In addition to the force of Justin Trudeau’s optimistic personality, an obvious explanation for the Liberals’ election victory is that they promised to spend more than they taxed. Focusing just on the amounts promised, there is no reason to fear any serious negative consequences as a result. But the lurking issue is how this victory changes political incentives in the future. The “deficit taboo” is gone – but with it, have we lost the force that keeps democratic politics from leading to a debt crisis?
The Liberal platform announced planned deficits of approximately $9.9 billion, $9.5 billion and $5.7 billion in the first three full fiscal years of the government’s mandate. In contrast, the NDP anticipated surpluses of between $3 and $4 billion per year. At least as these things are conventionally viewed, the Liberals thus outflanked their traditional rival on the left. It is hard to know for sure whether this manoeuvre won the Liberals the “change vote,” but there is no doubt that the conventional wisdom that deficit spending is electoral suicide has been reversed.
From a purely technocratic point of view, the differences between the Liberal and NDP fiscal platform are not that big a deal. The total federal budget for fiscal year 2015–16 is $290 billion. Even the biggest deficit number is less than 3.5 per cent of the total, and on conservative estimates of economic growth, if the Liberal government sticks to its plan the debt-to-GDP ratio will continue to decline.
The main argument given for the deficits is that they get the economy moving again and generate jobs. Behind this slogan are models of the economy. If the total amount that people in the country wanted to spend were constant (a proposition economists describe as “Say’s law”), then more government borrowing would just mean an equal reduction in lending to businesses and individuals. While the mix of jobs would change, the total number would not. But cyclical booms and busts for the entire economy (at least when they are not caused by obvious external events like hurricanes or wars) show that the amount people want to spend is not constant. Sometimes there is a “general glut” where people and resources are left unemployed, even though there are clearly social needs to be fulfilled. At other times people are trying to spend too much relative to what the economy can actually produce, generating inflation.
The classic “old Keynesian” approach was to spend in recessions and tax in recoveries, thereby evening out the business cycle and making Say’s law that supply creates its own demand true by approximation. But Keynes wrote the General Theory of Employment, Interest and Money in the 1930s. At the time countries abandoned the gold standard but the assumption was that fiat currencies, controlled by governments, would be temporary. Monetary policy was more or less fixed, and only fiscal policy could make Say’s law come true.
In a country with its own fiat currency, like Canada, it is important to recognize that fiscal policy can be counteracted by monetary policy. Governments can react to feared inflation by increasing taxes and reducing spending, and to feared unemployment by doing the opposite, but central banks can react by reducing base money (if worried about inflation) and by increasing it (if worried about unemployment). What politicians do to aggregate demand, central bankers can undo. Since the budget cycle is much longer than the time for a central bank announcement, the central bankers have the last word.
In the early 1990s, the Rae government in Ontario ran large deficits with explicit Keynesian justifications, and the Mulroney federal government did the same without them. But the Bank of Canada was engaged in a tight monetary policy. The result was an unusually severe recession in comparison to that in other economies – even as Canada’s debt-to-GDP ratio reached its highest level ever (government debt maxed out at 101.7 per cent of GDP in 1996). In contrast, in the second half of the 1990s, both the federal and provincial governments engaged in serious fiscal austerity for the first time in a generation. The Bank of Canada lightened up and let the dollar fall. The result was a recovery and lower unemployment rates.
Milton Friedman’s belief that the amount of demand in the economy depended only on a particular monetary aggregate turned out to be wrong. But through the Great Moderation between the 1980s and 2008, he appeared to be right that a central monetary authority can offset whatever shocks occur to aggregate demand. A sufficient increase in the monetary base can offset a decrease in velocity (and vice versa). Thus, the central bank can keep overall nominal spending (and therefore inflation) on an even keel if it wants to. The New Keynesian synthesis took this experience into account: while changes in fiscal position as a result of automatic decreased revenues and increased spending on means-tested programs have a useful countercyclical effect, there are limits to what fiscal policy can achieve in light of the monetary offset.
The 2008 financial crisis complicated this picture. When it hit, nominal interest rates were already very low. To the extent that monetary policy has an effect through lowering interest rates, it looked as if the Bank of Canada (along with other central banks) was close to the “zero lower bound”: since interest rates cannot go below 0 per cent, many thought monetary policy could do little if deflationary forces occurred even when money was being given away for free. Thus even Stephen Harper – whose master’s thesis was an attack on countercyclical fiscal policy on the grounds that it will inevitably be driven more by politics than by economic need – undertook some fiscal stimulus via increased deficit spending. But central banks were not as constrained as people thought. They reached for unconventional measures, such as Quantitative Easing, a new term for creating money, which was used to buy government bonds.
The mini-recession of 2015 is not a “general glut” as in 2008–09; it is a partial glut of energy commodities. Canada has to adjust somehow: the dollar has fallen, which makes manufacturing exports cheaper and imports more expensive. This is in effect another form of monetary stimulus. On the day of the election, the Bank of Canada announced that it is maintaining its overnight rate target of 0.5 per cent – which is low, but still leaves some room for conventional monetary policy, let alone unconventional alternatives. In any event, the problem that budget cycles are too long to address fluctuations in aggregate demand is still there: by the time the new spending promised by the Liberal Party platform is put in place, the Canadian macroeconomy may be in a completely different position.
The second argument made by the Liberals for deficit spending builds on the point that interest rates are at an all-time low. If the government can borrow very cheaply, then it only needs a low return on its investment for borrowing to make sense. This is a good argument in principle: provided the value of project benefits offset the (currently low) cost of borrowing the necessary funds. Unfortunately, the Liberal platform refers to all public spending as “investments,” which denies any meaning to the word. We are told, for example, that a Liberal government will “invest” in the middle class by cutting taxes. To be fair, building infrastructure is investment, and it is too soon to know whether it will be infrastructure sufficiently useful to offset its costs. And, in any event, what really matters for our future fiscal position is the debt-to-GDP ratio – something which the Liberal platform promises not to increase.
But the technocratic economic perspective may not be the most important. Politicians get rewarded for pleasing voters, and most voters are not macroeconomists. It is puzzling that democracies can maintain any fiscal balance at all. Spending is popular and taxes are unpopular. Between the mid-seventies and the mid-nineties, that simple dynamic led to an explosion in public debt. The cycle was finally ended two decades ago when the political incentives changed, and deficits became political taboos.
By definition, a taboo is something that is not done for a rational reason. But taboos often evolve into cognitive shortcuts to obtain a (misunderstood) good. Whether or not avoiding pork in the Bronze Age Middle East was a good way of escaping the wrath of God, it was a good way of escaping the risk of trichinosis.
In an ideal world, “bad deficits” will continue to be political poison, while “good, technocratic deficits” will be okay. But making the correct distinction places a big bet on the sophistication of the electorate’s political psychology. No one can intuitively think in terms of billions of dollars, whereas everybody knows what it means to spend more than you bring in.
The generational consensus that deficits are basically bad is now over. What we need to worry about with this election result is not so much Trudeau’s budget numbers as what he and other politicians conclude from his poll numbers.