Munir A. Sheikh is former chief statistician of Canada and executive fellow, School of Public Policy, University of Calgary.
Balanced budgets became a key issue in the last federal election, when the Liberals took a stand that running "modest" deficits was good public policy, while Conservatives and the NDP were strongly in favour of balancing the books, regardless. Mercifully, the discipline of economics won over ideology.
That, however, does not resolve the challenge. If deficit financing is appropriate for the economy at this time, two questions arise: Is there a limit to how large deficits could be; and, should they come to an end and, if yes, when?
These issues have led to a wide range of opinions. The original Liberal proposition was a starting deficit of $10-billion, followed by a balanced budget in a few years. With the recent fiscal update, it seems more likely the next budget may have a deficit of $30-billion, declining over a longer period of time than originally envisioned. Others have opined that, given Canada's commendable debt/GDP ratio, a better target is a stabilization of this ratio, which would allow continuing deficits in the $20- to 30-billion range. The Globe has shown a liking for this approach in a recent editorial. The Conservatives are still holding on to the balanced budget mantra.
What does the discipline of economics have to say about an appropriate fiscal anchor? As I understand economics, the answer is: nothing. The reason is simple: Any fiscal anchor cannot be appropriate for all the ups and downs an economy goes through over any period of time.
The problems with a balanced budget anchor have now been known for more than three-quarters of a century. One big problem, among others, is that such a policy makes business cycles worse. The problems with a debt/GDP ratio are less well understood, but serious nonetheless. First, nobody has a clue what the right ratio is. Second, any such ratio has the same pro-cyclical properties as balanced budgets. The stable debt/GDP ratio approach can work briefly, when one can run deficits with a weak economy with a view that the debt/GDP ratio can be increased. After that, once you are happy with a stable debt/GDP ratio, an economic contraction increases both deficits and debt and lowers GDP, which raises the debt/GDP ratio. To keep it stable means cutting the deficit during a downturn, which is pro-cyclical and makes the economy worse.
What advice does the discipline of economics actually offer for the conduct of fiscal policy? In my read, it offers the following four principles:
- The automatic deterioration in a budget balance as a result of economic weakness should be allowed to run its course, as it would self-correct when the economy recovers;
- Governments may/should undertake discretionary stabilization, with the constraint that such actions be reversed over the course of an economic cycle;
- Citizens should pay for what they get from the government. This means that current expenditures should be financed by the generation that benefits from them, except for temporary business cycle deviations. Expenditures that have long lasting benefits, such as infrastructure spending, should be financed by permanent deficits. Expenditures to be incurred in the future on the current generation, such as health care, should mean running appropriate permanent budget surpluses. The net impact on the longer-run budget balance, therefore, is an empirical question, not an ideological one;
- Needless to say, all taxation and spending decisions should follow the principle of getting the best value for money, to eliminate waste and inefficiency.
If a government followed these principles, meaning it is disciplined, and if citizens could figure out complex policy issues, meaning they would not favour ideologically preconceived notions, fiscal policy would produce optimal outcomes without any fiscal anchors. But in real life, these assumptions do not hold. What does one do in these circumstances? It is for this reason that simplistic fiscal anchors find a life as substitutes for sound economic principles. But that is not a desirable substitute. Such anchors, any anchors, can produce economic outcomes that are highly undesirable.
Consider running a deficit, which does stabilize the debt/GDP ratio, used to fund inappropriate spending, even on infrastructure. Consider pro-cyclical fiscal policy to stabilize the debt/GDP ratio in a severe downturn. Consider a government continually establishing new debt/GDP ratio targets.
There are no easy solutions when economists' assumptions do not hold, as the problem then is not economic, but political. Economic history amply demonstrates the continuous challenge on this front. The best we can do is encourage governments to follow sound economic principles and take steps to improve the level of public discussion and discourse on serious policy matters. The media has an important role to play in this.