Imagine if the CEO of a large corporation pledged his company would never again borrow a single dollar. “Debt is bad,” he might announce to the annual meeting. “Our company will steadily pay off the debt we have, and never take on any more.” Financial analysts would recognize this as a bizarre, superstitious way to run a business, and immediately commence efforts to have the CEO kicked out of office.
Suppose, too, that consumers decided debt is evil, and vowed never to go in the hole again. Some Canadians actually believe this; thankfully for our economy, most do not. Without debt, the typical consumer couldn’t finance their Christmas presents, let alone buy their house. Without debt, our economy would grind to a halt and the living standard of Canadians would suffer immensely.
How strange, then, that in Canada’s public sector, debt is now treated as the eighth deadly sin. Conventional wisdom, after our gut-wrenching fiscal adjustment of the 1990s, states that politicians can’t even think about running a deficit (unless they can blame it on the government that preceded them). Canadians now so deeply respect the virtues of balanced books that— eight years after the federal deficit was eliminated— federal politicians still compete to portray themselves as the most prudent of the lot. And even though the deficit is near-ancient history (at the federal level, anyway), spending restraint continues to be justified by the need to reduce the accumulated debt burden.
The 2004 federal budget, tabled by Finance Minister Ralph Goodale, reflected this conventional wisdom. The federal Liberals were especially anxious this year to paint themselves as fiscally responsible, in the wake of the fallout from the sponsorship scandal. This motivated the most significant innovation in this year’s budget: a new debt-reduction timetable, according to which the federal government will work its debt down to 25 percent of GDP over the next ten years.
Like fiscal conservatives before him, Goodale cloaked his debt-reduction initiative in the language of common sense, “kitchen table” economics. The average households of the land have to balance their books, and so should government. “On the matter of debt,” Goodale said in the budget speech, “Canadians instinctively know that paying it down is the right thing to do— for themselves and for their government.” Easy, populist language— but is it true?
In fact, the finance minister is dead wrong to claim that government is mimicking the citizenry with its commitment to reduce the debt. Indeed, Canadian consumers ran up their debt last year by $50 billion, more than the largest federal deficit ever. Consumer debt now equals 101 percent of disposable income— the highest debt burden ever. Canadian business, for its part, plays just as fast and loose with its own fiscal bottom line. Non-financial private corporations carry $1 trillion in debt, equivalent to almost ten times their annual before-tax profits.
Debt must be handled with care, of course. No one can pile it on forever. But debt can be a rational and efficient mechanism for bridging time gaps between income and expenses, and for financing long-term investments. Consumers and businesses understand this point well. If we need to make a major productive investment, or if we can generate a higher return with borrowed money than the cost of borrowing, then it is economically beneficial to borrow. For government leaders to eternally swear off debt, even when it makes economic sense, is cheap political pandering.
Debt makes sense for governments (like households) which face short-term gaps between revenues and expenses— resulting, say, from recession. In this case, debt allows government to sustain program spending until the economy (and tax revenues) recover. The alternative— cutting programs during the recession— makes the recession worse. Some provincial governments, like Ontario, are facing up to this reality; at the federal level, however, there’s no present need for a countercyclical deficit (barring a major economic downturn).
But new debt may also be the right course for governments making new investments in long-lived capital assets like badly needed repairs to transportation infrastructure, waterworks and other public facilities. The public capital stock deteriorated badly in the tightmoney 1990s; rebuilding it is a historical priority. Under new accrual accounting methods, the government writes off only a portion of new investments each year (just like corporations), based on the expected lifespan of each asset. This allows the government to balance its budget (including depreciation), while still turning to capital markets to finance long-term capital projects.
The federal government could undertake several billion dollars per year in new borrowing to finance these sorts of productive, long-lived investments, and yet its debt burden (relative to GDP) would continue to fall. The alternative is to either allow the public capital stock to continue to deteriorate, or else to invite private sector partners to finance the needed work with their own (higher-cost) borrowing. In either case, the failure of government to borrow is both economically inefficient and fiscally imprudent.
Canada’s public debt burden has plunged since the deficit was eliminated in 1997 (see Figure 1). Net federal debt currently equals 41 percent of GDP— down by 26 points since 1997, and good enough for second-lowest in the G7. This turnaround, dramatic by any measure, was not mostly due to debt repayment. Almost 85 percent of the “work” was done by economic growth (which boosted the denominator of the debt-GDP ratio, far faster than debt repayment shrank the numerator).
Indeed, suppose the federal government had not paid back a single loonie of debt since 1997 (balancing the books instead of running significant, allegedly “unplanned” surpluses). The debt ratio would equal 45 percent of GDP today, instead of 41 percent, still second-best in the G7. Meanwhile, the government would have $50-odd billion to spend on other stuff— things (like housing and childcare) that were ignored in this budget, like previous ones.
Now let’s look forward. As illustrated in Figure 1, on the assumption of nominal economic growth of 5 percent per year (reflecting the combined effect of real growth and inflation), the government will likely meet its new tenyear debt reduction target by doing absolutely nothing except balancing the books (something it has promised to do anyway). This would seem to be a case of political double-dipping: claiming credit twice for the same act.
From this perspective, Goodale’s grand debt-reduction timetable mostly reflects a government trying to dress up a status-quo budget as innovative and disciplined (“Look at us Liberals, prudent once again”). The debt-reduction initiative nevertheless begs a couple of interesting questions. First, what exactly is the point of allocating $3 billion per year to debt repayment, when it’s not necessary to meet the government’s own target? Lots of other priorities are aching for that money. All Ottawa achieves with $3 billion per year is to reach its threshold in nine years, instead of ten.
Second, what will the government do once debt falls to 25 percent of GDP? Public debt would then be at near-record lows, and Ottawa would need to start running planned annual deficits (in the order of $25 billion per year) just to keep the debt burden from falling any further. Indeed, if Canadians were satisfied with the current debt-toGDP ratio of 40 percent (which, after all, is lower than the average indebtedness we have experienced over the whole postwar period), the federal government could begin to deliberately run deficits right now in the order of 2 percent of GDP (or $25 billion per year), with no impact on the debt ratio.
Sooner or later, in the face of continuing demands for spending and an evaporating debt burden, Ottawa will be virtually compelled to start running deficits again. But for a government whose greatest claim to fame is eliminating the deficit, this inevitable implication of our rapidly shrinking debt burden is too hot to handle. So Ralph Goodale’s timetable postpones that day of reckoning by a decade, leaving lots of time to back away from the Liberals’ solemn vow to never again run a deficit.
For the most part, then, this new fiscal timetable— intended to serve as the progeny of Paul Martin’s successful deficit-reduction timetable— is an economic non-event. It tells us what we already knew. But like the characters in Star Wars, it has a dark side. What if the economy doesn’t meet consensus expectations? What if we experience a recession similar to the early 1990s, and nominal GDP stops growing for a year or two?
In this case, if the government were really serious about its timetable, it would have to set aside large piles of cold hard cash (in the order of $20 billion per year) to reduce debt— at the very moment the economy desperately needed spending, not debt reduction. Incredibly, the deeper the recession, the more debt the government would have to pay off. This is why Martin consistently refused to establish debt-to-GDP targets during his own tenure as finance minister. But in this politically difficult time for Mr. Martin’s new government, the necessity of portraying the government as disciplined and decisive overwhelmed that prudent caution.
Let’s re-emphasize the seemingly incredible implications of the debtreduction timetable. If it were interpreted strictly, it would require the federal government to dramatically escalate its debt repayment during a recession. This implies more than just abandoning any notion of countercyclicality in fiscal policy (a goal which few policy-makers in Ottawa take seriously these days). It actually implies making fiscal policy hugely pro-cyclical: that is, the government would withdraw tens of billions of dollars of spending power from the economy when it was weak, then pump it back in once it recovered (when economic growth again could shoulder most of the debt-reduction responsibility).
If Goodale were serious about his new debt-reduction timetable, therefore, he would be committing the federal government to making future recessions much worse, while providing extra acceleration to the subsequent cyclical upturn. Fortunately, I doubt that he is at all serious about the timetable. The finance minister was careful to refer to it only as a “reasonable goal”— inviting obvious contrast with the hell-or-high-water rhetoric that Martin invoked back in 1995 regarding his own targets.
However, the budget sent confusing messages regarding exactly how serious the debt-reduction commitment should be interpreted. The text of the budget plan called it an “objective.” And an appendix to the budget called it a “commitment.” Is it a goal, an objective, a target or a commitment? Is it to be achieved on a strict annual basis (like the deficit-reduction targets were), or can we use the full ten years to get there?
At best, the government’s debtreduction timetable is a vague and economically meaningless gimmick, a promise that can be easily broken if it becomes difficult to achieve (much like the balanced-budget laws that were passed in many provinces during the 1990s, none of which is worth the paper it is printed on). At worst, this new timetable would consign Ottawa to amplifying future economic downturns, instead of helping to alleviate them.
Either way, the government shouldn’t have done it.
A shorter version of this article appeared in the Globe and Mail.
