National Post (National Edition)
An indebted nation
WE MUST PROTECT OUR ABILITY TO PAY FOR FUTURE SERVICES AS WE BORROW
The strong public-health measures Canadian governments enacted to control the pandemic have started to pay off. After nine weeks of self-isolation and physical distancing, our health-care systems have not been overwhelmed, new cases are beginning to fall, and governments are starting to plan a prudent and gradual reopening of their economies.
Governments have moved quickly to support hard-hit workers and businesses by providing a financial bridge until economic activity — and thus their incomes — returns to more normal levels. This provision of economic “relief” is different from conventional “stimulus” common during normal recessions. Whereas stimulus policies are all about getting people back to work and businesses back to normal levels of operation, the current relief policies are about replacing people’s incomes while they are safely isolating at home.
Sensible and necessary as these relief policies are, replacing a big fraction of the lost income is proving to be very expensive for Canadian governments, and the bill is being added to our public debt. Demands for the government relief programs to continue grow as it becomes clear that a return to full economic activity lies months, rather than weeks, ahead.
At the federal level, the Parliamentary Budget Officer (PBO) estimates that the budget deficit, projected last year to be about $20 billion, will rise to over 12 times this amount in a single year. Driven by a sharp decline in tax revenues and an even sharper increase in relief spending, an estimated budget deficit of $250 billion this year will be the largest ever recorded in Canada.
Perhaps surprisingly, there has been little worry expressed so far about the mountain of debt we are building. This lack of worry stems from two observations.
First, Canada’s federal net debt-to-GDP ratio in 2019 was only 31 per cent, very low by historical standards and also low by comparison with other developed countries. Even this year’s projected massive deficit of $250 billion is only about 11 per cent of 2019 GDP, suggesting an increase in the debt ratio to only 42 per cent once the economy fully recovers. This would still leave us with a debt ratio far below other countries and still substantially below its level from the mid-1990s, when Canada’s experience “hitting the debt wall” led to more than a decade of necessary but painful fiscal consolidation.
The second observation is less about the accumulated stock of debt and more about the annual interest payments required to service it. In today’s world of extremely low interest rates — Canadian 10-year government bonds currently trade at an unprecedented annual yield of 0.6 per cent — even $250 billion of new debt doesn’t require much in the way of annual debt-service payments.
However, there are two good reasons to worry about
Canada’s emerging fiscal situation.
First, it is likely that budget deficits will continue to be large for several years, so using this year’s deficit of $250 billion as the only number for debate is misleading. Second, given the large budget deficits across the world, it is likely that interest rates will begin to rise, and such increases would certainly impact our ability to service any new debt. Let’s unpack these two concerns.
To think about the likely path of budget deficits over the next few years, we need to predict the shape of the recession and the subsequent economic recovery. Rising tax revenues will depend on how many and how quickly Canadians get back to work; declining relief spending will depend on the same thing, and also on the ability of governments to resist the temptation to maintain these programs beyond the point when they are really necessary.
Many things enter this prediction. When will Canadians start going back to work en masse? Will the economy’s reboot happen gradually, sector by sector, or all at once? How many businesses will go bankrupt during the pandemic, thus eliminating the jobs that many returning workers would want to fill? Will there be a second or third wave of the pandemic that delays the entire recovery? We obviously don’t know the answers to these questions. To make matters worse, we have no previous experience from which to base sensible predictions.
One way forward is to think back to the financial crisis of 2008-09. It was admittedly a different economic event, with different underlying causes. Back then, the federal government’s fiscal response was large and immediate, much like today’s. But the fiscal deficits a decade ago didn’t disappear quickly; they lasted for six years, before the current government was elected on a platform of large budget deficits to finance expanded infrastructure spending.
The federal government entered the fall of 2008 in a strong financial position; its debt-to-GDP ratio was under 30 per cent and it had posted a budget surplus of $10 billion only six months earlier. With the onset of the financial crisis in late 2008, the government dusted off stimulus policies that hadn’t been used in many years. Over the next two years the government ran up almost $66 billion in budget deficits. The economy recovered over the next four years and federal deficits gradually declined. Over the six-year period between 2008 and 2014, federal budget deficits totalled $158 billion. So the deficits created during the first two years of the “crisis” period were only about 40 per cent of the total deficits incurred.
Why do deficits generally last well beyond the crisis that creates them? The answer is mostly political. Once money starts flowing into popular programs, especially those that flow directly to people, turning off the financial taps becomes politically challenging. And once governments reveal their willingness to provide financial support to larger businesses, the list of eager applicants is seemingly endless. It is worth heeding Milton Friedman’s famous warning from years ago: “nothing is so permanent as a temporary government program.”
What would happen in Canada if the economic recovery from this pandemic mirrored the one following the financial crisis? The government’s fiscal relief policies would be reduced substantially in the first year of the recovery as employment rises, and they would decline smoothly thereafter as the labour market returns to some semblance of normal. On the revenue side, tax revenues would rise in step with GDP, which would only return to normal if and when the economy returns to its pre-pandemic trend line. If we accept the PBO’s projected budget deficit of $250 billion for this coming year, we can then expect budget deficits over the subsequent five years to total about $350 billion, with fiscal balance being restored by 2025-26.
What does this deficit path imply for the federal government’s debt-to-GDP ratio, which was 31 per cent in 2019? The $600 billion of new net debt would represent a 78 per cent increase in its value from 2019. The path of GDP over the next six years is obviously unknown, but again we can look to the financial crisis for guidance. From 2008 to 2014, the current-dollar value of GDP increased by about 20 per cent (half of which was real GDP growth and half of which was inflation). If the same overall growth occurs between 2019 and 2025, the federal debt-to-GDP ratio would rise to 46 per cent by 2025. Such a debt ratio is not in itself a serious concern, but without a credible plan to keep it in check, it could easily get out of hand — as it did in the 1980s.
Our second concern is about interest rates. If Canada were the only country with massive budget deficits over the next few years, one could argue that interest rates would be unlikely to rise as a consequence of the heightened government borrowing. After all, the Canadian government continues to be seen as a responsible borrower.
But this pandemic is a global phenomenon, and many countries are implementing similar policies to provide relief to their citizens and businesses. Many developed countries will be running budget deficits as large as Canada’s (as a proportion of their economies), and some much larger. Globally, the International
Monetary Fund now projects that government debt as a share of GDP will rise by 15 points to 122 per cent by the end of this year. The result of this de facto co-ordinated expansion of government borrowing could well be an increase in world interest rates — even if our central banks are currently purchasing a significant chunk of this new debt.
To see how annual debt-service charges might be affected by the new public debt, let’s start with some basic data for the federal government. In 2019 there was $1,045 billion of interest-bearing debt and annual debt-service payments of $23 billion. Thus, the average interest rate across all of the different bond maturities was about 2.2 per cent. The average term to maturity of the federal debt is about eight years, implying that about one-eighth of the government’s outstanding debt is refinanced or “rolled over” each year.
Given this starting point, and the projection that the Canadian government will add $600 billion of new debt over the next six years, we can compute the change in the annual debt-service costs. If all of the new and rolled-over debt is financed at a very low rate, say 1.0 per cent, then annual debt-service payments would not change much. In this case, the government doesn’t have to make much of an adjustment to its other spending or taxing plans. But this may be too optimistic.
As we argued above, given that many countries are adding to their public debts at the same time and by large amounts, private lenders may not be prepared to finance these budget deficits without demanding higher interest rates on these new bonds. If rates rise from their current low levels so that all of the new and rolled-over debt is financed at the current average interest rate of 2.2 per cent, interest costs would rise from $23 billion this year to about $36 billion each year by 2025. If interest rates on new and rolledover debt rise only to 3.0 per cent, then the annual interest charges would double to about $46 billion.
How would any extra interest payments be financed? There are only two options: either program spending would need to be cut or some taxes would need to be raised (or perhaps a combination of the two). To put the size of this required fiscal adjustment in perspective, a single percentage point of the GST generates about $8 billion of revenue. Will Canadians soon be prepared to increase the GST by two or three percentage points, or to reduce other spending programs by a similar amount?
THE BOTTOM LINE
We draw several implications for government action now.
First, governments should be mindful about the likely future path of debt, and not simply focus on the large budget deficit planned for this year. They should also recognize the costs of servicing this new debt for many years in the future, and the fiscal adjustments that will be required to finance these debt-service payments.
Second, mindful of the high costs of these relief programs, we should be sure to target them only at those individuals and small businesses that need them the most. As a general rule, individuals (rather than businesses of any size) should be the primary focus of relief programs. And supporting small businesses is probably more important than supporting larger businesses, which have much better access to public markets for debt and equity.
Third, we need to ensure that the relief programs last only as long as they are absolutely needed to deal with the challenges created by the pandemic. Though governments will be under political pressures to continue these programs, their high fiscal costs should be enough to convince governments of the need to wind them down as we strive to return to a world as normal as possible.
Finally, governments should be mindful of how high debt-to-GDP ratios present challenges of their own, not least being the constraints they impose on governments needing to deal with the next recession and such longer-run challenges as the rising health-care costs associated with an aging population. We need to develop a clear and credible plan for managing deficits and ensuring that the debt ratio returns to low levels over the medium term. The development of such a plan will require tough decisions regarding public spending priorities and appropriate rates of taxation.
Canadian governments have responded creatively and vigorously to protect the population from the public-health crisis brought on by the pandemic. Their strong public-health measures are starting to pay off. As we tackle the complex problem of restarting the economy, we must also protect our ability to deliver and pay for public services in the future. Canadians are counting on it.
LITTLE WORRY EXPRESSED SO FAR ABOUT THE MOUNTAIN OF DEBT WE ARE BUILDING.
National Post
Paul Boothe is an economist and former provincial and federal deputy minister. Christopher Ragan is an economist and the director of the Max Bell School of Public Policy at McGill University.