Canada's (Silent) Economic Revolution

In the 1990s, Canada’s economic objectives followed the “Chrétien Consensus”: an implicit agreement that transcended political parties of all stripes for years. Regardless of political affiliation, politicians agreed to prioritize balanced budgets and declining public debt.

Fast forward to 2021, we are witnessing a new kind of consensus taking place in the Liberal party. This consensus doesn’t focus on balancing budgets or reducing debt, but instead on embracing an expanded role for fiscal policy – one which uses public finances to meet our societal goals.

The Chrétien Consensus led to cuts to federal spending termed austerity. Paul Martin, the federal Finance Minister from 1993 to 2003, cut federal transfers to provinces in an effort to manage federal debt. In 1995, federal transfers to provinces were combined into a single transfer, leading provinces to cut social and education programs.

The rationale for this was fairly straightforward. The federal government sought to keep finances under control after two decades of deficit spending. In 1993, interest payments on debt amounted to one-third of federal revenues.

Justin Trudeau broke from the Chrétien Consensus in 2015 when he decided to run fiscal deficits. Budget 2021 doubles down on this philosophy with $101.4 billion in new spending, and clear objectives of creating a national child-care plan, increasing Old Age Security, and making substantial green investments, among other goals.

This massive increase in public spending draws the ire of Trudeau’s biggest critics, namely the Conservative party. They cite a myriad of risks with massive spending. In spite of this criticism, why is the party that created the Chrétien Consensus so comfortable disavowing it?

It is worth noting that the interest rate, the basis of Paul Martin’s preoccupation with debt management, was much higher in the 90s than it is today. In the decade just before Martin took office as Finance Minister, interest rates were as high as 21%.

With a low interest rate environment, we can better understand that government debt does not work in the same way as household debt. Households have financial constraints – they only have a finite amount of money. Governments do not have financial constraints, but they do have real resource constraints, such as the finite amount of people they can employ. With unemployment being a perennial issue, governments can theoretically spend until full employment. Spending beyond this point results in inflation. These revelations have been popularized by Modern Monetary Theory (MMT).

Deficit hawks warn that mounting debt will result in hyperinflation. This thinking is rooted in the quantity theory of money (QTM), which states that general price levels will increase as a result of a proportional increase in the money supply, and vice versa. This economic orthodoxy tells us that the explosion of worldwide debt since the 1970s should lead to massive inflation, but this has not been the case so far.

Japan, in particular, has not only survived for decades without inflation, but it has struggled to even meet modest inflation targets despite extravagant public spending. Japan was one of the first major economies to utilize negative interest rates to stimulate economic activity.

Canada is also a counterexample to prevailing concerns around debt-related inflation. Combined federal and provincial net debt is projected to be 91.6% of the Canadian economy, doubling from $1 trillion in 2007-08 to $2 trillion in 2020-21. Inflation has steadily increased at an annual rate of 1.67% since then (well within the 1 to 3 percent target set by the Bank of Canada). Debt is not necessarily a precursor to inflation. The Liberal Party understands this, but the Conservatives remain stuck in the 1990s.

Another worry that dominates financial circles is the “crowding out” effect, which assumes that there is a finite amount of reserves available to creditors. The belief is that government borrowing uses up these reserves, crowding out private investment. Issuing bonds (borrowing) would therefore create competition for private savings that would push interest rates up and increase an individual’s propensity to save rather than invest.

This idea rests on the assumption that governments have to actually borrow the money they spend. Japan shows us that central banks don’t even need the private sector to purchase bonds. The Bank of Japan is the main purchaser of government bonds, which is similar to issuing IOUs without ever having to honour them. The Bank of Canada has engaged in a similar bond buying program during the pandemic.

When the government creates deficits, it results in a non-government surplus; money is taken out of the public sector and spent into the private sector. Bonds provide a stable investment for the private sector, but they are by no means a “funding” source for the government.
The Liberals understand that the federal debt is not inherently demonstrative of overspending. Overspending is better demonstrated by inflation, which has thus far been a no-show in Canada and the global economy until the recent supply shocks of the COVID-19 pandemic.^*

This is not an invitation for governments to spend recklessly, however. Functional finance still requires a focus on function. Useless government expenditures include subsidizing unprofitable zombie firms which require constant bailouts without contributing anything substantive to the economy. Without proper oversight, opportunistic politicians could mismanage public finances, padding the pockets of their friends and playing political favourites.

It should also be noted that this particular view of fiscal policy doesn’t apply to subnational jurisdictions. The provinces do not have the ability to issue currency. That means that provincial solvency is a legitimate concern, which introduces an added layer of complexity to the functional finance approach in Canada.

Despite these concerns, however, Justin Trudeau and Chrystia Freeland have decided to abandon the Chrétien Consensus and instead embrace expansionary fiscal policy. Questions about the effects of massive government spending are still unanswered. However, the evidence of modest inflationary pressure during the pandemic recovery to date largely has resulted from disrupted supply chains.

Instead of questioning the federal government on how much it’s spending or when the budget will be balanced, Trudeau’s critics should focus instead on indicators of a healthy economy. How is their spending addressing unemployment? How is their spending reducing the infrastructure gap in this country? Is housing affordable for most Canadians? Does every Canadian have access to clean water? Is every Canadian capable of living a prosperous life?

Focusing less on balanced budgets and more on a balanced economy should form the basis of a new consensus for Canada.

^* It should be noted that since writing this piece, the annual inflation rate in Canada jumped to 4.1% in August 2021 and in the United States, the Consumer Price Index surged to 6.2% in October 2021. There are a confluence of factors, such as pent up demand (especially as the unemployment rate recovers) as well as severely constrained supply chains (particularly given recent labour shortages), that have led to a generalized increase in prices. There is no causal link between low interest rates/high federal spending and recent inflation. It remains to be seen whether this bout of inflationary pressure will slow down or even reverse and policy prescriptions to ameliorate it is outside the scope of this piece, but it is worth mentioning once more, negative interest rates in Japan and the EU as well as deficit spending in Canada and the US have largely resulted in a low inflation environment, so the confounding factor of the pandemic is the exception that proves the rule.