Canadians have followed the unfolding government debt crisis in the United States and the European Union (EU) with a sense of detachment. While terms such as the “fiscal cliff,” “sequester” and “fiscal austerity” have entered our lexicon, they have not entered our consciousness. After all, a government debt crisis could never happen in Canada, right?
Wrong. It already happened in the not too distant past, centred on the federal government in the mid-1990s, and it could easily happen again in the not too distant future, this time originating with the provinces.
Figure 1 on total debt for all levels of government tells the story. The ratio of gross government debt to GDP is higher in Canada than in either the United States or the EU. Many Canadians will be surprised to learn that our government debt level relative to income is also higher than in the United States and the EU. After all, we emerged from the 2008-2009 financial crisis and recession in much better shape than the other major industrialized nations did. This confidence in our financial system and the appeal of the Canada brand to foreign investors attracted $274-billion in government bonds, pushing up the value of the Canadian dollar.
Figure 1. Source: Statistics Canada, Federal Reserve Economic Database and Eurostat
One encouraging trend for Canada is that the recent rate of increase for its government debt was not as rapid as in either the United States or the EU. Moreover, Canada proved in the decade after 1995 that it was capable of taking action to reduce a high debt load, a resolve that the United States and the EU have yet to demonstrate.
Much of the favourable perception of the state of government finances in Canada is based on federal government debt. As can be seen in Figure 2, the federal government’s share of debt relative to GDP was cut in half from its peak in 1995 until 2007, just before the recession hit. This long-term decline reflects the decisive action taken to reduce the federal deficit in the 1995 Martin budget, followed soon after by 10 years of budget surpluses. The federal debt ballooned during the recession and has since levelled off at just under 50 per cent of the GDP as the annual deficits were slowly brought down.
Figure 2. Source: Statistics Canada
The precariously high level of government debt now originates mostly at the provincial and local levels of government. Starting in 2002, their levels of debt have consistently exceeded the federal debt. Provinces and municipalities made little headway in reducing their debt relative to the GDP during the extended economic boom that covered most of the last two decades, similar to the manner in which the United States and the EU frittered away their opportunities to reduce debt when their economies were growing. The recession then boosted debt levels, as revenue plunged and Keynesian pump-priming of spending rose. However, provincial and municipal debt levels have continued to rise even as the economy began to recover, reflecting the difficulty of reining in spending, especially on education and health care. Infrastructure spending at the local level of government has proved hard to brake after a decade of heavy investment that was funded partly by rising local debt or provincial transfers (also partly financed by debt). As a result, provincial and local government debt as a share of the GDP was higher in 2012 than it was in 1995, the last time Canada faced a debt crisis.
For the moment, record-low interest rates are keeping the debt problem at bay. In Figure 3, the share of GDP spent on interest payments (some would say wasted, considering all the things this money could be spent on) for government debt fell below 4 per cent in 2012. This is lower than it was before the recession and well below its record high of nearly 20 per cent in 1995. However, the decline since the 2007 recession is an illusion created by record-low interest rates. Interest payments are the product of the level of the debt and the interest rate being paid. While debt levels have risen since 2007, this has been outweighed by ultra-low interest rates, reducing the burden of interest payments. The increasing level of debt leaves governments vulnerable to the inevitable return to more-normal interest rate levels.
Source: Statistics Canada, FRED and Eurostat
A major study by the Macdonald-Laurier Institute in October 2012 warned of the ominous trend of provincial indebtedness. It found that the path of provincial finances was unsustainable, with a significant risk of insolvency in all 10 provinces over the next three decades. This scenario reflected the impact of a rapidly aging population on lower economic growth and higher health care costs, a return to more-normal levels of interest rates and the dependence of some provinces on volatile natural resource revenue.
Already, the worrisome fiscal outlook is forcing unpopular choices onto provincial governments. This is most evident in Québec, where the newly elected PQ government renounced its big spending instincts. Instead, Finance Minister Nicolas Marceau declared, “Eliminating Québec’s deficit is non-negotiable.” Québec’s financial quandary is that while annual deficits are not excessively large, they are being piled onto a very high level of debt due to the persistence of annual deficits over long periods (Québec’s fiscal profile thus resembles that of Italy). Prioritizing deficit reduction has cost the PQ support among its left-wing base, but it had to be done after the threatened downgrade of government agency debt.
Other large provinces have received similar warnings. Bond ratings agencies downgraded Ontario last summer, citing its $15-billion deficit and high spending. British Columbia received notice of a possible downgrade. Alberta has not been able to stop running deficits despite a boom in oil prices and the oil sands development.
So, is the debt problem facing the provinces intractable? Fortunately, a road map out of the quagmire is readily at hand for them as well as the United States and the EU. In 1995, the federal government in Canada strained under a debt load so large that The Wall Street Journal ran an editorial on January 12 titled “Bankrupt Canada,” which said that if Canada did not take dramatic action in the next federal budget, Canada could hit the debt wall and ask for IMF intervention.
Fortunately, the federal budget plan ended the incipient crisis, mostly through spending cuts. On average, the operating budgets of federal ministries were trimmed 10 per cent. Transfers to the provinces also were cut, and the block fund of transfers to the provinces was capped. In three years, the federal government was running a surplus.
Lower federal transfers worsened the already-precarious fiscal position of the provinces. As early as 1992, Saskatchewan had to introduce draconian cuts because financial markets balked at funding more of its debt said then finance minister Janice MacKinnon. By the mid-1990s, governments committed to better fiscal management were elected in most provinces, most notably in Ontario and Alberta. Therefore, provinces have an “organizational” memory of what a fiscal crisis means and how to address it.
What is different now is the record deficit run by local governments. Last year, local governments posted a deficit of $9.2-billion, by far the largest ever. Before 2000, it was rare for local governments to run a deficit of more than $1-billion, but it jumped to $6.3-billion during the recession in 2008 and has widened since (the deficit is tracking above $10-billion so far in 2013). The source of this growing deficit is easy to pinpoint: The increasing fiscal prudence among provincial governments has already resulted in lower transfers to local governments since 2010, totalling more than $2-billion. Meanwhile, capital spending has more than doubled to $28.4-billion in the last decade alone, most of it for aging infrastructure.
Like the federal government, the provinces have learned that it is easier to cut transfers to lower levels of government and to let them deal with the political fallout than it is to cut their own spending programs. Alas, there is no level of government below the municipal one, so that is where the buck has to stop. Local governments will have to choose which programs to fund or face a fiscal future as bleak as Detroit’s.
In the mid-1990s, governments in Canada showed that with decisive action the debt time bomb could be defused in a very short period without triggering a recession. And unlike the mid-1990s, when an upturn in interest rates helped precipitate the debt crisis, the current period of record-low interest rates will alleviate rather than aggravate the problem if governments act quickly before rates start rising.
Still, difficult decisions about spending cuts need to be taken. For the provinces, this means addressing the rapid growth of outlays on education and health care, two sectors that account for more than half of their expenditure. A major overhaul of policy-making in these two sectors is long overdue. Governments continue to pour money into education, particularly universities, despite ever-worsening outcomes for students when they hit the job market. At the same time, the Canadian Council of Chief Executives identifies a shortage of skilled labour as the top concern of large firms. Meanwhile, health care expenditures are already one of the highest per capita in the world, even before the Boomer generation begins to tax the system. However, the Organisation for Economic Co-ordination and Development ranks the performance of our health care system as well below average. Spending more in return for worsening outcomes for both education and health care is symptomatic of systems that cry out for reform.
Again, there are precedents for overhauling major social programs to make them more efficient in achieving their social goals. Canada’s welfare system was reformed as part of government belt-tightening in the mid-1990s that cut the number of beneficiaries by half without any major consequence for poverty rates. As well, the Canada Pension Plan was put on a more-stable footing in 1999.
Politicians will always try to put off making hard choices. As an example, one of the dangers in the current policy environment in Washington is the thinking that the relatively small cuts programed under sequestration will be sufficient to solve the looming debt crisis. In fact, no real progress will be made in addressing the structural deficit in the United States until the so-called entitlement programs for pensions and health care are tackled. The paralysis in Congress on fiscal matters is reflected in how it has not passed a budget for four consecutive years, leaving the country to run on “continuing resolution” clauses. In Europe, for all the discussion of the rigours of fiscal austerity, remarkably few countries have actually cut government spending outright, content instead to slow its rate of growth. This is why the trajectory of government debt in both the United States and the EU remains on an unsustainable path.
Facing up to government debt problems is a matter of “arithmetic,” not ideology, in the words of former finance minister Paul Martin. Increasingly, for Canada’s provinces and municipalities, the numbers just do not add up. With Canadians already showing signs of tax fatigue, and many having to save more as their retirement approaches, the only politically sustainable solution is lower government spending. Although it is tempting for politicians to delay these decisions, MacKinnon warns, “The longer you wait, the worse it gets.”
Philip Cross is a Senior Fellow at the Macdonald-Laurier Institute. Prior to joining MLI, Mr. Cross spent 36 years at Statistics Canada specializing in macroeconomics. He was appointed Chief Economic Analyst in 2008 and was responsible for ensuring quality and coherency of all major economic statistics. During his career, he also wrote the “Current Economic Conditions” section of the Canadian Economic Observer, which provides Statistics Canada’s view of the economy. He is a frequent commentator on the economy and interpreter of Statistics Canada reports for the media and general public. He is also a Fellow at the C.D. Howe Institute and a member of the Business Cycle Dating Committee.