Government Debt and Budget Deficits

All decent people live beyond their incomes nowadays and those who aren’t respectable live beyond other people’s. A few gifted individuals manage to do both.

— Saki

When a government spends more than it collects in taxes, it has a budget deficit, which it finances by borrowing from the private sector. The accumulation of past borrowing is the government debt.

Although attention to the national debt has waxed and waned over the years, it has been especially intense during the past 35 years. Expressed as a percentage of GDP, the debt doubled from 1975 to 1985, and then almost doubled again from 1985 to 1995. By the late 1990s, the budget deficit had come under control and had even turned into a budget surplus, but it took some time for the level of debt to fall. As this book goes to press, almost 40 of the 50 percentage point increase in the ratio of the debt to GDP that had occurred in the 1975–1995 period had been reversed.

The previous large increase in government debt during a period of peace and prosperity was unprecedented in Canadian history. Not surprisingly, it sparked a renewed interest among economists and policymakers in the economic effects of government debt. Some view the large budget deficits during the 1975–1995 period as the worst mistake of economic policy since the Great Depression, while others think that the deficits matter very little. This debate flared up again in 2009 when—in response to the world financial crisis and the recession—the Federal Government’s budget involved the biggest deficit in Canadian history. Many Canadians viewed this increase in the deficit as fully appropriate, since they thought this was what the government had to do to keep the financial crisis from developing into something on the scale of the Great Depression of the 1930s. Others thought that any comparison of this sort was ridiculous, and so they viewed this return to big deficits as a betrayal of what they had voted for. This chapter considers various facets of this debate.

We begin simply by looking at the numbers. Section 16-1 examines the size of the Canadian government debt, comparing it to the debt of other countries and to the debt that Canada has had during its own past. It also takes a brief look at what the future may hold. Section 16-2 discusses why measuring changes in government indebtedness is not as straightforward as it might seem. Indeed, some economists have argued that traditional measures are so misleading that they should be ignored completely.


We then look at how government debt affects the economy. Section 16-3 describes the traditional view of government debt, according to which government borrowing reduces national saving, crowds out capital accumulation, and increases interest payment obligations to foreigners. This view is held by most economists and has been implicit in the discussion of fiscal policy throughout this book. Section 16-4 discusses an alternative view, called Ricardian equivalence, which is held by a small but influential minority of economists. According to the Ricardian view, government debt does not influence national saving and capital accumulation. As we will see, the debate between the traditional and Ricardian views of government debt arises from disagreements over how consumers respond to the government’s debt policy.

Section 16-5 then looks at other facets of the debate over government debt. It begins by discussing whether the government should always try to balance its budget and, if not, when a budget deficit or surplus is desirable. It also examines the effects of government debt on monetary policy, the political process, and a nation’s role in the world economy.