Dr. Ed Clark, the CEO of the TD Bank and Financial Group, has re-kindled the debate in Canada about how quickly and how the federal government should move to a balanced budget. Similar debates are taking place in the U.S. and throughout most of the EU. While there are many economists who still question the merits of expansionary fiscal policy and the resulting budgetary deficits when the economy is sinking into a recession, the majority did support the strong fiscal stimulus provided by most countries during the latter half of 2008 and the first half of 2009. As the recession gained momentum in 2008, the IMF rightfully called for a fiscal stimulus of at least 2% of each country’s GDP.

Timing is critical for reversing the fiscal stimulus. It would be premature to curb government spending and/or increase taxes before the economic recovery is sustainable and robust. So the focus of the debate should shift to how governments should eventually reduce their budget deficits, and whether the objective should be a balanced budget or surplus.

Let me digress briefly. Companies generate free cash flows when the cash they generate from their operations exceeds the amounts required for their capital investments. If accountants treated research and development and marketing expenditures as investments as advocated by economists, the calculations of free cash flows would include these investments as well, with the corresponding adjustments for operating cash flows.

Most companies do not produce free cash flows. Their capital investments usually exceed their operating cash flows.

Finance 101 shows that there are optimal debt-to-equity ratios for companies. In other words, when companies have negative cash flows, they need to borrow and/or issue additional equity. Successful companies increase their outstanding debt over time, and investors are willing to buy the new debt issued by such companies because they anticipate that these companies will have little difficulty meeting their future debt obligations. Thus, there is no need for most companies to “balance their budgets”; that is to generate zero free cash flows.

There are many expenditures made by governments which produce long-term benefits for the economy. Expenditures on education, infrastructure, the legal system and research fall into this category. Some of the expenditures on health care, social assistance and even defense also might fall into the category of investments which enhance the productivity of the private sector and the economy. Hence, there is no reason why government expenditures which are investments with long-term pay-offs (higher rates of economic growth resulting in larger tax revenues) should be financed solely through tax revenues in the years in which these expenditures are made.

Just as companies should finance part of their investment spending through debt, so too should governments. Of course, this leaves the question of what proportion of such spending should be financed through debt. And the debate still needs to address how much governments need to spend on operating expenditures, and what the tax structure should look like to yield the revenues required to cover their operating expenditures, including interest expenses, and part of the investment expenditures.

Arguing that governments must achieve balanced budgets and possibly re-trench in size misses the real debate.

The opinions expressed in this blog are personal and do not reflect the views of of either Global Brief or the Glendon School of Public and International Affairs.