Skip to main content

The argument that Ottawa needs to adopt a serious fiscal anchor is hardly a new one. But the events of the past few years have made it increasingly urgent.

Prior to the COVID-19 pandemic, economic critics urged the federal government to set stricter limits for itself around spending, deficits and debt, to embed firmer fiscal discipline into the entire process. Instead, the government preferred to talk about general goals to reduce deficits and debt burdens, calling those its “fiscal anchor,” while ducking calls to adopt the kinds of hard boundaries that would truly ground its budgets.

But the fallout from the COVID-19 economic crisis has left the government shouldering much higher debts and much higher interest rates. The federal ratio of debt to gross domestic product, the gauge that the government has pledged to lower “over the medium term” without setting any specific targets, sits at about 42 per cent, up from 31 per cent prior to the pandemic. The government has projected that annual interest costs on debt as a share of revenue – an important measure for fiscal sustainability in past periods of high interest rates – are headed to 9.4 per cent in the 2023-24 budget year, up from about 7 per cent in pre-COVID years.

Those numbers make the case for a hard fiscal anchor more pressing. Without one, proponents say, the government risks drifting into fiscal unsustainability.

It’s the argument contained in a paper published by law firm Bennett Jones and the Business Council of Canada, which landed late last month, just as the federal cabinet gathered for a prebudget planning retreat. The paper garnered media attention for its assertion that the government’s fiscal projections are too optimistic. But its underlying message is that high interest rates and high debt have left government finances far more at risk if those projections do, indeed, fall short.

The analysis – by Bennett Jones senior advisers David Dodge (former governor of the Bank of Canada) and Richard Dion (a former economist at the central bank), in collaboration with Business Council senior vice-president of policy Robert Asselin (former Department of Finance policy and budget director) – indicates there is “significant risk” that the current elevated interest costs and debt-to-GDP levels could “exceed comfortable levels over the remainder of the decade.” Critically, the report says there are several possible scenarios in which the government could miss its projections that would all tip the annual interest costs over 10 per cent of revenue – a threshold above which, they argue, would “signal risk of unsustainability.”

Mr. Dodge believes that because of the surge in interest rates over the past year, this interest-costs-to-revenue ratio is the fiscal anchor on which Ottawa should align its budget planning. He argues that setting the anchor at 10 per cent would provide “a prudent rule for guiding fiscal policy.”

Why has this ratio become so critical? To understand that, it’s important to look at a long-standing rule of thumb for fiscal sustainability that has been flipped on its head in the past year.

A common assumption about deficits is that as long as interest rates … stay lower than GDP growth, the debt-to-GDP ratio won’t get out of control, and overall debt will continue to be manageable,” a summary of the report says. But when it’s the other way around, interest costs will grow fast than revenue – and the cost of servicing government debt starts to take a bigger and bigger bite out of each and every budget.

“In a context of persistently high interest rates and elevated debt ratio, interest costs may come to absorb such a high proportion of revenues as to ultimately compel the government to constrain program spending and/or raise taxes,” the report says.

Mr. Dodge is painfully familiar with this phenomenon; as deputy minister of finance in the mid-1990s, he was a key architect in the Jean Chrétien government’s successful battle to rein in runaway debt. At the time, interest expenses consumed nearly 35 per cent of revenue, and interest rates were racing about four percentage points above revenue growth. It was fiscal quicksand. The only way out was deep and painful cuts to spending on programs.

Clearly, it’s a lesson that still resonates with Mr. Dodge. We’re nowhere near the interest-costs-to-GDP imbalance that we were in the 1990s, but with interest rates above GDP growth, we’re heading in a dangerous direction.

At least over the next five years – the horizon covered by budget projections – there’s not much the government can do on its own to flip that rates-versus-GDP dynamic around. It can pursue programs to stimulate the economy’s growth potential; but those can take many years to bear fruit and, paradoxically, cost money that could put upward pressure on deficits and debt in the nearer term. Interest rates are the purview of the Bank of Canada, and will remain elevated as long as inflation remains a problem.

But the government can recognize the longer-term risks associated with its changed fiscal conditions, and adopt a serious fiscal anchor that is aligned with the source of the potential problem. Then build its budgets with a prudent eye on living within the anchor’s specified thresholds.

This is no mere question of government credibility. It’s a matter of taking the steps now, before it’s too late, to safeguard long-term fiscal sustainability.

Follow related authors and topics

Authors and topics you follow will be added to your personal news feed in Following.

Interact with The Globe