National Post (Latest Edition)
DEBT DANGERS. MINTZ,
Governments throughout the world seem to believe the following truism: Low interest rates will let them to run up debt with little consequence for many years to come. Why? As the argument goes, debt costs are manageable so long as — after the initial COVID slowdown has passed — the economy grows more quickly than the debt.
Public debt as a share of GDP is an important indicator to investors as to whether a government will be able to cover its debt obligations without a financial crisis and currency devaluation. The ability to roll over public debt and pay interest charges depends on investor confidence in a government’s capacity to raise revenues. This is why rate agencies typically focus on debt as a share of GDP to measure the “debt burden.”
The debt-to-gdp ratio can spiral, however, for two reasons: prolonged periods of what economists call “primary deficits” and interest rates in excess of GDP growth rates. Let me explain each in turn.
A primary deficit occurs when public revenues don’t cover the government’s non-interest expenditures. right now, the federal government is running an eye-popping primary deficit. It expects its spending, excluding debt charges and net employee accrued losses, to be $621 billion in fiscal year 2020-21. On the other hand, its revenues will be only $275 billion, which means the federal primary deficit is $346 billion or 16 per cent of GDP.
Ottawa last ran primary deficits in the Trudeau/mulroney decade of 1975-1986. But they were puny by comparison, averaging just two per cent of GDP each year. Even so, with the high inflation and interest rates of those years, accumulative primary deficits eventually led to Canada’s almost going to the IMF for a bailout in 1994.
The fall economic statement predicts primary deficits for three years after 2020/21 before we get back to a primary surplus. That seems rosy. It ignores the expected hike in spending
GOVERNMENTS STIMULATING DEMAND WITH BOND- OR MONEY-FINANCED DEFICITS COULD LEAD TO STAGFLATION.
to fulfil rich speech from the throne promises. And it is based on robust revenue growth at 5.6 per cent annually for five years after 2022/23. That’s 2.2 percentage points higher than in the 2010-2015 recovery, when interest rates were also low.
Interest rates really are key to these forecasts. Even if the primary deficit is zero, the government has to borrow to pay interest, which means its debt grows each year by the interest rate. Meanwhile, GDP increases by the nominal growth rate. If the interest rate is more than the growth rate, government debt grows more quickly than GDP, so the debt-gdp ratio rises (or falls if the growth rate is greater than the interest rate).
Because interest rates have been so low since the financial crisis, many economists confidently predict governments can continue running deficits without debt growing over time. Olivier Blanchard, former research director of the International Monetary Fund, has been the most prominent proponent of this argument, stating in his 2019 American Economic Association presidential address: “The gap between (the GDP growth rate and interest rate) is expected to narrow but most forecasts and market signals have interest rates remaining below growth rates for a long time to come.”
So much for forecasts. With the 2020 COVID recession, the growth rate plummeted to well below the interest rate (a whopping 6.25 percentage points in our case). Over the past five years (2016-2020), nominal growth rates have averaged only two per cent, the lowest in decades. It is true that interest rates were lower than growth rates through 2019, but the 2020 reversal swamped these earlier years. It would be justified to take a longer period. Based on the years 1985 to 2020, for example, the Canadian average nominal growth rate was 4.5 per cent, about one and a half percentage points below the average interest rate on federal debt.
A July 2020 IMF paper estimates that a negative interest-growth rate differential in rich countries reverses itself to a positive one in five years, on average. highly indebted countries could find that the growth-interest rate differential could be as much as four points higher after a reversal. Canada’s indebtedness is less than the world average but, using the IMF analysis, the huge jump in our debt may shorten the time by one year before interest rates start surpassing growth rates.
And there is reason to expect higher inflation and interest rates within five years, assuming the absence of another recession. Sectors that are growing are already bumping up against supply shortages. Businesses expect to shorten their supply chains to reduce risks, but this will lead to higher costs. Goldman Sachs predicts the climate change and infrastructure agenda will result in a commodity price surge. Trade and regulatory restrictions could push prices up further.
Most important, governments stimulating demand with bond- or money-financed deficits could lead to stagflation with higher prices even in face of permanent unemployment. Not surprisingly, u.s. treasury bill interest rates moved up this past week as the market anticipated more stimulus spending and higher inflation rates as a result of the democrats taking over the Senate. Expect more to come.
Minister of Finance Chrystia Freeland argues higher debt loads will be easily manageable over the next five years. But they put Canada at risk. Large primary deficits in the next several years and rising interest rates will destroy the fiscal firepower we would need should another recession come our way.