In 2009 the government of Greece ran into a financial wall. Like most other governments in Europe (and the Canadian government, too), the Greek government was running a large budget deficit, which meant that it needed to keep borrowing more funds, both to cover its expenses and to pay off existing loans as they came due. But governments, like companies or individuals, can only borrow if lenders believe there’s a good chance they are willing or able to repay their debts. By 2009 most investors, having lost confidence in Greece’s financial future, were no longer willing to lend to the Greek government. Those few who were willing to lend demanded very high interest rates to compensate them for the risk of loss.

Figure 13-10 compares interest rates on 10-year bonds issued by the governments of Greece and Germany. At the beginning of 2007, Greece could borrow at almost the same rate as Germany, widely considered a very safe borrower. By the end of 2011, however, Greece was having to pay an interest rate around 10 times the rate Germany paid.

Why was Greece having these problems? Largely because investors had become deeply worried about the level of its debt (in part because it became clear that the Greek government had been using creative accounting to hide just how much debt it had already taken on). Government debt is, after all, a promise to make future payments to lenders. By 2009 it seemed likely that the Greek government had already promised more than it could possibly deliver.

The result was that Greece found itself unable to borrow more from private lenders; it received emergency loans from other European nations and the International Monetary Fund, but these loans came with the requirement that the Greek government make severe spending cuts (commonly called austerity measures), which wreaked havoc with its economy, imposed severe economic hardship on Greeks, and led to massive social unrest. The Greek sovereign debt crisis has caused serious concerns about other members of the eurozone, such as Spain, that face similar problems; this may undermine the long-term viability of the euro.

No discussion of fiscal policy is complete if it doesn’t take into account the long-run implications of government budget surpluses and deficits, especially the implications for government debt. We now turn to those long-run implications.

When a family spends more than it earns over the course of a year, it has to raise the extra funds either by selling assets or by borrowing. And if a family borrows year after year, it will eventually end up with a lot of debt.

The same is true for governments. With a few exceptions, governments don’t raise large sums by selling assets such as national parkland. Instead, when a government spends more than the tax revenue it receives—when it runs a budget deficit—it almost always borrows the extra funds. And governments that run persistent budget deficits end up with substantial debts.

To interpret the numbers that follow, you need to know a slightly peculiar feature of federal government accounting. The Canadian government does not keep its books by calendar year. Instead, budget totals are kept by fiscal years that run from April 1 to March 31. For example, the fiscal year that runs from April 1, 2012 to March 31, 2013 is called “fiscal year 2012–2013.”

At the end of the fiscal year 2011–2012, the Canadian federal government debt was $582.2 billion—33.8% of the GDP. Part of that debt represented special accounting rules specifying that the federal government owes funds to certain programs, such as Old Age Security. We’ll explain those rules shortly. For now, however, let’s focus on public debt: government debt held by individuals and institutions outside the government. The total federal debt was greater for 2011–2012 than for the previous fiscal year because the government ran a budget deficit. A government that runs persistent budget deficits will a experience a rising level of public debt. Why is this a problem?

There are two reasons to be concerned when a government runs persistent budget deficits. We described one reason in Chapter 10: when the government runs budget deficits while the economy is at full employment, national savings tends to fall and interest rates tend to rise, owing to a leftward shift in the supply of loanable funds curve. In turn, higher interest rates raise the cost of investment spending, which leads to a decrease in investment spending. In other words, when the government runs budget deficits instead of contributing to national savings, it is borrowing funds in the financial markets and competing with firms and households that plan to borrow funds for investment spending. As a result, when the economy is at full employment, government borrowing may increase interest rates, crowd out private investment spending, and reduce the economy’s long-run rate of growth.

But there’s a second reason: today’s deficits, by increasing the government’s debt, place financial pressure on future budgets. The impact of current deficits on future budgets is straightforward. Like individuals, governments must pay their bills, including interest payments on their accumulated debt. When a government is deeply in debt, those interest payments can be substantial. In the 2011–2012 fiscal year, the federal government paid $31 billion in interest on its debts, which is equivalent to 1.8% of GDP. The more heavily indebted government of Italy used 4.7% of its GDP in 2011 to service its debt.

Other things equal, a government paying large sums in interest must raise more revenue from taxes or spend less than it would otherwise be able to afford—or it must borrow even more to cover the gap. And a government that borrows to pay interest on its outstanding debt pushes itself even deeper into debt. This process can eventually push a government to the point where lenders question its ability to repay. Like a consumer who has maxed out his or her credit cards, it will find that lenders are unwilling to lend any more funds. The result can be that the government defaults on its debt—it stops paying what it owes. Default is often followed by deep financial and economic turmoil.

Canadians aren’t used to the idea of government default, but such things do happen. In the 1990s Argentina, a relatively high-income developing country, was widely praised for its economic policies—and it was able to borrow large sums from foreign lenders. By 2001, however, Argentina’s interest payments were spiral-ling out of control, and the country stopped paying the sums that were due. In the end, it reached a settlement with most of its lenders under which it paid less than a third of the amount originally due. By late 2011 investors were placing a fairly high probability on Argentine-type default by several European countries—namely, Greece, Ireland, and Portugal—and were seriously worried about Italy and Spain. Each one was forced to pay high interest rates on its debt by nervous lenders, exacerbating the risk of default.

Default creates havoc in a country’s financial markets and badly shakes public confidence in both the government and the economy. Argentina’s debt default was accompanied by a crisis in the country’s banking system and a very severe recession. And even if a highly indebted government avoids default, a heavy debt burden typically forces it to slash spending or raise taxes, politically unpopular measures that can also damage the economy. In some cases, austerity measures intended to reassure lenders that the government can indeed pay end up depressing the economy so much that lender confidence continues to fall—a process we’ll look at more closely in the Economics in Action that follows this section. In addition, the possibility that a country might default on its loans or have a huge, growing debt can cause that country’s credit rating to be downgraded. For example, in 2011, the United States was approaching its debt ceiling, the maximum amount it was allowed to borrow. Raising the debt ceiling was controversial, but U.S. Treasury Secretary Timothy Geithner argued that failure to do so would lead to a possible default and catastrophic effects on the global economy. Finally, in the summer of 2011, the U.S. Congress did raise the debt ceiling. Default was avoided, but even so, the timing was a bit late: Standard & Poor’s lowered the U.S.’s credit rating from AAA to AA+. This was shocking, because the U.S.’s credit rating had never been downgraded before. People with low credit ratings must pay higher interest rates, and it’s just the same for countries. Being downgraded meant the U.S. government and businesses might have to pay higher interest rates on future borrowing.

Similarly, some European countries saw their credit levels downgraded in 2011 and 2012, owing to worries over excessive government borrowing. Greece and Spain were the most notable examples, but Portugal, Italy, France, and Austria were also members of that unfortunate club. Table 13-2 shows long-term interest rates for some European countries in October 2009, before the sovereign debt crisis started, and afterward, in October 2012. Notice that the crisis-stricken countries of Greece, Spain, Portugal, and Italy saw their long-term borrowing costs increase. The interest rate on Greece’s long-term government bonds quadrupled. In contrast, Germany, which was not in the same situation, saw its borrowing cost decrease.

Some may ask why can’t a government that has trouble borrowing just print money to pay its bills? Yes, it can if it has its own currency (which the troubled European nations don’t). But printing money to pay the government’s bills can lead to another problem: inflation. In fact, budget problems are the main cause of very severe inflation, as we’ll see in Chapter 16. The point for now is that governments do not want to find themselves in a position where the choice is between defaulting on their debts and inflating those debts away by printing money.

Concerns about the long-run effects of deficits need not rule out the use of expansionary fiscal policy to stimulate the economy when it is depressed. However, these concerns do mean that governments should try to offset budget deficits in bad years with budget surpluses in good years. In other words, governments should run a budget that is approximately balanced over time. Have they actually done so?

Figure 13-11 shows how Canada’s federal government’s budget balance and its debt evolved from the 1970–1971 fiscal year to the 2011–2012 fiscal year. The burgundy curve shows the federal budget balance as a percentage of GDP. A positive number means a budget surplus while a negative number means a deficit. As you can see, the federal government normally ran deficits, except from 1997 to 2008, when it ran surpluses. This seems inconsistent with the advice that governments should offset deficits in bad times with surpluses in good times.

To assess a government’s ability to pay its debt, economists tend to use the debt-to-GDP ratio, the government’s debt as a percentage of GDP. We use this measure, rather than simply looking at the size (or stock) of the debt, because GDP, which measures the size of the economy as a whole, is a good indicator of the potential amount of taxes the government can collect. The purple curve shows the country’s debt-to-GDP ratio since 1970. As you can see, the (net federal) debt-to-GDP ratio rose until the mid-1990s. This rise was caused by large budget deficits and slower economic growth. Further, the continuing rise of the ratio indicated that Canada’s debt burden was increasing—and increasing amounts of resources were needed to service the debt.

Alarmed by the rising ratio, Canadians demanded that the federal government take appropriate action. So, when the Liberal Party won the federal election of 1993, Prime Minister Jean Chrétien made the reduction of budget deficits and the national debt one of his top priorities. To do so, government expenditures were cut significantly, particularly by large reductions both in transfer payments to the provinces and in government services. After four years, the federal government finally turned the corner and, in the 1997–1998 fiscal year, it began to run budget surpluses. With these favourable economic conditions, the debt-to-GDP ratio began to fall, and the outlook was positive again.

True, the financial crisis of 2008–2009 did push the budget back into deficits and caused the debt-to-GDP ratio to rise. However, the budget deficits were smaller (as a percentage of GDP) than in past years and the government has projected a balanced budget will return by the 2016–2017 fiscal year. Also, the OECD notes that Canada’s debt-to-GDP ratio was the lowest among the G-7, and far below the G-7 average (80.3% in 2011). Therefore, it is not generally expected that our debt burden will skyrocket.

To assess what burden a country’s national debt places on the country, look at the debt-to-GDP ratio: a country that persistently runs large deficits will have a rising debt-to-GDP ratio when debt grows faster than GDP. But if its debt is growing more slowly than GDP, then the burden of paying that debt is actually falling compared with potential tax revenue and the debt-to-GDP ratio will fall. In this case, a country can run budget deficits persistently. The For Inquiring Minds feature, which focuses on the large debt the Canadian government ran up during World War II, explains how growth and inflation sometimes allow a government that runs persistent budget deficits to nevertheless have a declining debt-to-GDP ratio.

Table 13-3 shows that in 2007, just before the recession began in 2008, the combined amount of government debt in Canada was about $23 000 per capita, that is, per person. Two thirds of this debt came from the federal government and one third was issued by all the provincial, territorial, and municipal governments combined. At the national level, this debt was about 50% of GDP per capita in 2007. It is interesting to note the great variability in the levels of per capita provincial, territorial, and municipal debt across the nation; this clearly shows that some jurisdictions, especially those in western Canada and the territories, were in better financial shape than others. In fact, based on the strength of revenues from resource exploration and extraction, several jurisdictions, most notably Alberta, Yukon, and Northwest Territories, had a negative level of combined provincial, territorial, and municipal debt, which means these governments actually had more assets than liabilities.

Looking at Figure 13-11, you might be tempted to conclude that until the 2008–2009 financial crisis struck, Canada was in good fiscal shape. The federal government was running budget surpluses and our debt-to-GDP ratio had fallen to a comfortably low level. The ratio did rise slightly in 2008, owing to budget deficit, but was still low compared both to historical experience and to other wealthy countries such as Japan and the United States. Even so, experts on long-run budget issues tend to view Canada’s fiscal position (not to mention that of other countries such as the U.S., Japan, and Italy) with a little alarm. The reason is implicit liabilities. Implicit liabilities are essentially debts that a government must pay at some future date but that are omitted from the usual debt statistics.

Canada’s largest implicit liabilities come from transfer programs, including the Canada Health Transfer (CHT), the Canada Social Transfer (CST), and benefits for retired and elderly people such as Old Age Security (OAS) and Guaranteed Income Supplement and Allowance (GIS). In each of these cases, the government has promised to provide transfer payments to future as well as current beneficiaries. So, these programs represent a future debt that must be honoured, even though it does not show up in the usual statistics. In the fiscal year 2011–2012 for example, spending on these programs reached $76.73 billion, or 28.3% of total federal spending.

The implicit liabilities created by these transfer programs seem worrisome. Figure 13-12 shows why. From 1966 to 2011 actual spending on OAS, CHT, and CST as percentages of GDP has tended to rise, making such promises harder to keep. Figure 13-12 plots projections from the federal Department of Finance presented in Budget 2012: Economic Action Plan 2010—A Plan for Jobs, Growth and Long-term Prosperity. According to these projections, the cost as a percentage of GDP for these transfer programs will continue to rise over the next few decades, implying more government resources will be allocated to these programs than others.

In the case of Old Age Security, what do the demographics reveal? The money for OAS benefits comes from the taxes paid by people who are working now. So, the ratio of workers to retirees is important when it comes to OAS. From 1946 to 1964, there was a huge surge in the birth rate, called the “baby boom.” At the time of writing, most “boomers” were of working age, so they were paying taxes, not collecting benefits. But as increasing numbers of boomers start to retire they will stop earning employment (taxable) income and start collecting benefits. Also, Canadians are living longer, which means they may have the opportunity to collect OAS benefits for more years than previous generations did. These two factors will have an effect on the ratio of workers to retirees, and subsequently have a major impact on the system’s finances.

One measure that approximates the ratio of workers to retirees is the ratio of people aged 20 to 64 to those aged 65 and over. The Department of Finance projects this ratio will fall from 4.8 in 2011 to only 2.4 in 2050. This means fewer working adults will be available to support retirees, which also increases the burden of the working population. But boomers may not pose a long-run fiscal problem after all. In 2011, the money spent on elderly benefits amounted to 2.2% of GDP. Jean-Claude Ménard, the head actuary at the Department of Finance, has projected that this amount will rise to 2.7% of GDP by 2050, which is a relatively small percentage increase. So although Canada’s population is aging, it seems we can still afford to provide promised social benefits to retirees.

How about the spending on Canada Health Transfer and Canada Social Transfer? CHT is the federal government transfer to the provincial and territorial governments to assist in the delivery and funding of health care. CHT is the largest major transfer to provinces and territories. Currently, the CHT cash transfers are set to grow at 6% annually until the fiscal year of 2016–2017; after that they will be reduced to 3% annual growth or a measure of the nominal GDP known as the “three-year moving average,” whichever is larger. On the other hand, CST is a federal block transfer to the provincial and territorial governments to support post-secondary education, social assistance and social services, early childhood development, and early learning and child care. The CST is growing at 3% annually. As Figure 13-12 shows, the Department of Finance projects that the shares of CHT and CST as percentage of GDP will be relatively stable, at around 2.3% of GDP.

Based on these estimates, it seems that Canada’s implicit liabilities will not pose serious problems for future federal budgets. But the outlook for provincial and territorial budgets is less optimistic. In Canada, provinces and territories, not the federal government, pay for their own health care and education. CHT and CST are just federal transfers that help provinces and territories to fund their programs. Many argue that owing to the planned reductions to CHT funding after 2016–2017, provincial and territorial governments will need to spend more on health care in the future. In fact, according to the Office of the Parliamentary Budget Officer, provincial and territorial health care spending will likely increase from less than 10% of GDP in 2012–2013 to about 14% in 2075–2076. This is a significant percentage increase, and this higher burden on provincial and territorial budgets could easily cause the net debt issued by these governments to rise.