Factors which Led to the Fiscal Deficit and the

Consequences of its Reduction

by John S. Butterworth, 31st March 2010
In its budget presented on the 4th March, our federal government pledged to reduce its
2009/10 fiscal deficit from $53.8Bn (3.4% of GDP) to almost zero over the next five
years. What factors led to this sudden deficit and what will be the consequences of its
elimination?
Factors which led to the Fiscal Deficit
Due to the economic downturn, from 2008 to 2009 Canada’s trade balance dropped by
$52Bn, from a surplus of $47Bn to a deficit of $5Bn.

Also, during this period, our terms of trade with our major trading partner, the USA (79%
of our exports, 54% of our imports) changed from an average of about $1 CAD=$0.87
USD in 2008 to about $1 CAD=$0.94 USD in 2009. This also reduced the
competitiveness of our exports and made imports cheaper.
Because of these two factors, the current account (which includes trade, investment
flows, services, travel and other factors) dropped by $49.4Bn, from +$8.1Bn to -$41.3Bn,
a dramatic reversal.
The way in which this drop in the current account relates to the fiscal deficit is governed
by the sector financial balances equation:*
Fiscal Balance + Private Sector Balance + Foreign (Capital) Balance = 0
Also, it is important to recall that the foreign “Balance of Payments” mandates that the
current account is equal and opposite to the capital account, or:
Capital Account + Current Account = 0
So we can re-write the sector financial balances equation as:
Fiscal Balance + Private Sector Balance – Current Account Balance = 0
By allowing a large fiscal deficit to develop, our government has stabilized the private
sector balance, which has changed very little from 2008, as can be seen from this
diagram:
This has prevented a private sector deficit
from developing, which would have meant
a deep recession.
The Consequences of Fiscal Deficit
Reduction
Changing the fiscal balance will cause
changes in one or both of the other two
sectors. The government has little direct
influence over the current account balance.
Devaluation of our dollar is not an option
given that many countries would like to do
this. Any improvement in the current
account will require an economic recovery and consequent improvement in our trade
balance.
More likely, a quick change in the fiscal
balance would force the private sector balance
into deficit from its $12.5 Bn surplus in 2009.
Firms and households would be forced to spend
more from savings or go deeper into debt.
Households are deeply indebted already, with
debt at a record 140% of disposable income.
Canada’s total debt/GDP ratio has jumped from
about 220% to 260% since the beginning of
2008 (see chart). Most of this is private-sector
debt. The government sector ratio is only 65%
currently (Federal plus Provinces).
The outlook is not a happy one. In demanding
a fiscal deficit reduction, we should be careful
about what we wish for. It may spell DEEP
RECESSION if we cut too quickly.

Source: McKinsey Global Institute via the

Economist magazine
*
This is an immutable accounting identity.
2