At least four recent developments have made that question much more pertinent:
The spread of the Delta variant and the ensuing fourth wave, along with related supply-chain issues, have chilled global growth. A more elongated recovery suggests that there could be a need for longer fiscal support broadly. The IMF expected budget deficits in the advanced world to drop heavily from more than 10% of GDP in 2021 to 4.6% in 2022, in its spring Fiscal Monitor. (For some perspective, these deficits were just below 3% of GDP prior to the pandemic; but, ballooned to nearly 12% of GDP in 2020.) That expected halving of the deficit next year may prove wildly optimistic if heavy government support is still required.
President Biden’s proposed $3.5 trillion spending plans look to be endangered by fiscal concerns among moderate Democrats. In turn, that tussle is holding up the narrower infrastructure package. The U.S. budget deficit has eased from its peak of just over $4 trillion early this year to just under $3 trillion now (on a rolling 12-month total), but that’s still nearly triple the pre-pandemic trend of $1.1 trillion. That widening represents nearly 8% of GDP, a massive net deterioration which has driven debt held by the public to above 100% of GDP. Meanwhile, rumbling away in the background is the seemingly never-ending debt ceiling issue, which will come to a head over the next month or so.
Some countries have started to move ahead with revenue measures to close the budget gap. The most recent example is the U.K., where Prime Minister Boris Johnson plans to raise taxes to help fund health and social care. He is proposing lifting payroll taxes for National Insurance (for both employers and employees) by 1.25 percentage points, as well as for dividend taxes. This did not go over well with some members of his party, but Parliament has backed it.
In Canada’s election campaign, some parties have proposed various revenue measures, but the overall thrust remains heavily on new net spending. No party is looking at anything close to fiscal restraint in the next few years—quite the contrary. While the contours and the details certainly differ among the major parties, the broad near-term deficit trajectories do not. That lack of urgency to rein in what is still a triple-digit shortfall this year (still expected to be a bit above $150 billion, or just over 6% of GDP) is largely due to the reality of long-term interest rates pegged well below 2%. And, the latest national accounts revealed that overall net government debt dipped somewhat in Q2 to just below 50% of GDP.
Overall, even with the collapse in real long-term interest rates, there is still very much a strong case that deficits do matter. No doubt, the debt arithmetic is much, much friendlier in a world of zero (or less) real rates versus the onerous 4% (or higher) real rates of the 1990s. But the counter case to the “deficits don’t matter” crowd is threefold:
The most obvious is that there is simply no guarantee that real rates will stay anywhere close to current friendly levels (friendly for debtors). After all, yields are being heavily suppressed by the waves of QE globally, and a variety of central banks are spying the exits, or already moving there. Even the ECB is now cooling its purchases, even if it doesn’t quite meet the taper bar. We are firmly planted in the low-for-long camp… but not this low.
Even the MMT crowd suggests that there are limits to budget deficits—and that limit is when inflation begins to spark higher. No matter your view on the transitory narrative, is there any doubt that the current level of fiscal support has helped revive core inflation quickly? We’ll get key readings on CPI next week in both Canada and the U.S., and all eyes will be on whether the core fades at all or keeps on forging higher. (Our guess is that housing will start to weigh more heavily on underlying inflation on both sides of the border.)
Finally, even in a very mild interest rate world, borrowers can still find a way into trouble. That could come about if lenders eventually doubt the debtor’s capacity to borrow more—a decision that can arrive very suddenly. Governments not repairing finances now, during an economic recovery, could leave them woefully vulnerable to the next major challenge. And, even absent a major crisis, it may well be the case that ultra-low long-term yields are telling us something important about long-term growth prospects. The conventional wisdom is that the long-term potential growth rate in the U.S. and Canada is in the 1.5%-to-2.0% range for real GDP. We’ll just note that economies that are further down the demographic line have seen much more modest average growth over the past 20 years—the Euro Area has averaged just under 1% in that spell, while Japan has been just below 0.5%.
The bottom line is that we will keep monitoring the budget deficit figures and debt dynamics closely, even if the market has all but lost interest. While not fiscal hawks, per se, and readily recognizing that the economy requires heavy support during this difficult episode, we would still assert that, yes, deficits do still matter.