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Fiscal risks of potential recession await next PM

Any voluntary increase in spending by the federal government would further exacerbate the deficit.

Many economists have warned of a U.S. recession in the near future, in part due to the rise of trade protectionism, political turmoil and market volatility. Of course, a U.S. recession will also harm the Canadian economy and create significant problems for federal finances.

So when the next Canadian government enters office after the Oct. 21 election, it must weigh policy options in response to a recession and decide whether to ‘stimulate’ the economy or rely solely on existing policies known as ‘automatic stabilizers.’

The latter are designed to help address changes in household income, without direct government action. Automatic stabilizers inject money into the Canadian economy during an economic downturn prior to any discretionary stimulus measures.

A recent Fraser Institute study examined the effect of automatic stabilizers during the 2009 recession, spotlighting the federal employment insurance (EI) program. When the economy slows or contracts, government spending on benefit programs automatically rises. A rise in unemployment automatically causes spending on EI benefits to grow.

The 2009 recession saw a pronounced increase in Canada’s unemployment rate, from 6.1 per cent to 8.3 per cent over one year, and unemployed Canadians received income from EI without requiring the government to draft new legislation. Regular EI benefits surged by 43.4 per cent or nearly $5.0 billion.

At the same time, EI premium revenues (money Canadians pay into the program) declined by 0.7 per cent or $126 million during the recession. When more people are unemployed, EI automatically collects less money while spending much more on benefits.

The boost of money from automatic stabilizers such as EI also increases the federal budget deficit (or reduces the surplus, if one exists) during a recession – without any government action. A 2019 study estimated that the federal deficit could hit $34.4 billion if the federal government relied solely on existing programs such as EI in the event of a recession.

Consequently, any voluntary increase in spending by the federal government would further exacerbate the deficit. Another study estimated that the annual deficit could skyrocket to $120.5 billion if the conditions of the 2009 recession repeated and government enacted a similar stimulus package.

The next prime minister must recognize that spending will automatically increase when the economy deteriorates, making it more difficult to balance the budget. Any discretionary measures government uses to try to stimulate the economy (increases in spending or decreases in taxes) will add to the existing automatic stabilizers.

There’s an increasing likelihood of a recession occurring in the not-too-distant future. It will be important the next government to not only understand how a recession can affect federal finances, but to also account for automatic stabilizers before discussing any potential stimulus package.

Jake Fuss and Milagros Palacios are economists at the Fraser Institute.

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