Why David Dodge thinks Ottawa's plans to restore fiscal balance are on shaky ground
The federal government’s carefully charted path back to fiscal balance may be more precarious than it seems, and could be disrupted by a number of daunting economic challenges in the coming decade, former Bank of Canada governor David Dodge is warning.
Dodge, who now serves as a senior adviser to Bennett Jones LLP, noted in the firm’s Jan. 23 fiscal sustainability report that Ottawa will have to stick closely to a plan that limits spending and borrowing as laid out in its Fall Economic Statement if it hopes to bring high debts racked up during the pandemic back down to pre-COVID levels. But it still faces the prospect that the country’s two main fiscal anchors, the debt-to-gross domestic product ratio and a ratio measuring interest costs as a percentage of revenue, remain elevated for years.
“The message is that there is a significant risk that both ratios exceed comfortable levels over the remainder of this decade, both because economic conditions will turn out to be more difficult than assumed in the (Fall Economic Statement) 2022 and because the spending budgeted will turn out to be insufficient to achieve the policy goals promised,” Dodge wrote.
Dodge and co-author Richard Dion, a fellow senior adviser, analyzed how the two anchors could evolve over the next decade using a number of scenarios. Their base case projects that net-debt-to-GDP will gradually decline from 46 per cent in fiscal 2022-2023 to a pre-pandemic rate of 35.1 per cent in fiscal 2032-2033, and that the interest cost revenue ratio would stay below 10 per cent.
The base-case scenario assumes a longer-term potential real GDP growth rate from 2026 to fiscal 2032-2033 of 1.8 per cent and that federal government program spending will remain the same as it was laid out in the Fall Economic Statement until fiscal 2027-2028, before picking up the pace to four per cent.
The report said when the government fought back against the negative impacts of the COVID-19 pandemic and provided aid for millions of Canadians who suddenly found themselves out of work or with businesses forced to close, it left the Department of Finance with a $328-billion deficit in fiscal 2020-2021 and a net debt-to-GDP ratio of 52 per cent.
“Clearly, the ballooned levels of debt and deficits in (fiscal year) 2021-22 that resulted mainly from spending increases in 2020 are unlikely to be sustainable,” Dodge wrote. “Action to restore a sustainable balance between revenue and expenditure was, and continues to be, required.”
Dodge and his team noted that the federal government laid out a “plausible but optimistic” path for the economy and interest rates through the year 2027 in Budget 2022 and the economic statement in November. The report then ran with these assumptions and extended the fiscal plan to 2032.
“Thus, if the assumptions turn out to be a reasonable representation of future economic and interest rate conditions, and if the federal government were to limit spending and borrowing to levels set out in the (Fall Economic Statement) 2022, it appears that the federal government would be able to access capital markets without paying any risk premium,” the report read, adding that interest rates would be higher following the increases in 2022.
“Planned borrowing would clearly be at sustainable levels,” Dodge wrote. “But there are risks to this scenario.”
Dodge laid out a few of them: increased government spending, full-blown recession and a lower supply scenario.
If the government fails to keep its spending under control and it runs at the same pace as its fiscal 2023-2024 levels instead of ebbing off as the economic statement projects, the debt-to-GDP ratio would still steadily decline, but would land at approximately 40.7 per cent by 2032-2033 and the interest costs as a percentage of revenue would stand slightly above 10 per cent. Dodge noted that as long as those levels continued to decline, the risk to financial stability would be low.
A recession, which many economists believe is in the cards this year, would also throw a wrench into the debt-reduction plans. Drawing from the Fall Economic Statement’s downside scenario, Dodge assumes the recession would be triggered by a combination of supply constraints that don’t unwind, sticky inflation and interest rates that stay higher for longer. In this case, the debt-to-GDP ratio would only reach 42.4 per cent a decade later and the interest cost ratio would hit 10.5 per cent.
If supply issues became the global norm, Dodge expects rates would have to stay higher for longer to dampen demand. Dodge wrote that this would lead to interest rates that are permanently higher and real GDP growth that is temporarily lower, eventually leading the debt-to-GDP ratio to reach 39.8 per cent in fiscal 2032-2033 and the interest cost ratio to 11.6 per cent.
Dodge also flagged the possibility that a combination of these risks could work in tandem to undermine the government’s road map back to fiscal balance. If all risk scenarios gripped the economy at once, Dodge projected the debt-to-GDP ratio would jump to 51.2 per cent by 2032-2033 — nearly as high as the pandemic peak. The interest ratio cost would also rise to 14.1 per cent in that same time frame.
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The Department of Finance adopted the debt-to-GDP ratio as its fiscal anchor in the preamble to Budget 2022, after economists called on the department to establish such a measure to keep the country’s finances from spiralling out of control in the wake of unprecedented fiscal spending during the pandemic.
“This is our fiscal anchor — a line we shall not cross, and that will ensure that our finances remain sustainable so long as it remains unbreached,” Freeland wrote in April of last year.
Economists will get a better sense of whether the government is making progress on that ratio — as well as an update on the costs of many of the new programs and goals the Liberal government announced during the last budget and in the economic statement — in the next fiscal budget expected in March.
Dodge cautioned that because of the need to be more conservative in spending and because there are risks on the horizon, the federal government could fall short on funding their goals, such as their climate initiatives and housing affordability measures.
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