Inflation may not follow large debt, this time

The 2020-21 federal deficit is estimated at more than $450 billion, the largest in Canada’s history. As a result, there is a growing fear on the part of many in the financial sector that there is a high probability of significant inflation once the recovery from the pandemic begins to gain momentum.

With government borrowing at such a high level and substantial deficits likely to continue for several years into the future, they reason — based on past experience — that higher inflation is almost a certainty. Is this true? How else could the government handle the mountain of debt?

Traditional economic theory says that, when governments borrow to pump money into the economy, the growth in the money supply (currency, deposits in banks and chartered bank balances with the Bank of Canada) leads to inflation — especially if that growth exceeds the growth rate of the real economy.

But as with many aspects of theory, there are several assumptions built into the argument. These assumptions are that the economy is running at full employment, that the labour market is tight and that there is a significant level of optimism about a strong future of economic growth. Well, right now these assumptions just don’t hold.

Unemployment is still far greater than it has been in the past few years. Many sectors, particularly hospitality, including restaurants and accommodation, and tourism-related activities, including air travel and cruise lines, are almost moribund.

With many small businesses closed permanently, it will be a while before the service economy (which employs most Canadians) faces tightness in the labour market.

In addition, the impact of the coronavirus has been so extensive and extended that it appears to have modified consumer behaviour.

In 2019 and early 2020, there was a rising concern about household debt and the need for increased saving was much touted. Then the virus resulted in a drop in consumer expenditures simply because much of the economy was shut down.

True, e-commerce has boomed and gained market share, but for many consumers, bank balances grew substantially and debt was paid down.

For those who lost jobs and income and accumulated significant debt in the last year, their first focus when the economy recovers will be trying to reduce those debts by not consuming beyond rent, food and clothing.

For the economy as a whole, there will continue to be some hesitancy to run up spending until the majority believe that economic stability is more likely than a resurgence of the virus or some other calamity.

Action taken by governments are also important in reducing risk of inflation.

First, I believe it highly probable that future borrowing at the federal level will shift substantially toward the longer term.

Ten- to 30-year rates are low, so it is now very cheap to reduce dependence on shortterm borrowings in order to give the feds some breathing room. I think the federal government will also consider some tax increases, even though they might face an election. A likely candidate will be reversing the twopoint cut former prime minister Stephen Harper made to the GST.

The bigger squeeze will be at the provincial level. Provinces will have to both increase taxes and reduce expenditures in all sectors, except, perhaps, for health and education. Look for premiers exerting increased pressure for a rejigging of the distribution of total tax revenues among the different levels of government.

There is no doubt in my mind, however, that the total tax take by governments will have to increase.

The trend over the past decade or more of more and more tax cuts cannot continue if we are to meet rising costs of health care and social services, particularly childcare and support for the elderly.

In turn, this will also require adjustments in our consumption levels, particularly in discretionary spending.

Finally, governments will have to respond to climate change, the aging of the population (despite immigration partially offsetting this trend) and the continuing redistribution of the population from rural to urban centres (despite the growth in tele-working).

This all means saving and investing, not spending with abandon. So, it’s unlikely uncontrolled inflation will occur in the foreseeable future.