Federal Finance Minister Paul Martin’s budget is based on a 1.1% increase in real gross domestic product in 2002 and 3.9% in 2003. The assumption is that the economy will pick up steam in the second half of 2002.

As the budget notes, private sector forecasters were a little more optimistic about 2002 when Finance surveyed them in October. They predicted 1.5% economic growth and, likewise, are looking for 3.9% growth in 2003.

The assumption of 1.1% growth allows Martin to project a balanced budget, although with only a small contingency reserve — $1.5 billion in the fiscal year ending March 31, 2002, and $2 billion in 2002-03. Normally Ottawa carries a $3 billion contingency reserve, but this is not currently possible given the weak economic conditions.

Finance expects revenues to fall 4.1% in 2001-02 and increase just 2% in 2002-2003. With program spending expected to rise 4.7% next year on top of this year’s 9.3% hike, the only thing saving Martin is reduced interest payments on the pubic debt. They’re expected to be down to $36.3 billion in 2002-03, from $39.2 billion this year and $42.1 billion in 2000-01.

Nevertheless, Martin is walking a tightrope. There’s little real difference between a balanced budget and a $1 billion or $2 billion deficit, but there’s a huge psychological difference. Financial markets can react very negatively to any deficit, however small. And it would be all too easy for a deficit to materialize if the economy is even a little less buoyant than expected.

Finance’s sensitivity analysis indicates that one percentage point lower growth in real GDP would lower the budgetary balance by $2.4 billion in the first year, and $2.6 billion in the second year. One percentage point lower inflation would drop the balance by $1.4 billion in year one and $1.3 billion in year two.

It should be noted, though, that if either lower growth or lower inflation materialized their negative impact on the balance could be partially offset by lower interest rates. Finance says 100 basis points lower interest rates would improve the balance by $800 million in the first year and $1.4 billion in year two. The budget assumes 91-day Treasury bill rates will average 2.4% in 2002 and 4% in 2003, while 10-year government bonds yield 5.5% and 5.9% respectively.

The economic outlook at the moment is very tied to the United States where the critical factor is a return to strong business and consumer confidence following the September 11 terrorist attacks. This is by no means certain and there are some economists who think recovery could be either slower or less buoyant that expected.