THE FEDERAL DEFICIT:
SOME ECONOMIC FALLACIES
IS THE DEFICIT A PROBLEM?
THE HAZARDS OF
ADJUSTING THE DEFICIT
THE FEDERAL DEFICIT:
SOME ECONOMIC FALLACIES
A federal budget always
encourages commentators to brandish their essays, speeches and editorials
on the deficit. This year such comments appear to be more noticeable.
With the stress on the deficit in the budget of 26 February, public debate
on this subject is likely to remain strong.
The recent dramatic fall
in the Canadian dollars value, has highlighted the international
marketplaces view of Canadian economic policy and the need for a
reduced budgetary deficit. Whether or not this view is accurate
it probably is is largely irrelevant. It puts pressure on the Minister
of Finance to curb spending (raise taxes), which is what the Canadian
business community has been urging for some time, as witnessed by the
statements of the Business Council on National Issues.(1)
On the other hand, a number
of newspaper editorial writers and economists have been arguing that there
is no need to reduce the deficit further. They suggest that the Minister
of Finance has either beaten back the deficit monster, although the public
has not yet noticed, or he is looking at the wrong deficit concept. According
to this view, laymen and business leaders look at the nominal deficit
figures as they are commonly published and perceive a crisis; if only
they would only put the figures in perspective, examine the proper concepts
and make the appropriate adjustments, they would see that no problem exists.
These views, as put forward
by some economists, form the basis of this paper. As the reader will note,
this broad approach has a great deal of appeal. Reducing the deficit problem
is much easier and less painful than reducing the deficit itself.
THE DEFICIT A PROBLEM?
As the deficit grows, so,
apparently, does the number of commentators who claim it is not really
In 1982 it became clear
that the federal deficit had very quickly ballooned to what appeared to
be dangerous proportions. Soon afterwards, however, some economists(2)
were calling for even larger deficits on the grounds that the adjusted
deficit was really not large at all; in fact it was far too small. The
Department of Finance entered this debate with a paper(3)
that put federal deficits in their "proper" context and concluded
that the federal deficit was in fact much smaller than was commonly thought
to be the case.
The observed deficit is
misleading because, unless adjustments are made for distortions caused
by the level of economic activity and the rate of inflation, the stated
deficit is not an accurate reflection of the governments fiscal
When the economy performs
below its potential, revenues are lower than they would otherwise be and
expenditures tend to be higher. This is because revenues and some expenditures
are functionally related to the level of national output. Discretionary
changes in both spending and tax measures can accentuate this trend.
Over the course of a business
cycle, then, the deficit will increase as the economy declines, and fall
as the economy recovers. It is this automatic movement which requires
a cyclical adjustment in order to identify the governments fiscal
After having made a proper
adjustment for cycles in economic activity, we are left with the concept
referred to as the "structural deficit," which reflects the
inherent fiscal position of the government more accurately. A large structural
deficit indicates a long-term or chronic problem, whereas a large cyclical
deficit is a temporary phenomenon.
It is important that this
adjustment be made correctly. If the budget is to balance over the course
of a cycle (and it should be pointed out that this is the strict interpretation
of Keynesian fiscal policy), the adjustment must be made on the basis
of average performance over the cycle and not peak performance. It is
common practice for proponents of such adjustments to use unreasonable
base levels of economic activity. The Bossons/Dungan paper used a 6% unemployment
rate as the basis of adjustment. The Department of Finance paper used
a cyclically adjusted unemployment rate concept based on a "normal"
adult male unemployment rate of 4.0% - 4.5%. Thus, it is not surprising
that these two documents go a long way towards demonstrating that a deficit
does not exist. In fact the bias in these measures can be seen from the
fact that the Finance adjustments show an output gap starting as far back
as 1977. It is likely that the Departments measure is picking up
changes in labour supply and treating them as changes in labour demand.
Since the trough of economic
activity in the last quarter of 1982, at least three years of recovery
have taken place. Real output has more than regained what was lost since
1981 and real per capita output has also increased since then. It is quite
evident by now that we should no longer be arguing that the deficit is
largely a cyclical phenomenon,(5)
particularly since cyclical adjustments, as they are made in practice,
tend to push the size of structural deficit downward.
In summary then, the whole
point of the cyclical adjustment was to discover the part of the reported
deficit that is structural in nature. This is important from the point
of view of fiscal policy. A cyclical deficit is something the economy
can grow out of very quickly, whereas a structural deficit requires explicit
policy or action either to cut expenditures and/or to raise taxes. Those
who argue for policy action aimed at the deficit view it as a structural
phenomenon, while those who argue against such measures view it as largely
The business cycle is not
the only factor that may distort the meaning of deficit figures. Rising
prices also have a distorting effect. Assets with a fixed nominal value
exhibit declines in real value over time with positive levels of inflation.
To compensate for this loss when inflation is expected, a premium is attached
to interest rates. Thus in times of rising prices, part of the nominal
interest payments are in fact a repayment of some of the original principal.
The use of nominal interest costs thus imparts an upward bias to the real
measure of the deficit.
The Department of Finance(6) has calculated the decline in the real value
of net fixed-value liabilities, using this figure to inflation-adjust
the deficit. In 1981 and 1982, this type of adjustment lowered the observed
deficit/GNP ratio by about two percentage points.
The Department provided
estimates only as far as 1982. These have been updated to 1985 using the
Departments methodology and are presented in Table 1. Whereas the
inflation adjustment significantly reduced the deficit measure in the
early 1980s, it is now proving to be a minor consideration. This adjustment
reduces the deficit/GNP ratio from 6.2% to 5.3% in 1983, from 7.0% to
6.0% in 1984, and from 6.6% to 6.1% in 1985.
The deficit adjustments
suggested by various economists are designed to measure the extent of
the properly stated structural deficit. At the time of writing, the papers
by Professors Bossons and Dungan and the Department of Finance argued
that the deficit was not a problem since it was due to either the recession
or the accelerated repayment of real government debt.
If we apply the methodology
of Bossons and Dungan and the Department of Finance, only one conclusion
can be reached: the deficit is a very serious problem and has become progressively
more so. The deficit is almost entirely structural in nature in 1985-86(7)
and prescriptions for growing out of the problem have, therefore, little
chance of success.
Inflation-Adjusted Federal Government Budget Balances
(National Accounts Basis)
Actual budget balance
Decline in real value of net fixed-value
Inflation-adjusted budget balance
Percentage of GNP
Source: Canada, Department
of Finance, The Federal Deficit in Perspective, Ottawa, April 1983,
Having demonstrated that
we have a large structural deficit, one might expect that the debate has
been resolved and that no one would argue that the "real budget"
is close to balance. On the contrary, it is always possible to find an
economist with a new deficit concept.
One such concept that has
not yet become a standard feature of the debate is the primary deficit.(9) This measures the difference between government
revenues and program expenditures only. This is simply an indirect
way of saying that interest payments are ignored. When such interest payments
constitute a large part of total expenditures, their elimination can easily
convert a large deficit to a balanced budget or even a surplus. Then again,
if we ignore social spending or transfers to provinces, the surplus will
be even larger. And if we also ignore defence spending and payments to
There is a very specific
advantage to using a primary deficit concept: it can be used to blame
monetary policy for high measured deficits, rather than fiscal policy,
as is normally the case. To quote from a recent newspaper editorial:
But spending isnt
the problem. Real interest rates that exceed growth in the economy are.
What reason on earth is there for wage earners and businesses to sacrifice
a steadily rising share of income they produce to unproductive interest
payments? And why should those who depend on worthwhile government programs
pay the price? In his budget, Wilsons got two choices for reducing
the mountain of public debt: Deal with the real problem, or mask it
by cutting valuable programs that make this country work.(10)
By dealing with the "real
problem," the editorial means reducing real interest rates through
expansionary monetary policy. The Department of Finance does not resort
to this shifting of blame. In a pre-budget consultation paper, it states:
The fiscal problem is,
in essence, one of structural imbalance between expenditures and revenues.
Monetary policy cannot address this fundamental problem.(11)
There is no conceivable
justification for ignoring interest payments when calculating the deficit,
unless of course the government has no intention of honouring its debts.
Whenever the government runs a deficit and borrows from capital markets
it must incur an interest expense. This is simply the opportunity cost
of using this resource and is no less legitimate than the opportunity
cost of using labour or raw materials.
Yet another way of looking
at the deficit is to examine its impact on the debt/GNP ratio. As long
as this ratio is stable over time, it is said, the size of the deficit
should not be of concern. This argument ignores an important question
about the level at which we attempt to stabilize the ratio. It is one
thing to keep debt at 30% of GNP, it is another to keep it at 100% of
GNP, as the following discussion will show.
The debt/GNP ratio is an
important economic variable. If the economic agents view public and private
sector financial instruments as perfect substitutes, an increase in the
degree of public debt held by the economy necessarily crowds out the amount
of private debt held. This is worrisome because public spending tends
not to be as productive as private spending. Indeed a large part of public
borrowing is aimed at financing current consumption rather than investment
in capital (whether tangible or human). As a result, the deficit not only
fails to stimulate economic activity in the short run, it also has adverse
effects on longer-term economic growth and productivity change.
A rising debt/GNP ratio
is not a problem in itself. If the level of productive public investment
was too low, we would in fact want a rising ratio! The present concern
with the governments fiscal position and its trend comes from the
belief that too much public debt has already been accumulated, or will
be accumulated in the next few years. Stabilizing the debt/GNP ratio is
a necessary condition for fiscal prudence but it is clearly not sufficient.(12) The policy issue is then not when
the ratio is stabilized but where it is stabilized.
The Department of Finance
has recognized this constraint in its most recent statement on deficits
and debt. The medium-term goal is to stabilize the debt/GNP ratio by the
early 1990s, while the longer-term goal is to reduce it to the pre-recession
Consider the implications
for government policy of attempting to maintain a stable debt/GNP ratio.
If the governments fiscal position is in a steady state (i.e. it
is running deficits that maintain the debt/GNP ratio at some constant
level), then the following relationship must hold:
Primary Deficit + Interest
Rate x Debt = GNP Growth Rate x Debt
If the primary deficit is
zero and the monetary sector is in equilibrium (i.e. inflation rate equals
expected inflation rate) then a constant debt/GNP ratio requires real
interest rates to equal the rate of real GNP growth. If they are higher,
the debt/GNP ratio will grow, even with a primary balance. This is the
situation to which the Minister was alluding when he said "Real interest
rates higher than real rates of economic growth compound the current fiscal
problem."(14) He went on to make the following
analogy, "The situation can be compared to making an investment with
borrowed funds. If the return on that investment is lower than the rate
of interest being paid on the debt, the result is obvious."(15)
But what is the lesson to
be learned from this? It is that if the rate of interest exceeds the rate
of return, one should not make the investment not that one should
make the investment and then complain about high interest rates. Rather,
if real interest rates are too high, the government must run a primary
surplus(16) to stabilize
the debt/GNP ratio. Since the government has far more control over the
size of the primary deficit/surplus than over the real rate of interest,
that is the variable it should control to achieve its goal.
THE HAZARDS OF ADJUSTING
There is a legitimate reason
for making certain adjustments to the observed deficit in order to put
the governments fiscal position into perspective. Economic cycles
and inflation affect the observed deficit and it is important to note
the origins and implications of such changes. It is not only legitimate
to look at the debt/GNP ratio, it is unwise not to do so. It is, however,
not legitimate to view this ratio only in terms of its constancy. It is
even useful to look at the concept of the primary deficit; but it is clearly
not legitimate to use it as a basis of policy. The debt accumulated in
the past is part of the legacy of any current administration and the costs
associated with such a debt cannot be ignored.
Having said all this, why
should we view such adjustments with scepticism? There are several reasons,
chief of which is that these new views of the deficit are promoted by
those who would like to see the government incur much higher deficits.
It is one thing to try to hide the real size of fiscal imbalance to avoid
embarrassment or hysteria; it is quite another to use this mathematical
wizardry to promote even greater deficits. What we have, then, is a potential
It has been pointed out
elsewhere(17) that mischievous results can
flow from cyclical and inflation accounting and it may in fact be possible
to make the deficit and debt/GNP ratios unstable. The two essays cited
give a more detailed view of this problem, but we can relate some of the
If the cyclical adjustment
is made on the basis of an unrealistic benchmark, the governments
fiscal stance will be biased toward larger and more frequent deficits
than desirable. If these deficits are themselves the source of poor economic
performance, then todays high deficits justify tomorrows high
deficits, which justify next weeks higher deficits, and so on.
Inflation accounting tends
to put a floor under the current real value of net debt and to create
a strong disincentive for ever reducing this real value. In this way,
any temporary and unexpected increase in the deficit produces a permanent
legacy in terms of higher debt and higher future deficits.
Treating the deficit issue
as solely a problem of stabilizing the debt-to-GNP ratio can also provide
an incentive for higher deficits. The deficit/GNP ratio that will stabilize
a particular debt/GNP ratio can be defined according to the following
Debt x GNP Growth
By stabilizing the ratio
at the 1990/91 forecast level rather than the 1980/81 pre-recession level,
the government more than doubles the size of deficits it will run into
perpetuity. And this is based on a prospect of steady growth. A recession
in the meantime would increase deficits and the level of debt at which
its growth could be stabilized with the result that the floor on the deficit
would again be raised.
To make this argument more
concrete, consider the case where Canadian GNP grows by 6.5% per year.
To stabilize the debt/GNP ratio at its forecast 1990-91 level(18)
allows an annual federal deficit as high as 4.1% of GNP. If, on the other
hand, the government attempts to stabilize this ratio at its pre-recession
level of 0.28:1, annual federal deficits could not exceed 1.8% of GNP.
On the basis of 1984 Gross National Product, this difference represents
in excess of $10,000 million of allowable deficit per year.
The greatest threat to fiscal
stability comes from the use of the primary deficit as the relevant fiscal
concept. Like it or not, any government is constrained by the actions
of its predecessors in accumulating debt and the drain on financial resources
resulting from the associated interest cost. We may have a primary surplus
today but the debt and todays observed deficits are due to all those
primary deficits in the past.
Interest charges represent
the opportunity cost of borrowing money and a recognition that these financial
resources have other useful purposes elsewhere. If government was to be
convinced that borrowed funds were free, the quantity demanded would rise
dramatically. In other words, interest rates are a check on the size of
deficits. Some might feel that this check is not very important, but we
need only look at how other zero-priced resources are used to get a good
idea of what would happen to the size of deficits if interest rates were
As economic science becomes
more sophisticated, it is better able to place certain variables within
their proper perspective. "Sophisticated" economics, however,
also has a propensity for deriving rather bizarre conclusions. It is quite
conceivable that when the federal deficit reaches $500 billion per year
and exceeds 50% of annual GNP some analysts will be telling us that the
deficit is not a problem, that tighter fiscal policy would be a disaster
and that what is really needed is an economic policy based on the needs
of the people and not the wishes of international currency speculators.
The four ways of looking
at the deficit presented here all have some merit in very specific contexts.
However, indiscriminate reliance on them would be dangerous; and could
simply provide an excuse to produce even higher deficits.
In 1983, we were told that
the deficits would go away with economic recovery and reduced inflation.
A sceptical view was that "the current consolidated government deficit
in Canada is very large and barring changes in the fiscal structure
likely to remain large in the foreseeable future (this is particularly
true of the federal deficit, which is proportionately much greater than
that of the provinces and municipalities)."(19) The more we make use of these new views of
deficits, the greater will be the accuracy of the sceptics predictions.
Finally, a comment on economic
analysis and the deficit seems worthwhile. The four approaches to the
deficit presented here are ways that economists might look at the issue
but that accountants, for example, might ignore. The approaches have some
economic rationale. It is, however, incorrect to view the current debate
as one with the business community on one side (arguing for rapid deficit
reduction) and economists on the other (arguing for a more sensible approach).
Such a view ignores the fact that a large part of the economic community
views the deficit and debt with alarm and has argued for significant reductions
in both. Should the February 1986 budget be judged to do little about
the deficit, it does not mean that Mr. Wilson has sided with economists
in general, although he may have sided with some in particular.
The subject matter of this
paper is still sufficiently imprecise and subject to enough differences
in opinion to be able to be used to "prove" almost anything.
This is in sharp contrast to mathematical analysis, which can prove whether
the second derivative of a linear function is itself an exponential function
or whether two plus two equals five.
The use of economic analysis
cannot reduce the current federal deficit. Such analysis confirms that
the deficit is a problem. If we look at the situation in its proper perspective
and make the appropriate adjustments, we see that the shortfall in government
revenues is very great. Economic analysis can be misused, however, to
show quite the opposite.
Council on National Issues, The Federal Deficit: Some Options for Expenditure
Reduction, Ottawa, 2 August 1984; and Business Council on National
Issues, National Deficits and Debt, Meeting the Challenge, Ottawa,
(2) See for example: J. Bossons and D.P. Dungan,
"The Government Deficit: Too High or Too Low?", Canadian
Tax Journal, Vol. 31, No. 1, January-February 1983, p. 1-29. The authors
of this study argued that the consolidated fiscal position of all governments
contributed to the worsening depression in economic activity
" and "without significant additional fiscal stimulus
from the government sector
the Canadian economy will experience
close to zero growth in real GNP during 1983." In fact, real growth
in 1983 turned out to be 3.3%.
(3) Canada, Department of Finance, The Federal
Deficit in Perspective, Ottawa, April 1983
(4) Technically, the proper measure of the deficit
should also include such items as the unfunded portion of CPP/QPP liabilities
which are excluded in published figures. This inclusion would have increased
the size of the federal deficit by an average of $18,100 million over
the past seven years. The inclusion of the unfunded liability in government
superannuation plans would have added another $2,300 million to the federal
deficit in 1984. The federal governments CPP liability is strictly
limited to the size of the fund and as such it would be more appropriate
to add this change in the value of unfunded liabilities to the consolidated
government deficit. Nevertheless, the unfunded liability represents a
future increase in CPP contributions which will be required to meet commitments.
Since these contributions are viewed as federal taxes, an increase in
this unfunded liability has the same effect as an increase in the size
of the federal deficit.
(5) This is not to suggest that economists will
not make such arguments. In the summer of 1985, it was argued that the
federal fiscal position was highly restrictive. The structural deficit
was calculated to be 3.7% of GNP in 1985 and only 1.8% of GNP in 1986.
But this would indicate that the Canadian economy was once again in recession.
See: T. Wilson, "The Fiscal Stance and the Economic Outlook
The Short-Term Impact," in D.D. Purvis (ed.), Report of the Policy
Forum on the May 1985 Federal Budget, John Deutsch Institute for the
Study of Economic Policy, July 1985.
(6) Canada, Department of Finance Canada (1983).
(7) The ratio of cyclically-adjusted (structural)
deficit to the measured deficit was 70% in 1984, 54% in 1983, and 50%
in 1982. This ratio should be even higher for 1985 and 1986. These figures
come from Department of Finance data and, as argued in this paper, likely
give an underestimate of the size of the structural deficit. See: Canada,
Department of Finance, Economic Review, April 1985, Ottawa, 1985,
(8) The last three entries have been calculated
using the Departments methodology as outlined in the above document.
(9) The expression "primary deficit"
has been used in the Budget Papers but no policy inference was drawn.
(10) "Attack on Deficit Misses the Mark,"
Toronto Star, 7 February 1986.
(11) The Hon. Michael Wilson, Reducing the
Deficit and Controlling the National Debt," Department of Finance,
Ottawa, November 1985, p.17.
(12) N. Laurie, "Wilson Doesnt Have
to Reduce Deficit Further," Toronto Star, 29 January 1986.
(13) The Hon. Michael Wilson (1985), p. 17
(14) Ibid., p. 11.
(16) The equation on p. 9 would have a negative
entry for the primary deficit.
(17) See: B. Zafiriou, "Deficits: How
Big and How Bad?" and M. Wrobel, "Policy Implications of Inflation-Adjusted
Government Deficits," in The Economic Review (5): Issues in Stabilization
Policy BP 69E, Research Branch, Library of Parliament, Ottawa, May
(18) This calculation uses the 1990-91 debt/GNP
ratio forecast in the May 1985 federal budget, namely 0.63:1.
(19) Zafiriou (1983), p.18.