Why the fiscal news is bad

There are a few things that need to be kept in mind about the “Update of Long-Term Economic and Fiscal Projections” released by the federal Department of Finance last month. Firstly, the projection does not lead directly to a debt crisis. Secondly, the fact that the most recent projection does not lead directly to a debt crisis does not mean that we shouldn’t be concerned about the Liberal government’s spending habits.

But the real story in a forecast is the revision, not the projection. What is the new information that is being incorporated into the updated scenario? A popular take is that the long-term outlook for the Canadian economy has deteriorated since the 2014, and with it, the outlook for the federal government’s finances. It’s not immediately obvious where this conclusion comes from.

Yes, future economic growth is likely to be slower than it has been: the combination of population aging and lower prices for oil and other commodities makes for a strong head wind against which the Canadian economy will be struggling for some time to come. But then again, these are not new developments that have only come to light since November of 2014. Oil prices peaked in mid-2014, and we’ve known about the effects of population aging for decades now. The information we have now about the long-term outlook is pretty much the same information we had then.

Long-term projections are driven by assumptions about the long-term trend: there’s no point in trying to predict the evolution of the business cycle more than five years into the future. In Finance’s framework, this means making assumptions about the growth of labour inputs and in the growth of labour productivity: projections for GDP are obtained by multiplying the projected number of hours worked by the projection for output per hour.

Projections about labour inputs are driven by demographics, and Finance is still working with the same set of demographic projections that Statistics Canada published in September of 2014.

These projections will be revised when the population data from the 2016 census are finalized, but until new projections become available, there’s no reason for Finance to change them. So the 2016 projections for labour inputs are essentially the same as those published in 2014.

The story for productivity is similar. Since there’s not much in the way of new data to force a revision to beliefs about long-term productivity, the 2016 projection for productivity growth after 2020 is almost identical to that in used 2014.

So where did the downward revision come from? As far as I can tell, it’s a bit of a kludge that comes from Finance’s decades-old decision to outsource short- and medium-term forecasting to the private sector. I’ve argued elsewhere that this is a practice that should have ended long ago, and it needlessly complicates matters here. Although there’s almost no reason to think that the long-run outlook has changed since 2014, Finance has to link an unchanged trend to whatever short-term scenario is handed to them.

Their way of handling it is to sharply downgrade estimates for productivity growth out to 2020 so that GDP growth between now and then would mimic the short-term forecast.

The growth rate of GDP reverts back to the original projection for the following 30 years, but at a level somewhere between 5 and 6 per cent lower than projected in 2014.

Since government revenues are roughly proportional to GDP, they are also revised downward by a similar amount.

Finance’s analysts have their hands tied, and this kludge is perhaps not the worst way of splicing the long-term projection to the short-term forecast. But the information that has come available in the last 24 months can hardly justify a downward revision of the future paths of GDP and revenues by 6 per cent for the next 35 years.

The other important change in the outlook is on the spending side: federal expenditures in the 2016 scenario are set to be roughly 4 per cent higher (the equivalent of about 1.3 per cent of GDP, or $25 billion in today’s terms) throughout the projection horizon than they were in the 2014. The Conservatives’ 2014 projection left a lot of fiscal room — for instance, the federal debt was projected to be paid off by 2040 — and the Liberals have moved to occupy it.

Others have pointed out that the projection doesn’t make provisions for the expected surge in health expenditures as the population ages, that provincial debt-GDP ratios are increasing, and that there’s always the risk that a recession will blow public finances off course.

These risks are manageable, not least because the outlook for revenues is probably brighter than what the projections suggest.

But the news is in the revision, not the projection. And once again, the news is that the Liberal government is planning to spend more, run larger deficits, and to balance the budget even later than it had previously planned.

This pattern of everworsening projections is more worrisome than the projection itself.

FINANCE’S ANALYSTS HAVE THEIR HANDS TIED.