Fiscal “Crisis” In Context: Two Indicators

With all the predictions of doom and gloom coming from the austerity camp, one would think that Canada was already about to hit the famed (but never seen) “debt wall.”  Before we get too carried away, however, with the scary debt stuff, consider these two indicators of the fundamental fiscal fragility/stability of Canadian governments.

The first figure shows the net financial debt of the federal and provincial levels of government, measured as a share of GDP.  This is total outstanding net financial liabilities.  Federal net debt reached almost 70% of GDP in the mid-1990s, fell back steeply to below 30% by 2008, and since has bounced (modestly) to 34% as a result of the fiscal consequences of the meltdown and recession.  It’s interesting to note that the federal debt burden has already levelled off (meaning that nominal net debt has been growing no faster than nominal GDP).  You don’t need to strictly balance the budget in order to stabilize the debt burden (measured, appropriately, as a share of GDP).  At the current level of indebtedness, so long as Ottawa’s annual deficit is less than about $20 billion the debt burden will still decline (since nominal GDP grows fast enough to absorb that new debt, in absolute terms, within a falling debt ratio).  Future deficits would be smaller than that even without the Harper government’s cutbacks; moving forward, the federal debt burden will now start to fall significantly, long before the budget is balanced.

Of course, Canada is unusual among countries in having significant amounts of sub-national debt, mostly with the provinces — whose fiscal situation has been undeniably worse than Ottawa’s.  The red section of the figure layers on provincial debt as a share of GDP.  The rise and fall of the larger federal debt burden still sets the overall shape of the figure.  Provincial debt rose to 27% of GDP by the mid 1990s, falling almost in half by 2007.  It has since bounced back to over 20% — and unlike the federal debt, still grew modestly last year as a share of GDP.  Nevertheless, even on a combined basis, federal and provincial net debt (now equal to 55% of GDP) is far lower than most other OECD countries, has increased by only 10 points of GDP since the financial crisis started, and is already leveling off.  Big cuts in public spending are not necessary in order to stabilize and gradually reduce public debt in Canada.

If anything, I suggest this figure overstates the true “debt” of government because some of those liabilities were issued to pay for real (non-financial) assets which have enduring (and in many cases tradeable) value.  If government capital spending were accounted for on an accrual basis (as makes sense, since this is how companies treat long-lived capital assets), then the true increase in the net debt burden since the recession would be even smaller.

An even more interesting indicator is provided in the next figure, which shows total public debt servicing charges (again as a share of GDP) for both the federal and provincial governments.  This is from CANSIM Table 380-0022; I think (but am not 100% sure) that it is a gross number: that table does not separately report interest income for governments, but it does report a broader category called investment income … so it is likely that the data in this figure overstates the problem (by counting only interest expense, and not adjusting for interest income on the governments’ own financial assets).

According to this figure, not only has government debt service expense declined dramatically as a share of GDP since the bad old 1990s (when it peaked at close to 10% of GDP).  Moreover, debt service has continued to decline despite the (modest) rebound in debt resulting from the recession.  Debt service costs for all levels of government fell below 4% of GDP since the recession.  How could debt service costs decline, even while the debt burden (modestly) grew?  Because average interest costs have declined.  Like home-owners, governments have been able to refinance their debt to take advantage of today’s ultra-low rates.  (Remember, even fiscally pressed provinces like Ontario can still borrow money today for 10 years at real interest rates not much above zero.)  As older bonds come due and are refinanced, governments reduce their interest costs dramatically.  Those savings have more than offset the incremental debt service costs associated wtih additional debt.  So the claim that rising debt service costs are squeezing out more useful forms of public expenditure (not that conservatives support those programs, either) is empirically false.

Running up public debt for the sake of running up debt makes no sense.   There are costs associated with debt, and limits to how much debt can rise.  But there are benefits associated with debt-financed spending, too.  That includes the productivity of long-lived public capital assets that can be financed with debt (just like companies or households prudently finance long-lived assets, from factory equipment to homes, with debt).  In a demand-constrained macroeconomic context, another benefit of debt-financed spending is the positive spillover effect on overall employment and income that results from that spending (even when it’s on current services rather than public capital).  Based on the preceding graphs, Canadian governments are far from any meaningful constraint on their ability to borrow.  Hence, we should make a rational decision as a country regarding how much new debt is optimal, rather than being dominated by an initial quasi-religious assumption that “all debt is bad.”

In short, choosing today to slash spending on useful public programs very much reflects a political choice, not a fiscal necessity.  In the long run, we can and should pay for the public services we need by putting Canadians back to work.  In the meantime, there is clearly ample capacity for governments to continue to carry the cost of these programs.  Since governments can borrow at near-zero real interest rates, even as companies and households are beginning to deleverage, it is counter-productive to impose austerity in the public sector on top of the other painful economic challenges we are facing.