Finance Minister Bill Morneau is busy planning his 2018 budget but no one seems to care very much. The upcoming budget is receiving very little media attention, and in fact surprisingly no media attention at all. In the past there would have already been considerable speculation about the deficit outlook and what new policies might be introduced.
Our analysis (3dpolicy.ca) of recent fiscal data suggests that the deficit in 2017-18 will be lower than the deficit in 2016-17 and that the deficit, as a share of GDP, will be well below one per cent over the next five years, resulting in the debt ratio declining steadily to historical lows.
From a fiscal perspective the Finance Minister should be a very “happy camper” in planning his budget. But this does not mean he couldn’t mess it up. Our advice is not to spend this fiscal dividend given the initiatives already introduced in previous budgets. Mr. Morneau faces major political and policy challenges, which he needs to overcome, if he is to restore credibility and secure his political future.
Despite all the rhetoric the Finance Minister, and also the Prime Minister, have failed to show that they really understand the long-term growth challenges that face the Canadian economy and that they are prepared to make the tough policy decisions (income tax reform and restructuring) that are required to strengthen economic growth.
In the meantime Canada (and the rest of the global economy) is at the mercy of events unfolding in the U.S. The possibility that the U.S. might withdraw from NAFTA is not surprisingly a central preoccupation of Canadian policy makers these days. Such an event would be extremely disruptive for the Canadian economy. But Canadian policy makers should equally be concerned about the irresponsible budget policies just passed by the Administration and the U.S. Congress.
Over the past 12 months any commitment to sound fiscal budget making has been completely absent in the Republican controlled Congress and Presidency. In a very short period Republican fiscal hawks have become Republican fiscal doves.
“Republican lawmakers in 2011 brought the U.S. government to the brink of default, refused to raise the debt ceiling, demanded huge spending cuts, and insisted on a constitutional amendment to balance the budget. On Wednesday, they formally broke free from those fiscal principles and announced a plan that would add $500 billion in new spending over two years and suspend the debt ceiling until 2019. This came several months after Republicans passed a tax law that would add more than $1 trillion to the debt over a decade. With all these changes, the annual gap between spending and revenue in 2019 is projected to eclipse $1.1 trillion, up from $439 billion in 2015”. (Damian Paletta and Erica Werner, WSJ, February 7)
Stephen Ratner, a former senior treasury official under Obama, concluded, “if current policies are maintained, the gap would exceed $2 trillion by 2027, according to calculations by the Committee for a Responsible Federal Budget. That would mean that the amount of debt relative to the size of our economy (the ratio of debt to gross domestic product) could reach a record 109 percent by 2027, exceeding even post-World War II levels. (NYT, February 8)”
This is a far cry from 2011 when Paul Ryan, then chairman of the House Budget Committee, proposed a budget-slashing plan that would lead to a $415 billion deficit in 2019.
In periods of economic slack a budget with this amount of stimulus might be justified. But such a situation does not exist today. The U.S. economy is already operating at full employment (an unemployment rate of 4.1%) and a combined tax cut and spending budget of close to one per cent of GDP runs a very high risk of being counter productive.
The Federal Reserve Board was already expected to raise interest rates by a full point this year before the budget. This new expansionary budget together with the tax cut could put even further pressure on the Fed to raise interest rates to offset possible new inflationary pressures. The big unknown for the FED is how strong any inflationary pressures are likely to be.
Most Republicans simply want to ignore the deficit now, because the President (aka the king of debt) doesn’t care about the deficit and debt, and they have signed on to him in their hope of surviving the 2018-midterm elections. The new “punch line” is that the deficit and debt can simply wait until after 2019 and probably even longer.
But bond markets are unlikely to wait that long to voice their concerns about the prospects for the rising deficit and the growing debt and debt burden. Recent large daily declines in stock market indices together with increased volatility in stock prices are clear indicators of concern in equity markets about future prospects in bond markets
Higher inflationary expectations (resulting from a re-emergence of recent strong wage increases) and higher risk premiums will soon begin to appear in long term interest rates and this will put additional pressures on public debt charges and the deficit.
“The Congressional Budget Office projected last year that annual interest payments on the debt would grow from $307 billion in 2018 to $818 billion in 2027. Interest rates are projected to rise at least one full percentage point over the next 18 months, and that could push up borrowing costs by $1.6 trillion over 10 years. The U.S. government already has more than $20 trillion in debt, and as of last year it was on the path to add more than $10 trillion in debt over the next decade before factoring in the new tax law and spending agreement.” (Damian Paletta and Erica Werner, WSJ, February 7)
So what does this mean for Mr. Morneau as he plans his 2018 and 2019 budgets? First of all the Governor of the Bank of Canada has already indicated his predisposition to raise interest rates in the coming year. Events in the U.S. may make him even more predisposed. He is unlikely, however, to fully match U.S. increases so we can expect some downward pressure on the exchange rate and upward pressure on inflation. Without offsetting wage gains (which are unlikely) average real incomes will decline.
We can also expect some steepening of the term structure of interest rates, but probably not as much as in the U.S. Any way you look at it, however, the Canadian consumer will face higher interest rates and higher mortgage rates in the coming years. With current high debt to income levels the overall impact on consumers could be very problematic
On the fiscal front, there will be some upward pressure on public debt charges but mostly on new debt. Most existing federal government debt has already been refinanced over longer maturities.
Perhaps most ironically for President Trump, who hates all trade deficits, is that higher U.S. interest rates will put upward pressure on the U.S. dollar and lead to a worsening trade deficit. It is a catch 22 he can’t avoid. We have seen this movie before under a previous Republican administration when China basically financed a growing U.S. government deficit.
C. Scott Clark held a number of senior positions in the Canadian Government, including Deputy Minister of Finance from 1998-2001. He has a PhD in Economics from the University of California at Berkeley and is currently President of C. S. Clark Consulting.
From 1990 to 2005, Peter C. DeVries served as Director, Fiscal Policy Division, at the Department of Finance. In that capacity he was responsible for overall preparation of the federal budget. He is currently a consultant in fiscal policy and public management issues.
Their Blog is 3dpolicy.ca