Canada Borrows with No Regard for Tomorrow. The Next Crisis May Break Us

Published in The Globe and Mail

Governments must manage debt levels and maintain a credible fiscal plan

by Christopher Ragan

As we approach the federal budget on Nov. 5, our thoughts may naturally turn to the level of government spending, the size of the inevitable deficit, and whether overall public indebtedness will continue rising.

The federal government’s net debt-to-GDP ratio stands at about 45 per cent today, well below its peak of 72 per cent from 1996, when Canada had just hit the “debt wall.” But the figure is still significantly greater than its low point of 32 per cent just before the 2008 financial crisis. And if we add in all the provincial government debt, the overall debt ratio is a lot higher – about 75 per cent.

How much debt is too much?

Consider our collective preparedness for the next big economic crisis, such as a war or a pandemic or a financial crisis.

I begin with the premise that our governments should spend and borrow aggressively to address these kinds of crises. They have always answered the call to protect their citizens whether dealing with two world wars, a deep economic depression, a global financial crisis, or a pandemic.

However, governments only possess such fiscal power if they maintain their ability to borrow, and this requires that bond purchasers continue to see the government bonds as safe investments. Government debt is only a safe investment under two conditions: when there is a credible fiscal plan to service and repay the debt and when bondholders are confident that future inflation will not be used to erode the real value of the debt.

When either of these conditions is not satisfied, bond purchasers will demand higher yields. Over the past year, the average yield on 10-year government bonds in the G7 countries has increased by more than 100 basis points, putting government bond rates at their highest level in well over a decade.

In extreme cases, such increases in interest rates will force the government to embark on sudden spending cuts or rushed tax increases. This is a situation of “forced austerity.”

Canada encountered that when it lost the confidence of its bondholders in 1995, when the combined federal and provincial debt ratio was 99 per cent and rising. The federal government was compelled to embark on serious budget cuts and deficit reductions for the next several years.

The same thing happened to Greece in 2011, although its debt ratio was much higher than ours was in 1995. Greece eventually defaulted, and the enormous cuts to government spending worsened and extended the economic slump.

A similar dynamic may be emerging today in the United States. That country’s federal budget deficit of more than 6 per cent of GDP shows no sign of being turned around, and the country’s outstanding debt has grown to an unprecedented level.

The point is not that Canadian governments are currently living through a Greek 2011 moment or that our public debt problems are as large as those in the U.S. Our fiscal situation is much better than both of those cases.

Yet another crisis similar in scale to the COVID pandemic, which raised our public debt ratio by 20 percentage points very suddenly, would put our federal-provincial debt ratio at a level just below where it was in 1995. Our governments may again find themselves in the situation of forced austerity. And this is well worth avoiding.

What should our governments be doing if they recognize these potential risks and want to be better prepared for the future? They have two broad options. The first is to convince Canadians that the new spending priorities – such as an expanded military and better trade-related infrastructure – are so important to us all that we should actually be paying higher taxes to finance them. Especially for the greater defence-related spending, it is hard to argue why our children and grandchildren should be footing the bill instead of us, which is exactly what happens if those things are financed with new government debt.

If the world is now a more dangerous place, and this drives the need for a bigger and better military, maybe we should all see this as just one more cost we need to bear in order to have a sovereign country – and we need to pay for it. Of course, the prospect of raising taxes to finance these new spending priorities is more difficult politically, but it would certainly focus the minds of Canadian voters and taxpayers. Are those things really necessary? How much do we actually value them? And how much are we prepared to pay in order to get the associated benefits?

The second broad option is to convince Canadians that our governments can’t do everything and that new spending on high-priority items should mean less spending on low-priority items. But this option, in turn, requires that governments establish a professional and dispassionate and objective approach for reviewing the thousands of existing spending programs and identifying the ones that are ineffective or no longer required.

This is also difficult politically because every existing government program has its recipients and its defenders, and these people will be the first to complain at the suggestion of program cuts. But governments really can’t do everything – and they shouldn’t try. Instead, they should do the hard work of reviewing existing programs so they can focus their spending on the things that really matter.

Do I think any of this will happen in the upcoming federal budget or in the many provincial budgets to follow? The short answer is no. Today, our governments are showing no signs of recognizing even the possibility that they will need to run very large deficits in order to address some future crisis on the scale of those from our past. They continue to borrow large amounts and hope that interest rates will remain low or that the economy will expand so quickly that we will be able to “grow our way out of debt.” And they might get lucky. But it is a risky gamble, especially since interest rates in many countries appear to be on the rise and we are facing several drags on growth caused by current geopolitical uncertainties.

In other words, our governments are suffering from “fiscal complacency.” If they were exercising genuine fiscal prudence, they would be trimming their spending or raising taxes enough to reduce their budget deficits and prevent further increases in their debt ratios. By doing so, they would be preparing themselves for the future crisis that will inevitably occur.

But the absence of a current crisis makes it all too easy to continue borrowing and driving up their debt ratios. They are doing what is easy and painless in the short run, but avoiding the tougher decisions that would better prepare them for an uncertain and risk-filled future. No Canadian should be comforted by this decision.