Jack M. Mintz: The Dangers of Debt

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Governments around the world seem to believe in the following truism: low interest rates will allow them to take on debt with little consequence for many years to come. Why? According to the argument, the costs of debt are manageable as long as – after the initial slowdown in COVID – the economy grows faster than debt.

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Public debt as a percentage of GDP is an important indicator for investors as to whether a government will be able to meet its debt obligations without a financial crisis and devaluation of the currency. The ability to refinance public debt and pay interest charges depends on investor confidence in a government’s ability to raise revenue. This is why rating agencies typically focus on debt as a percentage of GDP to measure “debt burden”.

The debt-to-GDP ratio can, however, skyrocket for two reasons: prolonged periods of what economists call “primary deficits” and interest rates above GDP growth rates. Let me explain each to you in turn.

A primary deficit occurs when government revenues do not cover government non-interest expenditure. Right now, the federal government is running a staggering primary deficit. It expects its spending, excluding debt charges and net employee losses, to amount to $ 621 billion in fiscal year 2020-21. In contrast, its revenues will only be $ 275 billion, which means that the federal primary deficit is $ 346 billion or 16% of GDP.

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Ottawa last experienced primary deficits in the 1975-1986 Trudeau / Mulroney decade. But they were puny by comparison, averaging only 2% of GDP each year. Despite this, with the inflation and high interest rates of those years, the accumulated primary deficits ultimately led Canada to almost turn to the IMF for a bailout in 1994.

The fall economic statement projects primary deficits for three years after 2020/21 before reverting to a primary surplus. It looks pink. He is ignoring the expected increase in spending to keep the rich promises of the throne speech. And it’s based on robust revenue growth of 5.6% per year for five years beyond 2022/2023. This is 2.2 percentage points more than during the recovery of 2010-2015, when interest rates were also low.

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Interest rates are really the key to these forecasts. Even if the primary deficit is zero, the government has to borrow to pay the interest, which means that its debt increases by the interest rate every year. Meanwhile, the GDP increases by the nominal growth rate. If the interest rate is higher than the growth rate, the public debt grows faster than the GDP, therefore the debt-to-GDP ratio increases (or decreases if the growth rate is higher than the interest rate).

With interest rates so low since the financial crisis, many economists confidently predict that governments can continue to run deficits without increasing debt 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 rate of growth of GDP and the interest rate) is expected to decrease but most forecasts and market signals have interest rates that remain below growth rates for a long time. “

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So much for the forecast. With the COVID recession of 2020, the growth rate fell 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 just 2%, the lowest in decades. It’s true that interest rates were lower than growth rates until 2019, but the 2020 turnaround overwhelmed those early years. It would be justified to take a longer period. Based on the years 1985 to 2020, for example, the average nominal growth rate in Canada was 4.5%, about one and a half percentage points lower than the average interest rate on the federal debt.

A July 2020 IMF document estimates that a negative interest rate differential in rich countries reverses to become positive in five years, on average. Heavily indebted countries may find that the gap between growth and interest rates could be up to four points higher after a reversal. Canada’s indebtedness is below the global average, but the huge jump in our debt could shorten the one-year delay before interest rates start to exceed growth rates, according to IMF analysis .

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And there is reason to expect inflation and interest rates to rise within five years, assuming the absence of another recession. Growing sectors are already facing supply shortages. Companies expect to shorten their supply chains to reduce risk, but it will come at higher costs. Goldman Sachs predicts that the climate change and infrastructure program will cause commodity prices to skyrocket. Trade and regulatory restrictions could push prices up further.

More importantly, governments stimulating demand with deficits financed by bonds or the currency could lead to stagflation with higher prices, even in the face of permanent unemployment. Unsurprisingly, interest rates on U.S. Treasuries rose last week as the market anticipated more stimulus spending and higher inflation rates following the Democrats’ accession to the Senate. Expect more to come.

Finance Minister Chrystia Freeland argues that higher debt levels will be easily manageable over the next five years. But they are putting Canada in danger. Large primary deficits over the next few years and rising interest rates will destroy the fiscal firepower we would need if another recession were to strike.