Back in the days when Canadian governments always ran deficits every year, there were always people who would argue that it didn't matter – that we could just go on doing that indefinitely into the future. Those people were wrong. Those deficits, piling up year after year, were like a mounting heap of explosives.

One illustration of what could have gone wrong was the so-called “Asian crisis” of 1997-98. The situation there was different in that the debt that blew up was mostly owed by private companies, but the nature of the debt was similar.

The debt of those Asian companies was mostly in the form of short-term loans. They actually needed the money for the long term – it had been used to build factories and purchase equipment. But that was not a problem. Every time a loan came due, they just took out another loan and used it to pay off the first one, the way most people do with a house mortgage.

Most of those companies were not in any trouble. They were profitable and sound and paying off their debts gradually.

So the system worked fine as long as those companies were able to get new loans. But at one point, lenders started to get nervous about getting repaid, and this became a self-fulfilling prophesy because, without new loans, companies really were unable to pay.

Companies went bankrupt or laid off thousands. Currencies collapsed in value. This crisis of confidence devastated many economies as it spread from country to country.

The Canadian national debt is mostly in the form of bonds and treasury bills - short-term loans that also need to be repaid at maturity by selling more bonds or treasury bills. This works as long as there are buyers for those securities. But if investors ever got nervous that a bond might not be redeemed when mature, the government, and all of us, would be in huge trouble.

So whatever you think of Jean Chretien and Paul Martin, they did us a huge favour by turning the situation around, starting to run yearly surpluses instead of yearly deficits, and paying down the debt. Federal government debt declined from 68% of GDP in 1995-96 to 39% in 2004-05. That has greatly reduced the danger.

But government deficits are not always a bad thing, and we may be getting into a situation where excessive attempts to avoid one could do a great deal of harm. During a recession, incomes of companies and individuals fall, resulting in lower tax revenues. At the same time, the expenses of some levels of government rise as they pay for help for the unemployed.

So there is a natural tendency for government finances to move towards a deficit in a recession. The automatically reduced taxes and increased spending tend to stimulate the economy, reducing the depth of the recession. Governments may also actively stimulate the economy by increasing spending or cutting taxes purposely to fight the recession.

Government programs are important to reduce the misery of a recession. Reducing the misery also fights the recession by giving people money to spend and so increasing demand.

These things are good, but they may not happen if governments are excessively fixated on never running a deficit, as Canadian governments were in the great depression. Such a government might cut spending just at the time when it is needed.

It is quite possible that a serious recession could be headed our way, courtesy of the crisis of confidence in the U.S. financial system.

So would our governments be prepared to run a deficit if it becomes necessary? They have made some statements suggesting otherwise.

In the most recent federal budget, commitment number 1 is to “maintaining strong fiscal management and continuing to reduce the debt”. In the most recent Ontario budget speech, Dwight Duncan talks about “projecting six consecutive balanced budgets in total – a feat not matched since 1908”.

These attitudes are fine if the Canadian economy continues to do well. I hope we never return to the bad old days when governments ran deficits through good times and bad just because it allowed them to spend more without raising taxes. But if we get a severe recession, we will need governments prepared to run deficits.

Reducing the debt will not be “strong fiscal management”. A balanced budget will not be a “feat”. And a deficit for a year or two will not be a failure, but simply a rational way of dealing with a bad situation.

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