Over the past three months, as Canada's 2016 economic expectations were repeatedly ratcheted down, a chorus of Bay Street economists began calling on the Trudeau government to stimulate the economy with budget deficits. The question of how large this stimulus should be – how many extra tens of billions of dollars worth of borrowing are we talking about? – has dominated the discussion. It's an important question. But it's not the most important one.
In a few weeks, likely at the end of March, Finance Minister Bill Morneau will deliver the Liberal government's first budget. It should not be judged solely on the size of its deficits. What matters is their nature. Look closely at the quantity of Liberal spending – but pay far more attention to its quality.
The Liberals broke the great deficit taboo in last fall's election, and a good thing too. Their move was a political winner, and economically prudent to boot. The national unemployment rate, currently at 7.2 per cent, is a couple of percentage points higher than it should be, and expected to continue rising this year. That means hundreds of thousands of Canadians are without work, through no fault of their own. Canada is still creating jobs – 126,000 in the last 12 months – but that's not enough to keep up with population growth, which is why over the last year unemployment shot up from 6.6 per cent.
Canada isn't in recession, at least outside of the oil-producing provinces, but growth is anemic. Back in the fall, most economists expected Canada to enjoy 2 per cent growth in 2016 – not robust, not enough to lower the unemployment rate, but at least enough to keep it from rising. As oil prices collapsed and the global economic backdrop turned darker, those predictions were halved, almost overnight. The expectation now is for 2016 growth of closer to 1 per cent.
The response so far has been left entirely to monetary policy. The Bank of Canada cut interest rates twice in 2015, pushing long-term borrowing costs to record lows, and causing the dollar to plunge. These are the right moves – a lower loonie is stimulating non-resource export industries, helping the free market to redeploy capital and replace jobs lost in the oil patch – but they have their limits, and they can come with side effects. Even as the economy is acting like it's taken a sleeping pill, real estate in Toronto and Vancouver is behaving like it's on uppers, at least in part because of those ultra-low interest rates. It's why the Bank of Canada, the Bay Street economists and international observers like the OECD are all calling for fiscal stimulus – meaning more federal spending and larger deficits.
More than any major developed country, Canada can do this. Ottawa has room to run a few years worth of modest, or even not so modest, deficits. The debt-to-GDP ratio, at just over 30 per cent, is far below our G7 peers, and a galaxy removed from any sort of danger zone. And thanks to borrowing costs lower than the rate of inflation, the cost of running a deficit has never been lower. According to a recent report by BMO Capital Markets chief economist Douglas Porter, in just the last three months, bond yields have dropped so much that Ottawa's debt interest costs have fallen by $1.5 billion a year.
It says something about how much worse the economic situation is, compared to when the Liberals unveiled their election platform, that their once revolutionary deficit promise now looks tentative. The Liberals pledged to temporarily increase spending and deliver a $10-billion deficit in 2016-17, with smaller figures for the next two years, and a balanced budget by the end of their mandate. But the economy has taken such a turn over the past few months that, even if the Liberals do nothing, BMO estimates Mr. Morneau's freshman budget is already $9-billion in the red. Some analysts put the figure even higher.
That's why the Bay Street Chief Economists' Choir has been urging the government to stimulate the economy through bigger deficits. CIBC's Avery Shenfeld says a $30-billion shortfall this year wouldn't be out of line, and would add half a percentage point to GDP growth; Gluskin Sheff's David Rosenberg is calling for $50-billion.
The Liberals have been dropping hints of blowing past the deficit plan they campaigned on, and that the figure that matters to them is the debt-to-GDP ratio. This move is politically convenient – but it has the benefit of being economically correct. The debt-to-GDP ratio is what matters. And Canada can run deficits of around $25-billion a year without seeing our low ratio rise. If the Liberal budget were to promise, say, $100-billion worth of deficits over the next four years, it would be a political bombshell – but would barely budge our debt-to-GDP ratio. This isn't ideology. It's just arithmetic.
The bottom line is that the budget box can get bigger. But within a modestly bigger spending envelope, the key questions must be about quality: How is Ottawa spending? On what? And why?
The Liberal platform was all about promoting long-term economic growth through infrastructure investment. That can work if Ottawa invests in the right infrastructure at the right price – a very big "if." The call for stimulus, in contrast, is about injecting short-term cash into a temporarily faltering economy. Both are reasonable ideas, and Mr. Morneau's budget can prop up the economy today, while fostering a stronger economy in the future. But they're different objectives, calling for different tools. And it's easy to get either or both wrong.
Should the Trudeau government run bigger deficits than it originally promised? Yes – but with a big caveat. Unless Ottawa spends wisely, using temporary stimulus spending to deliver the quickest and most pronounced immediate bang, while patiently directing long-term infrastructure money to investments with real long-term returns, the big deficit experiment will be a failure. The deficit devil is in the details. It's a subject we'll return to next week.