Recession, deficits and austerity in Ontario

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Ontario public service advocates and providers are becoming increasingly and rightfully alarmed about the direction of provincial finances, in the run-up to the public release of the Drummond Commission report, and a subsequent provincial budget that looks to be painfully austere.

The budget-cutting set are ramping up the rhetoric pretty dramatically: warning that Ontario is fast becoming the "Greece of Canada," that we are about to hit the "debt wall," that interest rates will skyrocket when the debt raters wake up, and similar nonsense. This is pure shock-doctrine stuff (reminiscent of like propaganda that set the stage for Paul Martin's austerity in the mid-1990s), and must be called out for what it is.

Ontario is not remotely Greece. A good way to make us MORE like Greece would be to throw tens of thousands of broader public sector workers out of their jobs, in a misguided effort to dig our way out of a hole. Investors love our bonds (and those of every other Canadian province) -- that's why they finance 10-year loans for interest rates barely above the rate of inflation. The key task in strengthening the fiscal balance is to put people back to work: paying taxes (instead of collecting EI), and buying stuff (instead of hoarding cash). While the provincial government's toolkit in that regard is not infinite (the feds have far more ability to influence job-creation, through macro, monetary, exchange rate, and other policies), we can't consider the provincial fiscal challenge without placing it in its appropriate macroeconomic context.

Here are 10 macroeconomic factoids to keep in mind as we prepare to counter the overarching claim that Ontario just can't afford our already-stretched network of public services:

1. We cannot forget that the recession caused the deficit, not "overspending" or an "out-of-control" public sector. After all, remember that the budget was balanced (with 3 years of surpluses, in fact) before the financial crisis hit in 2008-09.

2. Here's another way to make the same point. Due to both the reduction in GDP, and to a modest decline in provincial revenues as a share of GDP, the recession and its after-effects have reduced present revenue in Ont by $15 billion per year. About two-thirds of that amount is due to the fact that provincial GDP is 8-10 per cent lower than it would have been without the recession and resulting slow recovery. (I estimate that amount in reference to a non-recession scenario of continuing real per capita GDP growth of 1 per cent per year, multiplied by the actual GDP deflator; so this estimate is conservative as it is only capturing the real impacts of the recession, not the reduction in inflation as well.) About one-third of the lost revenue is due to the recession-induced decline in the revenue share (which fell by slightly under a point of GDP). With Ontarians paying a smaller slice out of a smaller pie in taxes to the provincial government, provincial revenues take a double-barrelled hit. Once again, it is clear that without a recession, there would be no deficit (since the 2011-12 provincial deficit will come in, interestingly, at almost exactly that amount: $15b).

3. Low nominal interest rates mean that:

a) the average effective interest rate paid in Ontario is declining (not rising), because each bond from the 1990s or 2000s that matures is replaced with a lower-interest-rate bond today (despite the overblown fear of rating agencies, downgrades, etc).

b) the debt situation is less explosive than it was in the '90s when the nominal interest rate was much higher than the nominal growth rate. With nominal interest rates broadly equal to nominal growth rates, the problem of "explosive" debt which was experienced in the 1990s (or in countries like Greece today) is not a factor.

4. In this regard, the doom-and-gloom projections of the impact of rising debt (not to mention a potential "downgrade") on Ontario's interest costs are vastly overstated. Total interest costs paid by the province this year will be no higher than a decade ago, even though the net debt is $100 billion higher.

5. Measured properly as a share of GDP, the rise in Ontario's debt since 2008 has been modest -- it's presently about 35 per cent of GDP, its growth has slowed substantially since 2010, and it will start declining (as a share of GDP) several years before the budget is actually balanced (as soon as the continuing rate of growth in nominal GDP outstrips the rate of growth in the debt). That figure includes the debt of school boards, colleges, and hospitals. The province's "accumulated deficit" (a narrower measure, which takes into account the value of the provincial government's non-financial assets) is much smaller: under 25 per cent of GDP. While there is no doubt that Ontario's deficit must be steadily reduced (unless we slip back into recession, in which case longer-lasting deficits should be accepted), the current accentuated sense of "crisis" over provincial debt is misplaced, and is being used manipulatively to justify unnecessary austerity.

6. Compared to a benchmark in which real per capita program spending is held constant, the austerity being touted by Mr. Drummond & Co. (with a rumoured annual increase in program spending of just 0.5 per cent, far lower than the 1.8 per cent forecast in the pre-budget fiscal plan that was more-or-less adopted by all 3 parties) would reduce program spending $12.5 billion per year below what it would have been in 2015-16.

7. The pre-election fiscal stance (accepted essentially by ALL 3 parties, incidentally) allowed for annual program spending growth in Ontario of just under 2 per cent. That is bad enough, and would translate into medium-term reductions in real per capita spending (since we need about 3.1 per cent to keep up with population and inflation). But Mr. Drummond & Co. are now saying it must be much lower than that: only 1.0 per cent per year they hinted before Christmas, or even 0.5 per cent per year in some more recent "trial balloons." (It will be interesting to see what the report actually forecasts.) Going at 0.5 per cent instead of 1.8 per cent would mean that the real per capita cuts would be TWICE as bad as under the 1.8 per cent scenario (3.1 minus 1.8 is a gap of 1.3; but 3.1 minus 0.5 is a gap of 2.6, twice as much -- see figure).

Ont. Program Spending Profiles

8. On the basis of plausible multiplier factors (such as those used by the federal Department of Finance), reducing program spending $12.5 billion below what it WOULD have been (under a constant real per capita service benchmark) would reduce provincial GDP by $19 billion (or 3 per cent) below what it WOULD have been (in a scenario which kept real per capita program spending constant). Depending on what happens in other sectors, this potentially could tip the province back into recession. If other sectors of the economy are growing quickly, then it might not result in an outright recession -- but in any event, fiscal drag on this scale will certainly hold back overall economic conditions, which are the crucial determinant of provincial fiscal health. That lesson is readily apparent in Greece and other peripheral euro economies; even the IMF now acknowledges that austerity is doing more harm than good over there.

9. Incidentally, fiscal drag is already exerting a negative impact on economic performance, both in Ontario and nationally. For example, in the third-quarter 2011 economic accounts released by Ontario last month, government spending by all levels in the province (especially capital spending) is now falling, undermining GDP growth and job-creation.

10. Ontarians voted for a deficit reduction timetable (essentially proposed by all 3 parties) in which program spending would be controlled at a relatively austere annual rate (below 2 per cent), and in which the deficit is eliminated slowly but gradually. They expressed no support for the notion that the province should take even harsher measures. There is no convincing evidence that economic performance over the medium-term will be weaker than was envisioned at the time of the election (if anything, conditions in the U.S., our main customer, are becoming better than was expected at that time). Therefore, one key recommendation that has been telegraphed by the Drummond process (namely, to tighten program spending well below what was contemplated in the election) is unjustified, both economically and democratically.

This article was first posted on Behind the Numbers.

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