Probably the biggest risk for domestic financial markets from a minority government is on the fiscal side, says a new report by BMO Nesbitt Burns Inc.

Senior economists Douglas Porter and David Watt worry that the new Liberal minority government of Paul Martin will be forced into risky spending decisions by the New Democrats, who essentially hold the balance of power in the new Parliament.

“Many pundits have suggested that any government under Paul Martin would dare not risk the hard-fought gains in eliminating the budget deficit,” Porter and Watt say. “However, the bigger concern should be that Ottawa will now usher in costly long-term programs, which could handcuff fiscal flexibility down the road, as well as curtailing any room for tax relief.”

The report looks at previous minority governments and their impact on financial markets. It notes that while Ottawa’s budget balance and debt position did not deteriorate noticeably during the tenure of recent minorities, it is also true that many occurred during periods of strong economic growth, allowing for flattering deficit- and debt-to-GDP ratios. But the report also notes that some of the minority governments locked in large spending commitments, spelling serious trouble for the fiscal landscape when the economy eventually turned sour later on.

“Thus, the proper way to judge this minority government is not whether it manages to keep the budget balanced in the next year, or so, but whether it locks in a raft of expensive long-term spending commitments,” the report says.

Douglas and Watt note that the days of government spending restraint are long gone — real government spending has increased at a 3.2% annual pace over the past five years, running slightly above GDP growth. “In the initial years after the budget deficit was eliminated, Ottawa held broadly true to its 50-50 rule – 50% of excess revenues went to tax relief and debt reduction, and 50% was aimed at new program spending. It is quite clear that the priorities have since tilted heavily to new spending.

“The Liberal election platform included $28 billion of new promises over the next five years, but not a dime for tax cuts. If the government seeks NDP support, these estimates should be viewed as a floor, not a ceiling, for new spending.”

The closest comparison to today’s situation, they say, is the 1972-74 period, when public spending surged spiking at a mind-boggling 20% average annual pace over the three years from fiscal 1972 to fiscal 1975. Nominal GDP growth was also very strong then, there was still a notable upward jump in government spending to GDP from the early to the mid-1970s. “The common theme from all recent minority governments is that public spending is considerably higher as a share of GDP in their aftermath.”

“We continue to believe that Canada’s still-healthy fiscal position and lower core inflation backdrop will help drive long-term bond yields below U.S. levels over the next year,” the economists say. “However, suffice it to say that this has become a riskier call in the face of the federal election results.”