tax rates to be lowered and still generate surpluses.

However, every boom must end -- the question is never if but when -- and the onset of the Great Recession saw the return of deficits.

With the rediscovery of Keynesian stimulus spending and declining government revenues, surpluses ended and a deficit of about $6 billion in 2008-09 has been followed by an estimated $56-billion deficit in 2009-2010.

Once again, we are on the verge of a giant gap between revenues and expenditures continuing.

To date, we have been spared the full onslaught of the debt leviathan because it is early on and inter­est rates have remained at historically low rates.

A drop in debt service costs fuelled by falling interest rates is unlikely to repeat itself. Interest rates cannot remain at historic lows forever and if deficits are not converted to surpluses by some combination of revenue increases and expendi­ture reductions, then the power of compound interest will eventually kick in and undo all the work that was done to restore the country's fiscal health since the mid-1990s.

We may wish to debate whether the deficit is structural or cyclical but the solution remains the same in either case. Our fiscal history suggests that the best remedy to restore fiscal health is to ensure that expenditures don't rise faster than revenues.

Livio Di Matteo is professor of economics at Lakehead University.