The Deficit:Hysteria and the Current Crisis

DeficitPapers-Chapter 2 – This essay  originally written in 1983-84 and the introduction to it (1992) was reprinted in my book with Phillip Hansen Toward a Humanist Political Economy published in 1992. I am including it here because it contains analysis that is still very relevant to the current outbreak of deficit hysteria that grips Western Europe and to a lesser extent North America.

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Chapter 2: The Deficit: Hysteria and the Current Crisis, from Toward a Humanist Political Economy. This essay was originally published as a monograph by the Canadian Centre for Policy Alternatives in 1984, a progressive think tank in Ottawa supported by the labour unions, a number of non-governmental organizations and individuals. I attempted in this essay to puncture the myths that lay behind the hysteria that the new Conservative Government of Brian Mulroney was stirring up about public sector deficits.  Much of what I warned about in this essay has come to pass.

Instead of a decade of prosperity the 1980s and early 1990s were marred by two very serious recessions and a drastic rise in the rate of long term unemployment.  In many respects the decade resembles the slump of the 1930s.  Indeed, at the time of writing, fall 1992, it appears likely that the current recession will drag on with little or no improvement in the rate of unemployment until 1994.  In fact, the situation may worsen.  Because of the worldwide nature of the recession and the absence of serious recovery, despite the recession having lasted over two years and the accompanying financial instability ranging from the collapse of stock prices in Japan, the savings and loan scandal in the United States and the crisis over the exchange rate mechanism in Europe, it is more accurate to call this a slump rather than a simple business cycle recession.

The average rate of unemployment for the past twelve years in Canada is close to 10 percent, the highest average rate since the great depression of the thirties.  Similar rates now prevail in Great Britain,

France, Belgium, Australia and Italy.  The official rate in the United States is somewhat lower but there are many more discouraged workers that are not counted as unemployed in the U.S. than in other countries.

Japan and Germany, which have avoided recessions up to now, both appear to be on the edge of the slump themselves.

The Japanese have attempted to buck the anti-Keynesian trend.  They have recently announced  a $100 billion programme of public sector investments financed by expanding their deficit.  They did so to the applause of both their own business federation and Wall Street.  The contrast with Canada could not be greater.  We shall see if this counter-cyclical strategy is enough to move the Japanese economy away from the precipice of recession.  The Germans, on the other hand, despite substantial expansion of (pg. 113) their public sector deficit, primarily to finance economic reconstruction in the former East Germany, still stubbornly stick to their policy of excessively high interest rates and may well lapse into recession later in the year.

Indeed it was the German policy of excessive high rates that ultimately forced Britain to leave the exchange rate mechanism.  However, as the British Observer commentator William Keegan pointed out, they deserved a medal of gratitude from Britain for this feat, for the exchange rate mechanism was simply a monetarist device for forcing Britain to deflate and raise unemployment to discipline wage demands.  The British are well to be rid of it.  Much like the gold standard of the late 1920s, it depressed British manufacturing and lowered prices by creating a recession.  One might call it “exchange rate monetarism” to go along with “deficit reduction monetarism” practiced here at home.

The Bank of Canada has also practiced exchange rate monetarism in keeping our interest rates higher than the American rates in order to ensure a higher exchange rate on the U.S. dollar.  This has had the effect of deflating the Canadian economy more than would have been the case had our real rate of interest been more sensible.  In both Britain and Canada the dogma of zero inflation monetarism has dominated public policy.  The policy has now accomplished its goal with the following results: Inflation is now (September, 1992) 1.2 percent.  If we subtract tax increases we now have negative inflation.  This is similar to the situation during the depression of the thirties when falling prices reflected the weakness in the economy.  Pessimism about the future of the economy abounds everywhere. Businesses continue to go bankrupt.  Unemployment continues to rise and may yet reach 12 percent or more.  What a Pyrrhic victory over inflation.  Zero inflation has come to mean zero economic growth and zero employment prospects for more than one and a half million Canadians.  It is hardly a policy to crow about!

Alas no one in power listened to what I warned about if a policy of sound finance and deficit reduction through austerity were pursued.  Sound finance and deficit reduction became conventional wisdom. Instead of prosperity, these policies have produced a decade of lost dreams and despair for several million Canadians.  Unemployment has become a chronic problem and we still have not succeeded in eliminating the debt.

Sound finance, eternally popular with lawyers and chartered accountants turned politicians, is once more the scourge of the unemployed and a definite obstacle to economic recovery.  Since this first essay I have published several other monographs on the problems of debt management and monetarism, including

The Deficit and Debt Management: An Alternative to Monetarism (1989) which is still available from the Canadian Centre for Policy Alternatives in Ottawa.

For me the deficit controversy has proved to be a rich intellectual ore body, but for many of the general public and the unemployed, in particular, (pg. 114) it has proved to be nothing less than a disaster and in some cases a tragedy.  The controversies of public policy and economics may seem dry and technical but the decisions that are made on the basis of these arguments and debates involve real blood, sweat and all too often tears.  I can think of no more important arena in which to practice a humanist political economy than around the controversy that rages over the question of the debt.



The tragically misguided economic “wisdoms” of the 1930s have once again come back to haunt us.  Then,as now, faced by chronic and catastrophic rates of unemployment, the federal and provincial government, most of the business community, and many professional economists argued for “sound” conservative public finance.  The cry was for deficit reduction and balancing the budget.

The result then was the continuation of the Depression with its awful impact upon personal and social life right up until the Second World War offered deliverance.  Can we be so foolish as to repeat this massive failure of public intelligence? Must yet another generation of Canadians suffer the painful fate of a “lost generation”?

Much of the current debate about deficits seems to ignore the lessons of the 1930s. Instead, we hear calls to cut the deficit, to reduce government expenditure, to let the private sector flourish.  On the whole, this chorus of opinion has its base in the corporate and financial community.  But, as in the 1930s, they have been joined by voices from the academic community.  The combination of corporate special pleading and academic legitimacy has been irresistible for the Canadian media.  The move to deficit reduction has become the conventional wisdom of the day.  The correctness of such a policy is projected as being beyond dispute.

To question it is to reveal oneself as unfashionable, out of touch and certainly suspect.

The new Progressive Conservative federal government promises the people of Canada a new deal. How cruel will be the disappointment of the electorate if their mandate for change is wasted upon the discredited policies of the past.  Let the new government recall the fate of R. B. Bennet’s insistence upon sound finance that ultimately saddled the Conservative party with its reputation for inflexibility and inability to manage the economy.

If the new government is to avoid making the same mistake, it ought to reconsider the advice it is receiving from the corporate community that deficit-cutting is the only road to restoring prosperity.  The recent Economic (pg. 115) Statement by Finance Minister Wilson, “A New Direction for Canada,” unfortunately has committed the new government to the bankrupt policies of the past.

The result of these policies will be continued economic stagnation rather than economic renewal.

Mr. Wilson argues that “the need for action” on reducing the deficit “is not a matter of ideology.  It is an inescapable reality we have to deal with.”  Yet, the facts show otherwise.

It is time then to re-examine the deficit issue more closely.  This short essay will look at some of the issues and some of the major myths in the debate about deficits.  It will be critical of some of the economic “wisdom” regarding deficits that has been taken for granted until now.


Much of the current debate uses the term “deficit” without ever defining precisely what it means.

Many people believe that public sector deficits are comparable to their own personal financial situation when they are in debt.  As many business people are so fond of repeating, “you can’t run a business constantly in the red.  Eventually you’re going to go bankrupt.” It is this kind of logic that is often incorrectly applied to government.

Some people confuse the public sector deficit with the current account deficit or surplus on our balance of payments.  Finally, many people believe that the deficit has reached an all-time high in Canadian

Finally, many people believe that the deficit has reached an all-time high in Canadian history.  As we shall see, all of these notions are quite inaccurate and misleading.

The term “deficit” when used with reference to government finance means simply the difference between government expenditure in total and government revenues.  When government expenditure exceeds government revenues there is a deficit.

When government revenues exceed government expenditure there is a surplus.

Because of the federal nature of the country, provincial and local government expenditure and revenues are a part of this calculation.  As well, the hospital sector and the Canada and Quebec Pension Plans are also part of this calculation.  In order to gauge the overall impact of deficits or surpluses upon the economy, economists calculate the deficit or surplus from information made available in the NationalAccounts.  The calculation is done this way in order to include information from the public accounts about government expenditure and revenues, and information from the National Accounts about changes in expenditures and revenues from “specified purpose funds” which are excluded from public accounts.[i]( see chart in table A at end of the paper.)

Unfortunately, media reports about the deficit rarely pay any attention to these complications.  As a consequence much of the information presented about the deficit is distorted or misleading. The actual economically significant deficit is the consolidated government deficit (or surplus) calculated on a National Accounts bases, as follows:


When the term “deficit” is used one must ask, “which deficit?” On what basis has it been calculated? Is it strictly the federal deficit? Or is it the consolidated government deficit including the hospitals and the Canada and Quebec pension plans?  Calculating the deficit itself involves several important steps and assumptions. When the word “deficit” is used without qualification or explanation one should be dubious about any policy conclusions drawn about the figure.

The deficit (or surplus) applies to a given budgetary year.  The accumulation of deficits year after year less any surpluses year after year yield the accumulated debt of the consolidated government sector.

The best way of gauging the size and importance of this public debt is to measure its size in relation to the size of overall gross national product.  The ratio of these two figures has been rising and falling and then rising again over the past 50 years.  Contrary to popular mythology it is not currently near its historic peak over the past 50 years.  That peak occurred during the period immediately following World War II. For example, in 1952 the total net Canadian federal debt alone as a proportion of the GNP was 51.7 percent.  In 1983 it stood at 33.5 percent of GNP.

Total government debt as a proportion of GNP was also higher in the early 1950s than the present level of 63 percent.  On the other hand, the total private sector debt as a proportion of GNP in 1983 was 98 percent.[ii] Yet, you would never know this from the hysteria about government debt in the business community.

During the war years 1942 to 1945 the annual consolidated government deficit averaged 16.9 percent of GNP. The debt to GNP ratio peaked in 1946 when it reached 106 percent of the GNP!


Despite a level more than the three times that it reached in 1983, the economy survived.  Indeed, the post-war years were years of prosperity.  The rate of inflation during the war averaged 1.9 percent and the rate of unemployment 1.9 percent.  In 1983, the consolidated government deficit was 5.9 percent of the GNP, the rate of inflation 5.8 percent and the rate of unemployment 11.9 percent.  So in very crude terms it would appear that increasing the deficit significantly as a proportion of the GNP has a positive effect in reducing unemployment.  It is not possible to say this about inflation as price controls prevailed during World War II.

I will return to this relationship between the deficit, inflation and unemployment in later sections.

At this point let me clarify two common misunderstandings about the deficit: the relationship between the current account deficit, and the comparison of public sector deficits and debt to household debt.

The current account deficit (or surplus) refers to the balance that results in our international trade in goods and services.  Like the public sector deficit (surplus) the calculation of the balance involves a number of components and is a little complicated.  The only connection that our balance of payments has with the public sector deficit is the extent to which the latter is financed by borrowings from abroad.  As I explain later, foreign borrowings are of relatively little significance in the financing of the federal government deficit, although they do play a much more significant (pg 118) role in financing provincial government

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deficits.  The only other complication that ought to be identified is the connection between the exchange rate on the Canadian dollar and interest paid on the debt. Just as deficits in the balance of payments can affect the value of the dollar, so too can interest rate differentials between Canada and the U.S. If the Government wishes to pursue an independent andeither higher or lower interest rate policy from that of the U.S. this difference in interest rates may have exchange rate implications.  I discuss these implications in section VI below.

It is often suggested that the most important difference between public sector and household debt is the fact that whereas the household must finance its debt from private financial sources such as chartered banks, trust companies and credit unions, the public sector has the power to tax, and in the case of the federal government it has access to the Bank of Canada.[iii]  The Bank of Canada has considerable influence over the money supply and can finance some federal government debt by creating money.  Where a private householder may face the real risk of financial insolvency it is almost never the case with the public sector. It is certainly not the case today.  This fundamental difference between the household and the government sector is very important but it is not the whole truth.

The fact is that government debt represents investment in public assets.  The total wealth of our public sector in Canada, our roads, expressways, rapid transit system hospitals, airports, ports, power plans, public buildings, universities, schools, crown lands and natural resources represent enormous wealth- producing assets.  It is the collective wealth of these assets that stand behind the liabilities associated with the debt.  If one has lost confidence in the net worth of these assets there can be little doubt that long before this point one lost confidence in the net worth of the private sector.

It is simply ideological blindness not to recognize that public sector assets represent the most secure assets in the land.  Furthermore, most government debt is used to finance the expansion of this asset base, either directly through additions to the physical stock of capital, or indirectly through producing and maintaining a healthy, educated and skilled workforce.

Government investments in the physical plant and social overhead capital of the nation are investments which generate wealth bearing assets that may last as long as 50 to 100 years.  It would be foolish indeed to attempt to finance these assets on a pay as you go basis.  No private corporation would dream of doing so. At the level of household finance, the notion of financing the purchase of a home through a 25-year mortgage is normally accepted as a sound financial decision.  Similarly, a portion of government expenditure through debt is at least equally sound.  Indeed, there is considerably less risk involved.

Finally, it must be understood that the vast bulk of government debt is owed to ourselves. Anyone who purchases a Canada or Provincial Savings (pg. 119) Bond or whose pension plan buys government bills and bonds is participating in funding Canada’s debt.  There may well be questions about income and wealth distribution that arise from these transfers, but on the whole, the effects are benign.  If one is concerned about these effects then the answer lies in changing the tax policy that affects them and ensuring that interestpaid on the debt is as low as possible.  Let us now examine in detail how Canada’s public sector debt is financed.


When governments run deficits in their expenditure-revenue accounts they have to finance their expenditures somehow.  Generally this occurs in one of two ways.  Either the government borrows money from the public or the chartered banks, or in the case of federal deficits, the Bank of Canada finances some of the government’s debt.  The former is by far the more common route taken.  The latter is called “monetizing” the debt and generally involves direct expansion of the money supply.

When the federal government finances its deficit by borrowings it sells either a Canada savings bond, a Treasury bill or a marketable bond to individual members of the general public or institutional savers or the chartered banks.  The length of term to maturity of each of these debt instruments varies from 91, 182 or 365 days for Treasury bills, to seven years for Canada saving bonds to anywhere from two to as long as twenty years for marketable bonds.

The vast bulk of these debt instruments are held by the chartered banks and the general public.  For example, in 1982 Treasury bills amounted to $25.7 billion, marketable bonds $47.9 billion and Canada Savings Bonds $33.7 billion.  Of this total of $107.3 billion of outstanding debt, $15.4 billion was held by the Bank of Canada.  In other words, in 1982, 86 percent of the outstanding debt of the federal government was held by the general public and the chartered banks.  The general public itself held 73 percent of the

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outstanding debt.

The principal difference between financing the federal debt through borrowings from the general public and financing the debt through direct purchases by the Bank of Canada is the effect upon the money supply.  Selling bonds to the general public reduces the money supply.  But if the Bank of Canada buys the securities and prints additional money to pay for them, it is expanding the money supply or monetizing the debt.  On the whole, this happens only a small percentage of the time.  In recent years because of the adoption by the Bank of Canada of very conservative policies, this has happened hardly at all.  It is one of monetarism’s contentions that monetizing the debt is always inflationary.  In fact, this is not so and depends upon the circumstances in which monetization takes place.  It must be remembered that selling bonds to the chartered banks also monetizes debt.  The difference is that the Government must pay interest to the chartered banks. (Pg. 120) In the case of the Bank of Canada the Government is paying interest to itself.

Provincial and local governments and the hospital and pension plan sectors do not have recourse to the Bank of Canada.  Their debt must be totally financed by private pools of savings.  In the case of provincial governments it is not uncommon for them to borrow on foreign, as well as domestic money markets.  Nevertheless, the vast bulk of all federal government debt (over 86 percent of itas of 1984) is held in Canada by Canadians.  If too much of the debt were held abroad this could create problems such as exchange rate implications.  (In 1992, 79% of federal debt was still held in Canada.)

While the debt represents an obligation for the federal and provincial governments that they must service by paying interest on it, for those holding the debt it represents an important secure asset.  However a number of quite conservative economists have recently suggested that government debt affects the expectations of savers and taxpayers about their future lifetime tax obligations to pay for the debt.  This argument suggests that government debt does not truly represent a wealth-bearing asset, despite the payment of interest associated with it.  As such, they say, debt financing through the sale of bonds has the same effect as financing the debt through the levying of taxes.  If this is so, it is argued that deficit financing cannot have a stimulative effect upon aggregate economic demand.  They claim the private sector anticipates these future tax liabilities and reduces its consumption and investment by amounts equal to the increased governmentexpenditure.  This argument, however, makes a number of quite critical and heroic assumptions, which are quite unrealistic about the long term rational planning activities of savers.

For example, it suggests that individual savers behave as perfectly rational, far-seeing calculators of their own interests, anticipating as far ahead and as comprehensibly as is possible, all likely market outcomes.  As such, they are part of an overall economic system that behaves in a far-seeing, rational and relatively certain manner.  Yet, as we know from present experience, the economy is a far cry from this ideologically inspired vision of a world of pure reason.  In fact, uncertainty and decision-making in the absence of information and rational expectations are the rule rather than the exception. As such, the argument that taxpayers repudiate debt because they rationally have come to expect the future tax consequences seems far-fetched and at odds with actual behavior.  Finally, it assumes quite wrongly that private sector economic activities are inherently more productive of wealth than public sector activities financed by the deficits.

When one compares the role played by hospitals, day-care centres, the school system, universities, highways and airports with that played by private sector firms it is rather difficult to sustain this conclusion.

Obviously wealth is created by the application of labour, technology and organization to the production of goods and services in the private or public sector.  To argue that only the private sector creates wealth because it produces (pg. 121) profits is very much at odds with the facts in a modern economy.  Indeed, it smacks of pure ideological assertion.

One of the problems with current economic policy is the excessive influence of neoclassical market dogma.  Many neoclassical economists stubbornly insist upon the sanctity of the market, its stable tendency toward perfect market clearing equilibrium and the rational expectations that prevail.  In such an environment the role of State intervention can only be one of shock and disturbance.  This idealized utopianmodel would be harmless if it were not for the fact that these same economists confuse it for the real world and attempt to prescribe policy from this perspective.  It is because of their deeply held set of beliefs, largelynat variance with reality, that so many neoclassical economists are prepared to attack public sector deficits as destabilizing influences upon the economy.  Among leaders in the business community, this attack contests

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the very legitimacy of the public sector itself.

Far too often, the media are unaware of these dogmatically held ideas that lie behind neoclassical policy prescriptions.  As I have already suggested these religious beliefs lead to perverse policy prescriptions.

One is the notion that the deficit has grown far too large in recent years.


In order to answer this question it is necessary to compare the current deficit and debt situation with what it was in past years.  As well, it is useful to make international comparisons and to assess the burden of the debt in terms of interest payments.  (See Section V).

When we consolidate the federal government, the provincial and local government and hospital sectors and the Canada and Quebec pension plan accounts, we get an overall picture of the total consolidated government deficit (or surplus).  If we compare this deficit (or surplus) to the total gross national product on an annual basis since 1930 it becomes quite clear that the size of the deficit in historical terms is high but nowhere near the levels it reached during the Second World War.  Rather, what is striking is that the consolidated deficit as a proportion of the gross national expenditure (GNE)—in other words in relation to the size of the economy—is roughly comparable to what it was during the 1930s.

The consolidated deficit today as a proportion of the total economy pales in significance when it is compared to the years 1942 to 1945 when it averaged 17 percent of the GNE.  During that period of massive government expenditure both inflation and unemployment were less than 2 percent.  More recently, the consolidated deficit as a proportion of the GNE has grown from 1.2 percent in 1981 to 6.4 percent in 1983.

During this period of time inflation fell from 12.5 percent in 1981 to 5.8 percent.  The deficit has continued to grow and the rate of inflation continues to fall. There is clearly no direct or necessary connection between the deficit and inflation.

(Pg. 122)

On the other hand, high rates of unemployment, because of the nature of our tax and expenditures system, do cause the deficit to rise.  If our deficit did not behave in this manner our rate of unemployment would grow even higher.  Further, in order to reduce the rate of unemployment and eventually the deficit in the longer term it is necessary to greatly increase the gap between government expenditure and revenues.

This is clearly what happened during World War II when the deficit rose from less than 1 percent of the GNE in 1939 to 21.7 percent of the GNE in 1944.  The unemployment rate fell from 11.4 percent to 1.4 percent during the same period.  In a period of less than 3 years after these enormous deficits, the resulting economic recovery produced a surplus in 1947 of 5.7 percent of the GNE.  This surplus position continued until 1954.

TABLE 2 PLACED HERE (See the table at the end of the article.)

What is significant about this first period of surplus in the post-war period is the fact that it contained two years of significant inflation; 1948 and 1951.  In 1948, inflation was 14.2 percent, in 1951, 10.6 percent.  Once again inflation appears to have little connection to deficits.  A similar situation occurred in the period 1973 and 1974 when inflation hit 7.5 percent and 10.9 percent despite the fact that the consolidated financial balance was in surplus from 1964 to 1974.

If there is demonstrably no necessary connection between deficits and inflation then why has the public been led to believe the contrary? In the first place it is argued, wrongly, that deficits always lead to expansion of the money supply and that expanding the money supply inevitably leads to inflation.  Again, the reasons have to do with the theoretical and ideological framework that informs both neoclassical economics and the business community.  Neoclassical monetarist economists, in particular, who have dominated the economics profession for a number of years, rely upon some variant of the “quantity theory of money” as a guide to explaining inflation.  On the basis of this theory they argue that the behavioural characteristics of people with regard to the length of time they hold on to cash is a relatively constant factor.

Or if it is not constant it changes so slowly as to be predictable.  If this is so, they claim, then there is a direct relationship between the money supply and the rate of inflation and the number of transactions in the economy.  If the total number of transactions can be held relatively constant then controlling the money supply can control inflation.  Since transactions are simply another way of describing output, and output always tends to full employment in their model the problem of inflation simply involves the money supply.

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The problem with this very old doctrine (it goes back to the sixteenth century) is that it ignores the fact that behavioural preferences for cash are variable and that transactions themselves are highly sensitive to the supply of money.  Put simply, Say’s law does not hold.  Markets do not always clear.  Involuntary unemployment is possible in a market economy.

Furthermore, the monetarist model confuses changes in the money supply that are the results of inflationary pressures with the causes of the inflation itself.  It also ignores the role of market imperfections such as large oligopolies, cartels and the collective bargaining process in industries that can act as transmission belts for inflationary pressures.  Perhaps most important, the theory pays no attention to price shocks such as occurred with OPEC and the rise in world commodity prices in the early 1970s.  The theory in its present form also operates with a distorted understanding of John Maynard Keynes’ original model of the economy which had a very well developed dual sectoral theory of the inflationary process.  Finally, to repeat my message, it ignores the empirical evidence that there is virtually no consistent correlation between inflation and deficits.

Because of the sensational nature of media reports on the deficit many people are under the impression that the consolidated government (pg 124) balance is always in deficit. Of course this is not so.

Indeed, over the past 53 years there has been a surplus rather than a deficit in eighteen of these years.


The deficit is the outcome of the balance of expenditures and revenues.  In difficult economic times the tax and expenditure structure is designed to increase the deficit dramatically.  If this were not the case the upward pressure on unemployment rates would even be greater.  During a period of economic decline there is a tendency for productive investment activity to decline and for pools of savings to accumulate without being invested.  In general, there is no necessary connection between the decision to save as opposed to the decision to invest.  These are separate decisions taken by separate sectors of the economy under conditions of uncertainty. But during hard times, when economic stimulation is needed, the conversion of savings into productive economic activity finances the deficit.

This savings pool, particularly that portion that is in the form of tax sheltered income, large accumulations of wealth and, as is increasingly the case, pension funds, all too often finds its way into excessively short term ventures that frequently involve no job creating productive investment in our economy. Some of the savings pool is also committed to speculative activities.  As well, in recent years growing chunks of Canadian savings have been funneled by our banks into international money markets.

Much of this money is involved in the casino like international exchange market where billions of dollars of currency are traded daily for no other reason than a speculative one.  Hence, arranging for the public sector to tap more of these funds is a way of ensuring that a higher proportion of savings are invested in the production of jobs in the Canadian economy.

Contrary to much of the current rhetoric about wasteful government expenditure, government in modern society is an important producer of wealth and economic activity.  The government sector can be wasteful, and excessively bureaucratic and it sometimes acts in a harmful way from the perspective of the economy or social welfare.  Clearly all large hierarchical bureaucratically organized institutions can displaythese characteristics, whether public or private.  But it is largely a myth that government institutions areinherently more bureaucratic and wasteful than private corporations.  What is needed is a restructuring of bureaucracy, decentralization and the promotion of greater public access and participatory control over these institutions.

As far as the corporate sector is concerned, particularly because of the growing concentration ofownership of corporate assets in a few hands, public accountability of the corporate sector is considerably more limited.  And yet consumers are asked to absorb corporate sector waste through the price system.  The discipline of market competition is often nowhere to be found. What competition does exist is that found between (pg. 125) giant oligopolies that are quick to arrive at price leadership and market share solutions to ensure that profits are maximized.  In the case of government, at least the electorate gets the opportunity to vote political leaders out of office. No such recourse is available in the corporate sector as shareholders are often disbursed in comparison to the controlling of group managers.


It is important to understand the difference between deficits and debt.  The cumulative total of government deficits less the cumulative total of government surpluses yields the total accumulated debt.

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This accumulated debt can be calculated on a federal level, or at the provincial, local and hospital level or at the consolidated level.  The composition of this debt is constantly changing as governments “retire” debt by redeeming debt instruments such as bonds and treasury bills by paying to their holder their face value.  The government then refinances its debt by issuing new securities.

As Table 1 above shows, the ratio of net federal government debt as a percentage of the GNP has been rising in recent years after falling from a peak of over 90 percent of the GNP that it reached in the immediate post-war period.[v]  It reached a post-war low of 15.5 percent in 1975.  Since then it has been rising steadily.  In 1983 the ratio stood at 33.5 percent, a figure still well below the post-war peak.  The rise in the ratio of debt to GNP reflects, of course, the enormous rise in the rate of unemployment.  In 1974 unemployment was 5.3 percent.  Today (1984) it stands at 11.3 percent. (Unemployment in 1992 has averaged 11.0% as of July, 1992.)


(Pg. 126)

Furthermore, the ratio of net federal debt to the size of the economy is not dramatically at odds with experiences in other major industrial economies.  For example, in 1981-1982 both Japan and the United Kingdom had a considerably high ratio of central government debt to the Gross Domestic Product than did Canada.  During the period 1975-1981 the average ratio of the federal deficit to the GNP was lower than in Germany, the United Kingdom, Japan and Italy.[vi]

If the size of the debt is nowhere near the historical peak that it reached in the post-war period then why all the fuss? Well, quite clearly, part of the reason is that far too few people have examined the issue from a historical and dispassionate perspective.  The recent dominance of very conservative economists over the economics profession is also partly responsible.  These economists essentially prefer as little government intervention in the economy as possible; they prefer “free enterprise.” They argue that government debt “crowds out” private investment and develops pessimistic expectations about future taxation to finance the deficit.  These theories are based on very dubious assumptions.

A final part of the reason for the outcry over the deficit has to do with a more legitimate problem—the interest burden of the debt.  The interest paid by government on the debt cannot be ignored.  Because of the extremely high real interest rates (the difference between the actual interest rate and the rate of inflation)that the Bank of Canada has fostered by its tight money policies and unwillingness to go separate ways with the American Federal Reserve, the burden of the debt has risen sharply in recent years.  For example, in 1983 interest payments on the consolidated government debt in Canada amounted to $27.7 billion or over 7 percent of the GNP.  This ratio is the highest since the 1932 to 1934 period.  This fact is no coincidence.

During the years 1930 to 1933 real interest rates were even higher than they are today.  The combination of high unemployment, large government deficits and excessively high real interest rates was exactly parallel to the current situation. Then, as now, the cry was to reduce deficits, restore “sound public finance” and let theprivate sector promote economic recovery.  Then as now, this policy was doomed to fail.

The real problem posed by large deficits is the burden of high interest payments.  This burden is both a direct one—high rates of interest discourage investment—and an indirect one—they impose a hardship on small businesses.  Conservative economists claim that high real interest rates are the product of large deficits in the first place.  But this argument ignores the role that a tight conservative money policy plays in pushing the rates up.

The current high real interest rates of over 8 percent reflect this kind of excessively restrictive policy.  A reduction of real interest rates of 5 percentage points would both reduce the burden of the debt and contribute to economic recovery by stimulating economic activity.


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(pg. 128)  The role of lower interest rates in reducing debt burdens is clear when we examine the period 1942 to 1945.  During this period the consolidated deficit averaged close to 17 percent (or about double the current ratio) as a percentage of GNP.  Yet, interest costs were considerably smaller than today (about ½ the size) as a proportion of the GNP.  Real interest rates during this period averaged less than 2 percent.

Clearly, then it is the policy of high interest rates and not the deficit that is the source of the problem.


Contemporary conservative economists argue that the deficit causes high interest rates.  Actually, this theory and the concept of “crowding out” that it has spawned were also circulated during the Great Depression of the 1930s.  Like many of the myths that surround the issue of deficits, it is an old notion.

During the 1930s many economists and businessmen believed financing government deficits by borrowing would displace or “crowd out” private investment projects by pushing up the rate of interest.

This argument misrepresents how interest rates are established.  In fact, the Bank of Canada can exercise considerable influence over interest rates through its “open market operations.” These operations refer to the bank’s role in buying and selling bonds and Treasury bills.

Some economists argue that reducing interest rates in this way will lead to inflation.  In fact, as I have explained above, the theory depends upon a number of assumptions which may not hold.  Furthermore inflation is currently not the problem, however, unconscionable excessive unemployment is.  It is certainly not beyond the Bank of Canada’s capacity to pursue a less rigid money supply in order to lower interest rates. Also, such a policy of monetizing more of the debt than it now does need not last indefinitely.  Rather, it is a temporary measure to ensure that the deficits have an opportunity to stimulate economic recovery anda greater supply of savings to retire the debt further down the road as the economy recovers and the deficit declines.  Thus, the timing, as well as the actual financing policy, used by the Bank is of importance in managing the debt.  Other things being equal, if the central bank allows a lag of sufficient time during which it monetized a certain portion of the debt before turning to the money markets to reduce the monetized portion through borrowings it will both reduce interest payments and unemployment.  Unfortunately, the Bank has not been following this policy.

Instead, the Bank has been following a restrictive monetary policy and not monetizing any significant portion of the debt before borrowing from the money markets on the federal government’s behalf.

The result, ever since 1975 when the Bank first declared itself in favour of these policies, has been rising interest rates and rising unemployment.  While price inflation has been dramatically reduced, the cost in terms of increased unemployment has been disastrous.

(pg. 129) The supposedly “tolerable” level of unemployment that these restrictive policies were to have created was grossly underestimated.  Unfortunately, for Canadians the Bank’s policies have seriously harmed the welfare of millions of citizens and contributed to the current malaise in our economy.

Of course, Canada’s interest rate policy is complicated by our excessive economic dependence upon the U.S. Since the U.S. Federal Reserve is also committed to a tight-money, high interest rate policy, the high U.S. rates have acted as a barrier to reducing Canadian rates.  First of all, it should be pointed out that the U.S. central bank has actually pursued since 1981 a slightly less restrictive monetary policy than our own central bank.  Nevertheless, American interest rates have still been very high and have encouraged the Bank of Canada to keep our rates up in order to prevent speculative outflows of Canadian savings to the U.S money markets.  These outflows tend to erode the exchange value of the Canadian dollar.  The Bank of Canada has argued that if it allows too great a gap to develop between interest rates in Canada and the U.S.rates we will experience too rapid and too large a depreciation in our currency vis-à-vis the U.S. dollar.

This fear of excessive exchange rate depreciation however, ignores the enormous cost in higher rates of unemployment that result from excessively high interest rates. There are alternatives to this policy which would improve our economic situation.  These alternatives include an interest equalization tax which would tax away the benefit of the interest rate differential between the U.S. and Canada. Such a tax would act as a disincentive for Canadian savers seeking higher rates of return in the U.S. It need not necessarily be resorted to in following a more independent interest rate policy.  This would be so, for example, if lower interest rates and a more sensible policy of debt management, along with a programme of major government expenditure directed at social and physical infrastructure, led to a major reduction in unemployment rates.

Such a significant recovery would counter the tendency toward exchange-rate depreciation.  Finally, it is important to understand that the crowding out argument assumes that the fund of savings is static, in other

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words, a fixed mass that does not alter in size over time.  In fact, this is simply not so. If the Bank of Canada were to change its policy, and, in particular, the timing of its entry into the money markets, government deficits would stimulate more economic expansion than is currently the case.  This expansion, in turn, would enlarge the pool of savings thereby reducing the pressure on the rate of interest.  Crowding out, at first glance, appears to be a convincing explanation of the risks of “excessive deficits.” However, when it is examined critically it loses much, if not all, of its explanatory power.  In the end, it is not much more than a reassertion of the old laissez-faire dogma in favour of sound finance and less government intervention in the economy.

Theoretically, it can be shown that the crowding out argument is a static one that misunderstands that the supply of total savings available, (pg. 130) looking back at any given time, must always have met the total financing demands placed upon it.  This misunderstanding occurs because the crowding out model confuses stocks and flows.[vii] The supply of available savings is the outcome of the flow in investment, savings and consumption decisions by both the private and public sector.  The pool of savings upon which the private sector has drawn in making its investment decisions that have resulted in less than full employment would have been reduced, if, in the preceding time period, government activities had been reduced.

Hence, attempting to avoid crowding out by cutting government expenditure plans in times of less than full employment can only shrink economic activity in the next round.The real thrust of the crowding out argument is once again the deep-seated hostility to government

involvement in the economy in the first place.  It is in this sense that it can be recognized as simply a restatement of the canons of laissez-faire faith.  In the present economic circumstances it constitutes a tragic and misleading policy confusion.  If it is allowed to influence government policy it can only lead to sustained high rates of unemployment.


According to economists, a structural deficit occurs whenever the expenditure and taxation policies of the governments are such that even at full employment and minimal inflation, the government’s expenditures would exceed their revenues.  This notion of the structural deficit raises a number of complications. Nevertheless, it is worth considering the concept briefly in order to make better sense out of the current debate.  Because of the long period of inflation that Canada experienced from 1973 until 1982, new accounting techniques were developed to adjust economic data to distorting impact of rising prices.

This kind of adjustment was also developed for the treatment of the deficit and accumulated debt.  It is generally accepted[viii] that one should reduce the value of the outstanding debt and the annual deficit by the impact of inflation upon the interest rate burden of the debt.  Since the portion of the interest rate that compensates for inflation simply guarantees the replacement value of the savings borrowed to finance the debt, it seems reasonable to deduct this amount when calculating the real burden of the debt.

The second adjustment concerns the normal swings in the business cycle.  Clearly a very substantial portion of the annual deficit in recent years is the result of the high rates of unemployment.

If unemployment were to return to a more normal rate of about 4 percent, the government’s revenue picture would change considerable for the better.  It is argued by many economists that the deficit should be adjusted by the (pg. 131) amount of additional revenue a normal full employment national income level would generate.

The inflation and cyclical unemployment adjusted budget balance would then look like this:

Budget balance = taxes (less transfers) minus government expenditure on goods and services minus interest paid on the public debt less inflation portion minus business cycle adjustment.[ix]

The resulting budget balance is very dependent upon whatever value is chosen for both the inflation component, and more importantly, the rate of full employment.  Many economists would not accept 4 percent unemployment as normal full employment.  Indeed, one prominent conservative economist, Michael Parkin, argues that full employment is closer to 10 percent unemployment![x] But clearly, choosing such a

Page 11 of 12

high rate for the acceptable natural rate of unemployment would tend to increase the occurrence of a structural deficit.

The question of where we have, now, a structural deficit depends upon the assumptions one makes in calculating the adjusted budgetary balance.  A number of important Keynesian and neo-Keynesian

economists[xi] argue that as recently as 1982, Canada, in fact, has an adjusted budgetary balance at the federal level that was a surplus, rather than a deficit.

Thus, attempts to cut federal government expenditure further and raise taxes in an effort to “lower the deficit” would be incredibly perverse policy.  It would increase unemployment rather than decrease it.

This increased unemployment would result in a larger actual debt ratio.


The present economic and political circumstances are eerily reminiscent of the 19030s.  The principal difference, of course, is the fortunate fact that Canada has a relatively well-developed “safety net” of income support programmes in place which have acted to prevent the very severe economic downturn of 1981 through 1983 from raising unemployment levels o those that prevailed in the years 1932 and 1933.

Nevertheless Table 5 (below) suggests that unemployment rates of above 11 percent are within the lower range of the high rates which prevailed during the 1930s. These rates are unacceptable.  They involve considerable hardship that is simply unnecessary.  As well, they are associated with unemployment rates for younger people which approach 18 percent to 19 percent.  Furthermore these rates have persisted now for three years.  There is absolutely no historical evidence that simply allowing the “market economy” to return the unemployment rate to its “normal” level will solve the problem.  Despite many of the critiques of the practical relevance of the work of Keynes there is still considerable evidence that his fundamental assessment remains correct.  The private sector left on its own cannot restore full employment.

Keynes pointed the way toward solving the last Great Depression through greatly increased government social regulation of the investment process, the reduction of income and wealth disparities and the weakening of power of rentier interests (that is, those who control great pools of wealth).

The current attitude that prevails in the business community and among a number of academic economists that government deficits are excessive and crowd out private sector investment is demonstrably wrong. But it is more than simply wrong.  It is a cruel and ultimately dangerous counsel.  Should these rates of unemployment continue we can expect growing numbers of disillusioned and embittered young people who will be the principal victims of these policies.  In the 1930s such prolonged unemployment caused extremely serious destabilizing political and social pressures.  In addition to the fundamental immorality of tolerating such high unemployment, there can be no doubt that politically and socially it is a disaster.

Surely we would not permit such a problem to persist in our own family if we had alternatives available.

Why should we permit it to persist in our own society?

It is beyond the scope of his essay to spell out in detail alternative policies.  The general direction is clear.  Rather than attempting to slash government expenditure, we should be using government to stimulate the economy.  We should do this by direct expenditures in labour-intensive activities such as housing, public works, educational and social expenditures.  We should reinforce this stimulative impact by implementing reductions in regressive taxes, (for example, sales taxes) and in the income tax burden on the middle and lower income classes.  We should ensure that government employment expenditures are financed both by borrowings in the money markets and by monetizing more of the government debt than the Bank of Canada has done to date.  Once the economy recovers the Bank can turn to the money markets to refinance that portion of the debt it has monetized.  Finally, the Bank of Canada should pursue a lower interest rate policy, independent of the U.S.

The combination of these policies would stimulate employment growth, reduce interest rates and restore a critical sense of optimism to the economy.  The problem of inflation which has currently disappeared could then be anticipated and planned for through consultation with government, the unions and

Page 12 of 12

the corporate sector.  But such consultation ought to be a part of an agenda for discussion once a situation of full employment has returned.

The current economic circumstances once again provide us with a critical test of both our courage and our intelligence.  History, as the philosophers tell us may well repeat itself, the first time as tragedy, the second as farce.  But there is nothing inevitable about such a repetition.  Let us commit ourselves to proving the philosophers wrong.  We can avoid repeating the tragedy of the 1930s.  The technical intelligence is available.  All that is lacking is the political courage.

If our elected leaders fail us they will have this burden of failure to carry with them for a long time to come.

[i]See the discussion in D.W.Conklin and Adil Sayeed, “Overview of the deficit debate”in D.W.Conklin andT.J.

Courchene, Deficits:How Big and How Bad? (Ontario Economic Council:Toronto,1983),

p.13ff., and theHonorable Marc Lalonde, Minister of Finance,The Federal Deficit in Perspective,

April 1983,pp. 23ff.

[ii] The Globe and Mail, Nov.3, 1984, B5.

[iii] See, for example Ruben Bellan, “The National Blessing,” Policy Options Vol. 5 #5 Sept. 1984. [iv]See

R. Barro, “Are government bonds net wealth?” Journal of Political Economy 82, 1974, 1095‐1117 and Franco Modigliani “Government Deficits, Inflation, and Future Generations” in Conklin &Courchene,Deficits.

See also P. Paquette and M.Seccareccia “Les Illusions de l’austerité” Policy Options Vol. 5, 1984.

For more recent discussion of these issues, see my 1989 monograph, The Deficit and Debt Management:

An Alternative to Monetarism; H. Chorney, “Deficits: Fact or Fiction? Ontario’s Public Finances and

the Challenges of Full Employment” in D.Drache, Getting on Track: Social Democratic Strategies

for Ontario,Montréal:McGill‐Queen’s University Press, 1992; J.Rock,ed. Debt and theTwin Deficits

Debate, Toronto:Mayfield Publishing, 1991; R. Eisner,How Real is the Federal Deficit, New York: W.W. Norton,1989; R. Heilbroner & P. Bernstein, The Debt and the Deficit:

False Alarms/Real Possibilities, New York: W.W. Norton, 1989.

[v] See chart 2 in Lalonde, The Federal Deficit, p. 2

[vi] See OECD Occasional Studies June, 1983 p. 22 Table 7., Lalonde, The Federal Deficit, pp.37‐38.

[vii] See, Edward Nell and Alex Azarchs, “Monetarism: Conservative Policy and Monetary Theory” in

Edward Nell, ed., Free Market Conservatism: Critique of Theory and Practice, (London: George

Allen & Unwin, 1984).

[viii] See Lalonde, The Federal Deficit; Conklin & Courchene, Deficits, in particular J.C. McCallum,

“Government Deficits: Historical Analysis and Present Policy Alternatives,” pp. 254ff.

[ix] Ibid, McCallum, “Government Deficit.”

[x] M. Parkin, “What Can Macroeconomic Theory Tell Us About the Way Deficits Should be Measured”

in Conklin & Courchene, Deficits.

[xi] See, for example, McCallum, “Government Deficits.”

DeficitPapers/Chap2/tables—five tables (graph on Federal Net Liabilities t/c)



Table A


Federal deficit on a National Accounts (N.A.) basis            = Federal expenditures on a N.A. basis (including deficits by specified purpose funds)       _ Federal revenues on a N.A. basis
                  +                       +                     +
Deficit of the (P) provincial – (L) local – (H) hospital sector on a N.A. basis            = Expenditures of the P-L-H sector on a N.A. basis       _ Revenues of theP-L-H sector on a N.A. basis
                  +                        +                     +
Net change in CPP and QPP balances            = Benefits paid by CPP and QPP       _ Revenues of CPP and QPP
                 =                                 =                         =
Deficit of the consolidated government sector (CGS) on a N.A. basis            = Expenditures of the CGS on a N.A.         _ Revenues of the CGS on a N.A. basis



Table 1: Net Federal Government Accumulated Debt National Accounts Basis as a % of G.N.P (%)


Year Debt % of G.N.P. Year Debt % of G.N.P.
1926-27 45.6 1969 25.0
1931-32 50.6 1970 22.1
1936-37 66.6 1971 21.0
1941-42 48.3 1972 19.9
1946-47 106.6 1973 18.8
1952 51.7 1974 17.2
1957 34.3 1975 15.5
1962 37.2 1976 17.2
1963 36.2 1977 18.0
1964 36.2 1978 21.4
1965 33.8 1979 24.6
1966 30.2 1980 26.0
1967 27.5 1981 27.4
1968 26.7 1982 28.0
    1983 33.5


Source: Department of Finance, Annual Review, April 1984, p.185


Table 2: Federal and Consolidated Government surplus or deficit (-) in relation to the Gross National Expenditure


Year Consolidated deficit Year Consolidated deficit as %
1930 -3.9 1957 -0.06
1931 -7.1 1958 -3.1
1932 -7.3 1959 -1.6
1933 -5.0 1960 -1.7
1934 -4.7 1961 -2.1
1935 -4.0 1962 -1.6
1936 -0.7 1963 -1.4
1937 -0.6 1964 0.2
1938 -2.8 1965 0.4
1939 -0.8 1966 0.7
1940 -1.0 1967 0.2
1941 0.7 1968 0.7
1942 -15.3 1969 2.4
1943 -16.1 1970 0.9
1944 -21.7 1971 0.1
1945 -14.3 1972 -0.03
1946 -1.2 1973 1.0
1947 5.7 1974 1.4
1948 4.7 1975 -2.4
1949 2.0 1976 -1.7
1950 3.0 1977 -2.4
1951 3.8 1978 -3.2
1952 0.2 1979 -1.9
1953 0.3 1980 -2.1
1954 -1.0 1981 -1.2
1955 -0.1 1982 -5.3
1956 0.8 1983 -6.4



Source: Department of Finance, Economic Review 1984 and Canada Statistical Year-book, 1948-1949.


 Table 3: Real Long Term Interest Rates (%)




1930-1935 Interest rate % 1979-1984 Interest rate %
1930 8.2 1979 0.1
1931 10.8 1980 1.1
1932 14.4 1981 4.6
1933 6.3 1982 3.9
1934 2.6 1983 6.4
1935 3.3 1984* 7.5



Note: Real rates are calculated by subtracting the rate of increase in the G.N.E. price deflator from the nominal long-term interest rate. Long-term rates refer to 15-year-and-over bonds for the 1930-1935, and 10 years-and-over bonds for the 1979-1984.


*1984 is for the first quarter.


Source: Statistics Canada, Current Economic Analysis and M. Parkin, Modern Macro-Economics (Scarborough: Prentice-Hall, 1982)


Table 4: Interest on the Consolidate Public Debt as a Percentage of the G.N.P. (%)



1930-1935 Interest as percentage of G.N.P. 1978-1983 Interest as percentage of G.N.P.
1930 4.3 1978 5.0
1931 5.4 1979 5.3
1932 7.2 1980 5.7
1933 8.1 1981 6.5
1934 7.2 1982 7.2
1935 6.5 1983 7.5



Source: Department of Finance Economic Review 1984 and Canada, Statistical Year-book, 1948-1949.

 Table 5: Unemployment Rates



1930-1945 Unemployment rate 1975-1984 Unemployment rate
1930 9.1 1975 6.9
1931 11.6 1976 7.1
1932 17.6 1977 8.1
1933 19.3 1978 8.5
1934 14.5 1979 7.4
1935 14.2 1980 7.5
1936 12.8 1981 7.5
1937 9.1 1982 11.0
1938 11.4 1983 11.9
1939 11.4 1984 11.3
1940 9.2    
1941 4.4    
1942 3.0    
1943 1.7    
1944 1.4    
1945 1.6    



Source: Statistics Canada


About haroldchorneyeconomist

I am Professor of political economy at Concordia university in Montréal, Québec, Canada. I received my B.A.Hons (econ.&poli sci) from the University of Manitoba. I also completed my M.A. degree in economics there. Went on to spend two years at the London School of Economics as a Ph.D. student in economics and then completed my Ph.D. in political economy at the University of Toronto. Was named a John W.Dafoe fellow, a CMHC fellow and a Canada Council fellow. I also was named a Woodrow Wilson fellow in 1968 after completing my first class honours undergraduate degree. Worked as an economist in the area of education, labour economics and as the senior economist with the Manitoba Housing and Renewal Corporation for the Government of Manitoba from 1972 to 1978. I also have worked as an economic consultant for MDT socio-economic consultants and have been consulted on urban planning, health policy, linguistic duality and public sector finance questions by the governments of Manitoba, Saskatchewan,the cities of Regina and Saskatoon, Ontario and the Federal government of Canada. I have also been consulted by senior leaders of the British Labour party, MPs from the Progressive Conservative party, the Liberal party and the New Democrats on economic policy questions. Members of the Government of France under the Presidency of Francois Mitterand discussed my work on public sector deficits. I have also run for elected office at the municipal level. I first began to write about quantitative easing as a useful policy option during the early 1980s.
This entry was posted in austerity, business cycles, Canada, classical economics, deficit hysteria, deficits and debt, European debt crisis, Federal Reserve, fiscal policy, full employment, J.M.Keynes, monetary policy, quantitative easing, U.S., Uncategorized, unemployment. Bookmark the permalink.

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