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ECONOMY

Deficit spending

The return of red ink

Last Updated: Thursday, January 22, 2009 | 8:56 PM ET

It might be around $4 billion, as was suggested by Canada's Parliamentary Budget Officer Kevin Page in late 2008.

Or perhaps TD Bank's guess back in October of about $10 billion is a better forecast.

The pre-budget media leaks, a standard process by which governments condition voters for bad news, have pegged the shortfall at $34 billion.

Then there is Prime Minister Stephen Harper's hair-raising musings that Canada's next annual deficit could reach $40 billion.

Whatever the number is when the dial stops spinning, Finance Minister Jim Flaherty is certain to be coloring Canada's bottom-line red when he presents the 2009-2010 federal budget on Jan. 27.

That wasn't supposed to happen — at least not on Harper's watch. He was renowned for a laser-like focus on maintaining a balanced budget.

Three months ago, that was the party line — tough-talking, free-market rhetoric.

"Ongoing, unsustainable budget deficits are quite rightly unacceptable for Canadians. These structural deficits must never return," Flaherty told a Canadian Club audience in Toronto in October.

Even then, however, the finance minister was saying, through clenched teeth, that a short-term deficit might be in the cards.

Two months later, and the deficit hawk had turned into fiscal dove, admitting that the global financial crisis was dragging down federal tax revenues and forcing Ottawa to look at aggressive spending measures to increase economic activity.

"It's quite clear, on the basis of the forecast and the continuing decline in the forecasts, that there will be a deficit," said Flaherty in mid-December after a Saskatoon meeting with provincial finance ministers.

Thus, after more than a decade of surpluses, Canada's fiscal position is about to turn negative once again.

For analysts and government-watchers who dislike the 'D' word, this is bad news.

"The government would be wise to listen to the voices of the past and future. Those of the past know the harm caused by systemic government deficits. Those of the future surely don't want to pay for yesterday's and today's financial imprudence," wrote Kevin Gaudet, provincial director for the Canadian Taxpayers' Federation in a recent online posting.

Other economic writers say a deficit is unavoidable if Canada is to prevent a further slide into the economic muck.

"This stimulus package is good for Canadians and it's good economic sense," said David MacDonald, coordinator of the Alternative Federal Budget for the Canadian Centre for Policy Alternatives, a group advocating a $33 billion financial aid program in the next budget, a move bound to produce a hefty deficit.

Where Canada stands

Until now, the country has been running in the black. In fact, not since 1996 has Canada had a negative sign associated with its fiscal balance.

That makes the last decade unusual in Canadian financial history.

Indeed, Canada has run deficits in 34 of the past 45 years, stretching back to the Conservative government of John Diefenbaker, through the bow-tied years of Lester Pearson and the turbulent times of Pierre Trudeau, to the back-to-back majorities of Brian Mulroney.

Jean Chretien's government, with Paul Martin as finance minister, finally broke this cycle in 1997-98 by posting a $3.0 billion surplus.

To be fair, some of these deficits were that in name only, such as the $372 million shortfall in 1964-65.

Others, however, were much more severe, such as Chretien's $39 billion behemoth in 1992-93.

As well, those deficits had a tendency to build on each other.

For example, the budgetary shortfall widened in 14 out of 15 years between 1970-71 and 1984-85, starting at slightly more than $1 billion and peaking at $37.2 billion in the final year of that streak.

Worsening economy

This period of widening deficits coincided with a time of rising and sustained unemployment in Canada.

In 1976, the national jobless rate stood at 7.1 per cent. As that decade's oil crisis began to bite into economies, the unemployment level starting climbing, not to go below the '76 level until the year 2000. In fact, the parallel upwards movement of Canada's unemployment and deficit figures are no fluke.

To a large extent, the rise in borrowing — with a commensurate jump in the national debt — occurred because of sustained increase in unemployment.

Following Keynes

To follow this train of thought, go back to the point when deficit financing became popular in the 1930s.

During that depression, famed British economist John Maynard Keynes figured a government that was spending borrowed cash would create more jobs than income earners who were saving their pennies.

For many years, governments and voters bought this theory. Keeping people employed appeared to be worth a small deficit and temporary debt.

In the eight years between 1930 and 1937, Canada's total net direct debt grew from $2.52 billion at the beginning of the decade to $3.54 billion just before Ottawa started spending in anticipation of the Second World War.

Meanwhile more Canadians had jobs and the economy had hope.

What kept the federal government's deficit somewhat under control was the politicians' abhorrence of borrowing money.

As well, Keynes himself warned governments to eliminate any deficit during peak economic times.

And for 40-odd years, this combination of old habit and new theory conspired to keep Canada's finances in decent shape.

Oil shock

The 1970s changed all that.

As Middle Eastern countries turned off the oil taps, western economies slowed and unemployment soared.

From 1976's level of 7.1 per cent, Canadian governments were grappling with a jobless rate that exploded to 12 per cent by 1983.

Similarly, a $139 million federal surplus in 1969-70 turned into a $29 billion deficit within 13 years. Ottawa, short of any other idea, kept spending, at least to show voters that the federal government was trying to guide Canada through tricky economic waters.

Fast forward to the first decade of the new century to find parallels.

Starting a couple of years before the turn of the century, Canada saw the beginning of a period of stellar job creation and an unemployment rate at 30-year low.

The drifting down of the economy began in 2007, however, and accelerated last year when the global credit crunch hit the world's markets in earnest.

Now, forecasters are predicting that countries like Canada and the United States will see higher unemployment in the coming months.

Even for those who have jobs, crashing financial markets and dour newspaper headlines have combined to give them a worse fright than Michael Myers did to Jamie Lee Curtis in the first Halloween slasher movie.

That poses a dilemma for governments.

On one hand, more economists than 50 years ago seriously question the use of traditional Keynesian financing.

"Many macroeconomists are skeptical of the Keynesian model," said Harvard economist Greg Mankiw — himself a prominent neo-Keynesian — in 2008.

Mankiw, Massachusetts Institute of Technology professor Olivier Blanchard, and others lead a group of economists that have helped to resurrect Keynes's thinking by arguing extra spending is necessary to boost an economy over a short period.

What has critics pulling their hair, however, is the inability of elected officials to actually follow Keynes's prescriptions.

"(Politicians) did not live up to the apparent Keynesian precepts; they did not match the deficits of recession with the surpluses of boom. The simple logic of Keynesian fiscal policy has demonstrably failed in its institutional application to democratic politics," wrote James Buchanan and Richard Wagner back in 1977.

Frightened voters, however, want government to do something.

Although many say they do not want big-government spending programs, Harper ran into trouble in the 2008 general election campaign when he appeared to ignore the plight of the average Canadian as the downturn accelerated.

In effect, a government balances the budget in these times at the risk that its electoral opponents will exploit the lack of an economic action plan to entice disgruntled voters.

A new deficit for a new era

As Canadians face their first deficit in more than a decade, however, there are some differences that might make the red ink this time around less a problem than in the 1970s and 1990s.

First, most governments appear to have little appetite for running huge deficits for decades.

Second, the Canadian economy is much bigger than it was the last time the government failed to balance its budget. That makes the country's ability to recover from any public shortfall less painful. In 1976-77, Canada posted a deficit of $6.9 billion, equal to 3.4 per cent of the country's gross domestic product. Twenty years later, when Ottawa ran its last budgetary shortfall, the deficit was $8 billion, which constituted only one per cent of Canada's GDP.

Thus, if Harper's threat of a $40 billion actually came true, that fiscal shortfall would only equal 2.5 per cent of the country's 2007 GDP. By way of comparison, the last $30 billion deficit — 1995-96 — was 3.7 per cent of the country's national output.

A perhaps more realistic appraisal of the upcoming budget's bottom-line — the TD Bank's $10 billion deficit — would equal 0.8 per cent of the country's national product.

In the new deficit era, another, more subtler improvement is the speed at which the shortfall can be eliminated.

Last time around, the government's deficit actually rose in small annual increments, often between $1 billion and $3 billion dollars. The biggest jump was $13.4 billion between 1981-82 and 1982-83. By contrast, Ottawa managed to eliminate a $38 billion within three years in the 1990s, cutting it $36 billion in 1994-95 to $8.7 billion by 1996-97.

Thus, contrary to the thinking of many deficit hawks, Canada has shown — at least once — the ability to narrow the deficit in a hurry.

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