...against fictions and other tall tales

Tuesday, 18 December 2012

Behind the deficit: high interest rates and recessions

As a follow-up to my previous article, I thought I would post this chart:

Primary government balance, Source: Statistics Canada

It shows Canada's consolidated government financial balance with and without interest on the debt.  The government's primary budget balance (i.e., current revenue less spending excluding interest on debt) is a good indicator of the magnitude of fiscal policy, declining during downturns and rising when real GDP increases. (Refer to this Statistics Canada table to view the relevant data)

The chart shows a few things.  First, it shows that interest on the debt (and the Bank of Canada's high interest rate policy in the 1980s) was an important contributing factor to the size of the deficit in the 1980s and early 1990s.  Notice how the gap between the two series shrinks as we move towards the 1990s.

Second, it drives home the point that recessions have a significant impact on the size of the government budget deficit by increasing the use of automatic stabilizers (i.e., unemployment benefits and other expenditures) and reducing government tax revenues.  Note that the primary government balance reached a surplus during the late 1980s as a result of the deficit reduction efforts of the federal Tories under Mulroney and of the provinces (see arrow).  The primary government balance only declined again as a result of the recession of the early 1990s.  The end of the recession restored the primary surplus.

Third, it makes it clear (given the above) that the series of government surpluses that Canada witnessed starting in the mid- to late-90s had their roots in the fiscal policy measures of the 1980s (e.g., tax increases and spending cuts) rather than solely in the cutbacks of the 1990s under the federal Liberals and of the provinces.  This is a point that very few commentators in Canada appreciate.

But the main lesson to take away from the above is that the large budget deficit of the early 1990s was caused by the recession. It was not a consequence of 'out of control' government spending, as most are led to believe.


  1. The Finance folks would probably retort that interest is a critical budgetary item that cannot be segregated from the rest of the fiscal sphere. Regardless, your last point is well taken: wasteful government initiatives have been rare in recent decades.

  2. !! C'est tres bien pense. Vous devriez prendre:
    The Liquidation of Government Debt, Carmen M. Reinhart, M. Belen Sbrancia, NBER Working Paper No. 16893
    Their work is relevant. Other work by R&S in the IMF should also be reviewed.
    As some of your readers like to say: Stay the Course! Circuit. As always Very Good work.
    Best Holiday wishes to FRB and all its readers and their families. Une Bonne et Joyeuse Nouvelle Annee a FRB.

  3. @TP: Thanks for the note. Chances are some folks there would probably also take issue with my final point as well. ;)

    @MI: Thanks for the link! I agree it's relevant. Is just me or are these historical empirical analyses some of the most useful papers around these days? They seem to provide lots of insight on ways to address our current predicament. I appreciate the paper's scope. IMO, any study that is able to discuss debt, fiscal policy and inflation from a historical perspective ought to be read carefully. It reminds me of a comment a while back about how a tad more inflation might be beneficial for helping debt reduction. Reinhart's sometimes co-author Ken Rogoff did a good job in trying to start the discussion.

    Merci également pour les souhaits. Je vous souhaite aussi une très heureuse année à venir!

  4. First of all Best Wishes for 2013.
    It should be another good year for FRB: the challenges emerging and requiring serious attention will be numerous. The most significant is the need for policymakers to navigate growth in jobs and spur innovation. They are fiscal concerns although the former may seek some footing in monetary policy. This underlying function requires that policymakers lend an ear to the pros and cons of all economic visions, regardless of their traditions, conventions and lack of political leadership.
    The times are trying for many, and I think it's important to take policy seriously. The issue is not ideological although the 'fiscal cliff' is ideologically trying! and nonsense when poverty parameters are 'in your face'. The issue is a matter of pragmatics, yet too many advisors seek the truth 'that is out there' Unfortunately, there is 'no truth out there' in matters of economics other than what empirical evidence heralds as appropriate indicators of which approach one can take and what road one could follow. The measures for evidence and truth are multivariate, and appealing only to history disregards the very nature of history that exact conditions that prevailed THEN, may most probably not prevail NOW, and almost certainly will not be replicated in the future. It leaves one with what MI so wisely recommended: take note of the best of anyone's work, mregardless of ideology, because it will, in some fashion, lay out detail blueprints of the challenges.

    So many thinkers deserve serious attention because they are and do serious work regardless of their own passions in the political arena. The challenge is to avoid the mediocre chatter and consider public policy as a major issue.

    Stay the course.

    1. Thank you for your thoughtful comments. I'm with you on the need for policymakers to focus on job growth and innovation. Also, as an evidence-based researcher (or commentator), I think you are correct when you say that what matters is empirical support for policies. The last few years in Europe have been a bit of a fiasco in this regard. The US (more specifically, the Fed) seems to be doing much better. As your comment on history, I'm reminded of Keynes's view of economics as a "science of thinking in terms of models joined to the art of choosing models which are relevant to the contemporary world". I tend to think that a historical perspective is an important element.

      As for your last sentence, I hope you enjoy my recent piece on Domar. I consider him to one of the thinkers whose ideas ought to be discussed more often these days.

    2. @circuit Best wishes to you and your readers. The column has been exceptionally well structured and your intentions, as GC points out, very refreshing.

      On sadder note. A few hours ago, one of the century's greatest public intellectuals has moved on: James M. Buchanan.

      I concur with GC: 'So many thinkers deserve serious attention because they are and do serious work regardless of their own passions in the political arena. The challenge is to avoid the mediocre chatter and consider public policy as a major issue.'

      James M. Buchanan was a monumental hurdle for any economist and politician. His insights and devotion to the community and his passion were exceptional. He was a seminal thinker that will be missed by all.