Canada’s Strange New Budget Legislation (Revised)

Thesis: A government outlawing deficit spending is overly idealistic and restricts lawmakers by making fiscal stimulus overcomplicated.

Tomorrow, April 21, Canadian Finance Minister will deliver his budget proposal, including an unprecedented piece of legislation that would outlaw government budget deficits, per the Wall Street Journal.  The bill includes a necessary loophole clause that would make exceptions for recessions or extraordinary circumstances such as wartime or a natural disaster.  It’s a proposal that seems to be addressing a problem where one doesn’t exist – Canada has historically run a fairly responsible budget, with a very modest ~35% net debt to GDP ratio.  And as one of the most politically and economically stable countries in the world, it doesn’t cost Canada much at all to borrow.

Basic countercyclical policy dictates that governments should spend during economic downturns in order to prop up aggregate demand, financing itself by issuing debt, which it then pays off during economic booms.  This law tries to make this behavior a mandate by forcing the government to cut spending during good time.  It’s a nice idea in theory, but it may make the use of fiscal policy to stimulate recessions a bit tricky.  Specifically, a problem arises when the government tries to define where a recession actually ends – cutting a stimulus package the moment a quarter shows a positive growth rate (however small) is rarely ideal.  In fact, we only have to look back a few years to demonstrate this in practice.  Canada’s stimulus package for the recent global recession was introduced in 2009 and continued throughout 2011, according to The Star, even though the Canadian economy showed positive growth rates as early as mid-2009.  By allowing stimulus to continue past the point where a recession technically stops, the government can ensure that the spending has boosted the economy throughout the entirety of the country, since growth rates in some outlier areas may skew the aggregate growth rate positive even when other parts of the country are still hurting.  It also gives consumers a solid timeline to base their expectations on – if households know that the fiscal stimulus could be cut off at any time, they may be more reluctant to go out and spend.

What the Canadian Finance Minister is proposing would force stimulus packages to be reluctantly designed in small, short-term packages, which may require the government to respond to a recession multiple times, dragging out its length.  What’s more, the increased scrutiny on deficit spending might make lawmakers reluctant to even consider introducing stimulus proposals.  And since the spending would have to be so short-term (and maybe even cut off if the economy recovers prematurely), the government can’t commit funds to longer infrastructure projects – a major component of many federal stimulus packages.  There’s no good reason for the Canadian government to restrict itself like this besides political grandstanding.  A more prudent step towards managing federal debt would be to expand the budgeting process to require a balanced budget over the course of a business cycle.

5 thoughts on “Canada’s Strange New Budget Legislation (Revised)

  1. Chang Tian

    If Canadian Government has to design small fiscal policy packages and restrict issuing long-term bond, what impact do you think the new budget legislation would have on the term structure? Do you think it would help with the inverted yield curve as in a severe financial crisis?

    1.'Lucas Morrison Post author

      First and foremost, if the proposal passes then I would expect the Canadian bond market to contract significantly, with the supply restriction driving up market prices. But the measure probably wouldn’t affect the term structure of Canadian bonds. Fiscal stimulus would have to be shortened because the government’s freedom to issue bonds could be cut off as soon as a recession technically ends, meaning the government wouldn’t be able to continue financing long term projects. But I don’t think the actual structure of that financing would change – Canada would probably continue to issue the same type of debt, just less of it.

  2. Jaewon Lee

    This is something that questions me about the effectiveness of the policy change. I personally think that as long as you can pay back the debt, there are circumstances where it is better to borrow now for better future.

    1.'Lucas Morrison Post author

      I completely agree – there are plenty of times where bond-funded spending can come in handy. Obviously the government should be responsible when issuing debt, but to completely restrict itself like this is very odd.

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