The federal government has let Canadians know that it will run a fiscal deficit in the ballpark of $30-billion in the 2016-17 fiscal year. The information has sparked a debate among economists and media commentators about the level of debt that is sustainable, reasonable or even desirable in the coming fiscal year and over the medium term.
Conventional economic wisdom says that, when evaluating what is a manageable level of public debt, governments should focus on the relationship between public debt and the overall economy, or gross domestic product. This is not a theoretical notion: We know from extensive experience that a country with a public-debt-to-GDP ratio higher than 80 per cent faces growing and serious risks in managing its debt, particularly if the debt ratio is still rising due to ongoing deficit spending. Credit downgrades and higher borrowing costs become much more likely at that level and beyond.
In contrast, a public-debt-to-GDP ratio below 40 per cent is good, and it's even better if the debt ratio is falling toward 30 per cent and lower. Canada's current public-debt ratio is about 35 per cent, which gives us a more comfortable starting point than many other countries.
But is debt as a share of GDP the best measure? Rather than focusing principally on the stock of debt compared to the size of the economy, we should also consider the affordability of that debt – the actual dollar cost of debt service within an annual budget. Such a measure is analogous to assessing debt service (or the share of income allocated to interest payments) when examining specific household or business debt burdens – rather than just looking at the overall amount of personal or business debt.
Federal debt service peaked at 30 per cent of spending in 1996-97 (when net debt exceeded 70 per cent of GDP). Since then, debt service has fallen progressively to 15 per cent in 2006-07, finally dipping below 10 per cent of federal spending in 2014-15. Although the federal government added about $200-billion in public debt after the 2008-09 recession, due to much-needed fiscal stimulus and deficit spending, it has been able to refinance its stock of public debt at very low interest rates. As a result, Ottawa is paying much less interest today on each dollar it has borrowed.
Interest on past debt that is equal to 9 per cent of the federal budget is still a lot of money – about $27-billion annually. That amount is equivalent to what the federal government spends each year on equalization payments and social transfers to the provinces.
The same analysis can be undertaken for Canada's provinces, where there are huge differences in the level of interest payments in annual budgets. Over the past decade, all provinces have seen their interest payments decline as a share of total spending, due to the combined effect of lower interest rates and improved fiscal positions in many cases. Currently, only Quebec and Newfoundland and Labrador spend 10 per cent or more of their provincial budgets on interest payments.
Despite these important improvements in long-term fiscal management, there is still a significant opportunity cost to paying for provincial debt that was incurred years or even decades ago. In most provinces, debt service is comparable to what each spends annually on its advanced education system – ranging from 6 to 15 per cent of annual provincial budgets, and rising. Virtually everyone would agree that investing in the education of young people is more important to the province's future than paying for past debt. Yet some provinces, notably New Brunswick and Nova Scotia, spend more annually on interest than advanced education.
The fiscal policy lesson is clear. Running fiscal deficits can help to stimulate immediate growth, which is often very necessary. However, borrowing to finance these deficits comes with a significant opportunity cost: The future programs that cannot be funded because scarce budgetary resources are being consumed paying interest on debt.
The central fiscal policy challenge is to get the balance right over time between supporting immediate growth and not crowding out other public spending priorities that are fundamental for long-term success. Economists should continue to focus their analysis on deficits and debt relative to the size of the economy, but understanding the cash flow implications of debt service within current budgets deserves more regular inspection and discussion.
Glen Hodgson is senior vice-president and chief economist at the Conference Board of Canada.