rollercoasterWith the federal government’s decision, in presenting its recent budget, to go C$30 billion into deficit spending, let’s discuss the logic of Canadian federal government deficit spending.  What we will conclude is that it is the government’s prerogative as the lender of last resort and manager of the money supply to legitimately determine its level of spending at any time.  There will be some consequences (both positive and negative) and attendant risks to the strategy, but if these are well managed and planned for, a competent government can use deficit spending to make real and positive change in the economy.

In theory, deficit spending is to be used by governments to smooth out the volatility of the economic cycle by creating greater demand for goods and services in periods of negative or slow growth.  This deficit spending is expected to be counter-balanced by surpluses in periods of positive economic growth, by way of increased tax and service revenues  that would be earned along with diminished government spending.  This theory gained prominence after the Great Depression when proposed by the economist John Maynard Keynes, and generally became known as Keynesian economics.

The opponents to this Keynesian policy were generally the monetarists, who argued that the economic cycle is driven by monetary factors (money supply, interest rates, and so on).  General economic activity is an outcome of these factors, monetarists argue, and not by some temporary spending that is not tied into the real economy.

Of course, as in most situations, both sides have merit and some valid arguments.  Through deficit spending, the federal government, in essence, increases the money supply, and either needs to borrow to do this or print money for that purpose.  The difference is that the excess money definitely lands in people’s hands.  Under monetarism, any excess money supply is fed through a banking system that may or may not end up in people’s hands, depending on the activity of banks in lending out that money , at what interest rate (cost), and whether the borrowers can afford to borrow.

Take the 2008 response to the financial crisis as the ideal example of this.  The monetary authorities flooded the banking system with liquidity at the onset of the crisis, but little of this increased money supply fed through to the real economy – it stayed in the banking system to help offset the damaged banks’ balance sheets.  Thus, employment and economic growth remained sluggish for a long time, and in many areas of the world remain so.  However, the action did help avoid a banking collapse.

The Keynesian challenge of deficit financing lies in the government’s ability to finance it – ie. attract buyers of its debt.  If this is difficult, interest rates must rise to attract those domestic and/or foreign buyers.  Alternatively, if financed by printing money, real asset values will decline through inflation as more money chases goods and services and drives up prices.  These are the risks, and they can feed through the exchange rate by way of a marked decline.

Fortunately, Canada (and the world) is in a period of low interest rates and no inflation (if not deflation).  As well, the value of the Canadian dollar has recovered marginally over the last month.  So, the risk with deficit financing in the short term is quite moderate.  Thus, if the federal government remains sensitive to this, and responds appropriately should such risks escalate, they are in a good position to see success from this policy of deficit spending.  The economy should pick up in terms of growth and employment.