User Discretion Advised: Fiscal Consolidation and the Recovery

Abstract

Since the financial crisis in 2008, controversy has existed over whether governments should use fiscal policy in an attempt to stimulate economic activity, or whether fiscal consolidation is preferred. Those who call for continued stimulation focus on how slow and incompletely shared our recovery has been, while those favouring austerity argue that postponement of deficit and debt reduction retards business expansion, thereby hurting the recovery. This study evaluates the many strands of this fiscal policy debate, and applies the lessons to the decisions currently facing the federal and Ontario governments.The main conclusions are:• In normal times, fiscal policy should focus on allocation and distribution questions – public good provision, support for those on low incomes, and debt control – and should not focus on the short-run cycles in economic activity. Cyclical problems are normally best addressed by relying on monetary policy to strengthen the economy’s self-correction mechanism.• In non-normal times – involving very low interest rates and synchronized recessions across countries – monetary policy is relatively ineffective and fiscal policy is decidedly more effective than usual. This situation – precisely what we have been confronting since 2008 – is the exception to the general rule. In this case, fiscal policy should take an active part in stabilization initiatives.• The federal government should delay its final stage of deficit reduction by three years. If its deficit-to-GDP ratio is held at one-half of one percentage point for three years before reducing it to zero, it is estimated that the nation’s unemployment rate would be four-tenths of one percentage point lower during this three-year period. This opportunity to help working Canadians should not be passed up – especially when the cost in terms of reaching the government’s stated debt-ratio target of 25 percent by 2021 is so small – a missing of that target by just one percentage point. • The federal government’s deficit and debt targets are internally inconsistent. A debt-ratio target of 25 percent – along with an ongoing nominal GDP growth rate of 4 percent – requires a permanent deficit ratio of 1 percent, not zero. The government could achieve internal consistency by eventually lowering its debt target to zero. However, achieving consistency by raising its deficit target back up to 1 percent makes more sense when there are other short-term-pain-for-long-term-gain initiatives that are needed to address more pressing objectives than lowering a debt ratio that is already the envy of the world. • The Ontario government should address its long-term sustainability challenge before it embarks on major new expenditures. Policy-created uncertainty cannot be overcome when the government’s plans involve an increase in the deficit before it may start to decline. Infrastructure investments are particularly appealing when borrowing costs are low, but credibility requires that these debt service costs be covered by well-identified reductions in the operating expenses associated with existing government programs.