Outlook 2010: Are the deficits here to stay?

As Ottawa trims to tackle the fiscal hole, what America does might matter more.

It’s easy to be optimistic that Canada will shrug off its Great Recession melancholy this year. For starters, Prime Minister Stephen Harper has promised to fight the federal deficit, expected to reach $56 billion by fiscal year-end, with “fiscal discipline” instead of tax increases. The country is well poised to lead its G7 peers in economic growth, and Ottawa remains committed to implementing its $47-billion stimulus package, which should provide a welcome boost to embattled industries this year.

But if our history of profligacy has taught us anything, it’s that Canada can’t afford to be complacent about the country’s more than $500-billion debt. After all, the federal government will add about another $165 billion to our tab before our books are expected balance again, and will quickly wipe out all the debt repayment gains it’s made since the mid-1990s.

Don Drummond, senior vice-president and chief economist at TD Bank Financial Group, says the sheer number of risks that could thwart Canada from returning to balance are unprecedented. “This should be the easiest time in the world to forecast the economy because you’re at the bottom, and what do you do when you’re at the bottom? You go up,” he says. “If you look at our cyclical experience in the past, we’ve tended to come off the bottom relatively quickly. But there are all kinds of things that could derail that this time around.” Some of the biggest question marks: possible shifts in the U.S. consumer’s save-versus-spend mentality, soaring household indebtedness and the increasing strain on a health-care system that’s already struggling.

On the one-year anniversary last September of Lehman Bros.’ collapse, Finance Minister Jim Flaherty spoke about Canada’s exit from the recession. He touted the soundness of our banks, Canada’s debt-to-GDP ratio (the lowest in the G7), and the fact that the deficit-to-GDP ratio is 3.7% — well below the peak of 5.6% in the early 1990s. But he also conceded that “we must remember just how quickly global turmoil can erupt, and how easily it can sideswipe Canada.” That’s a big lesson of this recession: Canada’s good standing didn’t really matter. As it moves through the recovery, the country will be tied, as usual, to the United States. In terms of output, Canada wasn’t hit as hard as the U.S., but the restructuring of industries like forestry and automotive will cause post-recession productivity to be languid across all of North America.

Drummond suggests that no matter how the Americans deal with the debt, it could throw Canada into a double-dip recession: “It could be a lose-lose, because if they deal with it in a draconian fashion, then they’ll kill off the recovery, but if they don’t deal with it at all, they’re going to see lower U.S. growth, drive down the U.S. dollar, raise the bond premiums — and that would be a disaster for Canada.” Flaherty worries about U.S. debt, too, calling it a “persisting concern” for Canada and highlighting the government’s interest in other foreign markets.

But Canada has problems of its own. Bank of Canada governor Mark Carney has warned that the biggest risk to the financial system is now household debt, even if it’s still “relatively low” and unlikely to reach levels that could cripple banks’ balance sheets.

According to Kevin Page, Canada’s Parliamentary Budget Officer, who provides independent analysis to Parliament regarding Canada’s finances, there’s an even larger structural issue: the country’s aging population will be an unavoidable strain on our economy. “As the next wave of boomers retire, Canada is expected to see lower revenue growth and higher expenditures for Old Age Security and health costs,” says Page. “This will cause significant strain to that budget balance problem in the long term.”

These obstacles mean that the sooner the government can eliminate the deficit, the better. Flaherty is still committed to a balanced budget by 2015 without raising taxes or making cuts to provincial transfers. Some economists say that it’s impossible to “grow yourself out” of this deficit, but Flaherty says a new budget expected in March will explain the “guideposts” of his big plan.

Other countries will no doubt be watching. After all, many of them have been studying Canada’s debt buildup in the ’80s and early ’90s, and then its debt reversal since the mid-1990s, for their own recession exit strategies. Now, the country needs to prove it can do it again — before the next unforeseen financial crisis hits.