The Dark Side Of Debt Reduction

by Violet WillettApril 1, 2004

Imagine if the CEO of a large corporation pledged his com- pany would never again borrow a single dollar. ”œDebt is bad,” he might announce to the annual meeting. ”œOur 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 immediate- ly 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 actu- ally 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 wis- dom, 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 feder- al 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 feder- al level, anyway), spending restraint continues to be justi- fied 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 spon- sorship scandal. This motivated the most significant innova- tion 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, ”œkitchen table” economics. The average households of the land have to balance their books, and so should government. ”œOn the matter of debt,” Goodale said in the budget speech, ”œCanadians instinctively know that paying it down is the right thing to do " for them- selves 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 corpora- tions carry $1 trillion in debt, equiva- lent to almost ten times their annual before-tax profits.

Debt must be handled with care, of course. No one can pile it on forev- er. But debt can be a rational and effi- cient mechanism for bridging time gaps between income and expenses, and for financing long-term invest- ments. Consumers and businesses understand this point well. If we need to make a major productive invest- ment, or if we can generate a higher return with borrowed money than the cost of borrowing, then it is economi- cally beneficial to borrow. For govern- ment leaders to eternally swear off debt, even when it makes economic sense, is cheap political pandering.

Debt makes sense for govern- ments (like households) which face short-term gaps between revenues and expenses " resulting, say, from recession. In this case, debt allows government to sustain pro- gram spending until the economy (and tax revenues) recover. The alter- native " 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 counter- cyclical deficit (barring a major eco- nomic 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 transporta- tion infrastructure, waterworks and other public facilities. The public capital stock deteriorated badly in the tight- money 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 pro- ductive, long-lived invest- ments, 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 bor- row is both economically inefficient and fiscally imprudent.

Canada’s public debt burden has plunged since the deficit was eliminat- ed 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 ”œwork” was done by economic growth (which boosted the denomina- tor of the debt-GDP ratio, far faster than debt repayment shrank the numerator).

Indeed, suppose the federal gov- ernment had not paid back a single loonie of debt since 1997 (balancing the books instead of running signifi- cant, allegedly ”œunplanned” surplus- es). 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 illustrat- ed 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 gov- ernment will likely meet its new ten- year 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 innova- tive and disciplined (”œLook at us Liberals, prudent once again”). The debt-reduction initiative nevertheless begs a couple of interesting questions. First, what exactly is the point of allo- cating $3 billion per year to debt repay- ment, 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-to- GDP ratio of 40 percent (which, after all, is lower than the average indebted- ness we have experienced over the whole postwar period), the federal gov- ernment 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 con- tinuing 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 elimi- nating the deficit, this inevitable impli- cation 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 charac- ters 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 bil- lion per year) to reduce debt " at the very moment the economy desperate- ly needed spending, not debt reduc- tion. Incredibly, the deeper the recession, the more debt the govern- ment 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 necessi- ty of portraying the government as dis- ciplined and decisive overwhelmed that prudent caution.

Let’s re-emphasize the seemingly incredible implications of the debt- reduction timetable. If it were inter- preted 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 counter- cyclicality in fiscal policy (a goal which few policy-makers in Ottawa take seri- ously these days). It actually implies making fiscal policy hugely pro-cyclical: that is, the government would with- draw 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, there- fore, he would be committing the fed- eral government to making future recessions much worse, while provid- ing extra acceleration to the subse- quent 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 ”œreason- able 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 confus- ing messages regarding exactly how serious the debt-reduction commit- ment should be interpreted. The text of the budget plan called it an ”œobjec- tive.” And an appendix to the budget called it a ”œcommitment.” 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 debt- reduction timetable is a vague and eco- nomically 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.

SOURCE: Policy Options Politiques Staff
VIA: Policy Options Politiques

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