Opinion: Which country’s finances are in better shape, Canada or the U.S.?

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Economist Olivier Blanchard has long been the most prominent advocate of the view that the decade-long, post-Great Recession era of too-slow growth, too-low inflation and ultralow interest rates offered governments an extraordinary opportunity – even an obligation – to run bigger deficits.

That was the analysis of the former chief economist of the International Monetary Fund, and I agreed with it. So did a lot of economists.

But economic circumstances have changed – as has Mr. Blanchard’s analysis. Earlier this week, he wrote that the challenge for governments, in this new era of higher interest rates and higher borrowing costs, is to make sure that public debt does not “explode.”

Are Ottawa’s finances positioned to avoid such a debt explosion? The answer appears to be “yes.” Really.

What’s more, Canada’s finances are in a much better place than those of the United States. But before I get into that, some history.

Coming out of the Great Recession, the developed world was beset by persistently low growth, dangerously low inflation, and historically low borrowing costs. As long as those factors held, a serving of moderate government borrowing offered the possibility of a kind of free lunch. It could boost economic growth without worsening the country’s fiscal position. A moderately bigger deficit would not lead to a higher debt-to-GDP ratio, or an increase in the weight of debt service costs.

That’s the theory. And it was borne out by hard experience. The 2009 recession was deep in Europe and the U.S., and their recoveries were long and slow. Yet both pivoted almost immediately from stimulus to spending cuts, which further slowed economies, lowered government revenues and even made deficits larger.

Canada recovered relatively quickly from the Great Recession (thank you, oilpatch investment boom). But it took the U.S. and Europe the better part of a decade to get back to the economy of 2008.

They should have run more stimulative fiscal policies. Bigger deficits would have pumped more money into the economy, got more idle people and businesses back to work, removed the threat of deflation and been cheap to finance, so long as borrowing costs remained so low.

After 2009, governments mostly borrowed and spent too little. But after COVID-19 hit, and with those previous errors of omission in mind, they did too much. The results are all around us.

On the plus side, employment is higher than before COVID-19. Wages are up. Unemployment is low. Compared with the Great Recession, the post-pandemic economic recovery was remarkably quick.

But because the stimulus was so big, the needle moved from deflation, past the happy medium of moderate inflation, into the red line of high inflation. Central banks had to raise interest rates to cool excessive demand. And borrowing costs, including for governments, shot up.

Which brings us back to Mr. Blanchard. On Nov. 6, he wrote a blog post headlined: “If markets are right about long real rates, public debt ratios will increase for some time. We must make sure that they do not explode.”

His equation hasn’t changed, but its inputs have. That’s because central banks, including the Bank of Canada, have pushed up short-term interest rates, and long-term borrowing costs have gone along for the ride.

In early 2020, the yield on the 10-year government of Canada bond hovered around 0.5 per cent. That was well below expected inflation, which made it like free money. In recent weeks, the 10-year yield has been around 4 per cent. That’s higher than any time since the Great Recession, and higher than expected inflation.

The era of free lunch is over. Maybe not forever, but definitely for now.

For countries with large deficits, that spells danger. Their debt-to-GDP ratios are at risk of being shoved onto a high-speed escalator. To avoid that, Mr. Blanchard wrote that “stabilizing the debt ratio implies reducing primary deficits to zero.” However, he points out that in much of Europe and especially in the U.S., that can’t happen quickly.

“A drastic, immediate consolidation,” he wrote, “would most likely be catastrophic, both economically in triggering a recession, and politically, by increasing the share of votes going to populist parties.”

In the U.S., the federal deficit is big, and there’s no prospect of it being tackled through spending cuts or tax increases. A dysfunctional political system has instead delivered tax cuts paired with spending increases. That’s how you end up with forecast annual federal deficits in the neighbourhood of US$2-trillion – for years to come.

And Canada? It feels almost taboo to say this, but we’re in a better place.

As the accompanying graphic shows, the latest estimates from the Parliamentary Budget Officer show Ottawa’s deficit at a fraction of Washington’s level, and falling. And the federal primary deficit – the deficit not excluding debt-servicing costs, and a key figure right now for Mr. Blanchard – is in an even better position.

The U.S. Congressional Budget Office forecasts Washington will run a primary deficit of 3.3 per cent in 2023, barely falling to 2.9 per cent in 2028. As a result, the U.S. debt-to-GDP ratio is going to keep on rising.

In Canada, by contrast, the latest PBO estimate shows Ottawa running a small primary surplus this year, and larger surpluses in years to come. Barring significant new spending or tax cuts, the federal debt-to-GDP ratio will fall.

Such a happy outcome would require a radical and politically impossible change of course in the U.S. But it’s the planned budgetary course in Ottawa.

This country has problems. But assuming the federal government can control itself, the current path of debt and deficit do not appear to be among them.