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Prime Minister Justin Trudeau and Deputy Prime Minister and Minister of Finance Chrystia Freeland in the House of Commons on Parliament Hill in Ottawa, on Nov. 3.Justin Tang/The Canadian Press

John H. Cochrane is a senior fellow of the Hoover Institution at Stanford University and author of The Fiscal Theory of the Price Level, available January, 2023. Jon Hartley is a PhD student in economics at Stanford University and a research fellow at the Foundation for Research on Equal Opportunity.

The most important source of Canada’s inflation is simple: Starting in 2020, the government borrowed more than $700-billion, and mostly handed it out. People spent it, driving up prices.

It was, of course, proper for the government to help people and businesses gravely hurt during the COVID-19 pandemic. And debts and deficits do not automatically cause inflation – Canada can borrow an immense amount without an impact on the price level if the government has a believable plan for repayment.

But the government had gone too far in borrowing and spending, without such a plan. People try to get rid of public debt, pushing up prices until its real value is back to what people think the government will repay.

Fiscal and monetary policy are related. The key to untangling the current mess is acknowledging that the government cannot borrow more without causing more inflation.

The Bank of Canada bears some responsibility for the problem. It waited a full year from the breakout of inflation, finally raising interest rates from 0.25 per cent to 0.5 per cent last March. Whether the bank’s slowness to act made inflation worse is a topic of debate, but it surely did not help.

Other popular arguments do not work. Supply chain shocks raise one price relative to another, not all prices and wages together. Energy prices have risen and fallen many times without sparking inflation. Greed has been with us always.

Some inflation is imported from the U.S. When that country experiences inflation, Canada must follow or adapt to a higher exchange rate. It chose inflation.

Deficits are now thankfully fading, and inflation is down to 6.9 per cent in September from 8.1 per cent in June. But the situation is still dangerous: Canada is now saddled with debt greater than 100 per cent of GDP. And the economy is clearly running at full capacity.

Each percentage-point rise in the interest rate now increases interest costs on the debt by 1 per cent of GDP, adding to the deficit and raising inflation. Raising interest rates may not lower inflation at all, and Canada is also vulnerable to a rise in global rates.

The government’s plan to provide billions of dollars in cost-of-living inflation relief is almost comical. It sent people money and caused inflation. In response, it sends people even more money. Around we go.

In the next recession, the government will want to respond with more bailouts, stimulus and transfers. But these are now likely to spark more inflation.

And if a big crisis such as a war or larger pandemic hits, Canada would somehow need to borrow large sums. What then?

Economic stagnation is the deeper problem. Canada’s real GDP per capita has only grown from $53,834 in 2007 to $56,197 in 2021. In U.S. dollars, it has barely grown at all, from $US42,097 to $US43,945. Even the dysfunctional U.S. has done better, rising from $US54,300 to $US61,280. American incomes are now a shocking 40-per-cent larger than Canadian ones.

Inflation teaches us that Canada cannot borrow and spend its way to growth. So what can be done?

A robust program of supply-side, growth-oriented policies is the only answer. It is the surest way to tackle debt and inflation: Higher income produces more government revenue for the same tax rate, and reduces the need to spend. By contrast, tackling fiscal problems with higher taxes is like walking up a sand dune.

Canada cured debt, inflation and stagnation in the early 1990s, with no painful recession. The same ingredients can work again. Start by getting serious about central bank’s inflation mandate. An inflation target means inflation, not employment, climate change or other goals properly left to elected politicians.

Fiscal policy must commit to fighting inflation – to repaying rather than growing debts. Also, the government needs an economic package centred on spending and regulatory reforms, and supply-side growth. For example, get energy moving again, remove housing restriction and fix occupational licensing. Get the sand out of the gears.

Every successful disinflation in the past has included monetary, fiscal and microeconomic reform. Attempts to stop inflation without all three have usually failed.

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