When the Bill Comes Due, Part I

Matthew Lau
June 13, 2020
In many ways these are magical times. Governments seemingly exist to protect us from all harm and negative consequences. When a pandemic hits, the existing gusher of public spending becomes an unchecked torrent, interest rates are lowered to effectively zero, yet inflation remains caged. Almost any item large or small can be purchased with instant credit on easy terms. Individuals, organizations and groups in trouble are showered with financial beneficence. But where is the money actually coming from? Who, if anyone, is to pay for it all? Can nothing bad come of the unprecedented profligacy? Matthew Lau reminds us that reality will reassert itself and when the spell is broken at last, potentially ruinous consequences lie in wait. Lau evaluates the options available to debt-burdened governments – most of them bad. Part I of a two-part analysis.

When the Bill Comes Due, Part I

Matthew Lau
June 13, 2020
In many ways these are magical times. Governments seemingly exist to protect us from all harm and negative consequences. When a pandemic hits, the existing gusher of public spending becomes an unchecked torrent, interest rates are lowered to effectively zero, yet inflation remains caged. Almost any item large or small can be purchased with instant credit on easy terms. Individuals, organizations and groups in trouble are showered with financial beneficence. But where is the money actually coming from? Who, if anyone, is to pay for it all? Can nothing bad come of the unprecedented profligacy? Matthew Lau reminds us that reality will reassert itself and when the spell is broken at last, potentially ruinous consequences lie in wait. Lau evaluates the options available to debt-burdened governments – most of them bad. Part I of a two-part analysis.
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Before Covid-19 swirled into our lives, a person who grew up in Canada since the mid-1990s had never experienced high inflation, high interest rates or prolonged periods of economic stagnation. And previous generations, who’d grown up with some or all of those circumstances, had a quarter-century to forget what the bad times were really like. Erased from our collective memory were those often bitter personal financial trade-offs that once circumscribed any major purchase or financial decision. The last time a serious recession threatened, in 2008-2009, governments simply spent their way out of trouble as tens of billions of dollars of new government largesse miraculously appeared. Following this resulting massive accumulation of new debt, economic growth proved somewhat sluggish over the past decade − but nothing catastrophic ever occurred. 

So in the midst of an even bigger crisis today, expectations have been pushed that much higher. Business groups demand government aid far more unctuously than they grovel for the privilege of reopening. From students and seniors to non-profit organizations and the unemployed, everyone wants a bigger handout. To millions of regular people, it seems, all this new money simply comes from “the government”, in the same way food comes from “the store”. 

But does it, really? Eventually the bill for all this extra spending will come due. And then what happens?

A Numbers Game, and the Numbers Keep Getting Bigger

Last December, federal Finance Minister Bill Morneau informed Canadians his budgetary shortfall for 2020-21 would be $28 billion. While this was a grave disappointment, given the steady stream of red ink produced by the Trudeau government during five years of solid if unremarkable growth, such an eleven-figure sum would soon be considered “the good old days.” When the coronavirus hit the economy like a sledgehammer in March, Parliamentary Budget Officer Yves Giroux quickly revised the year’s projected deficit to $113 billion. By early April, it was $184 billion. Then a few weeks later, a stunning $252 billion

Picture of Finance Minister Bill Morneau, who announced earlier this year Canada's deficit to be $28 billion.
Picture of Parliamentary Budget Officer, responsible for forecasting Canada's national debt and deficit.
Longing for the good old days of $28 billion deficits: Finance Minister Bill Morneau (above), Parliamentary Budget Officer Yves Giroux (below).

And we may not be done. Last month Giroux told reporters he considered his latest quarter-of-a-trillion-dollar deficit target to be “on the very optimistic side.” All that before Ottawa announced that its emergency wage subsidy, which originally had a price tag of $71 billion over 12 weeks, would be extended for an additional 12 weeks – possibly doubling the expense. Nor does paying for any of it seem to be top-of-mind among political leaders. When Ottawa last week offered another $14 billion in borrowed money to the provinces, Ontario premier Doug Ford, an alleged conservative, didn’t wonder where the money would come from or how it would be repaid. Instead, he sniffed at the seemingly paltry amount, declaring “it just won’t cut it”.

As for the provinces, the Royal Bank predicts they’ll run a cumulative deficit of at least $63 billion this fiscal year − almost certainly another underestimate. Many of them appear to be in far worse shape than Ottawa. Newfoundland and Labrador, with the country’s highest debt per capita, was already teetering on the edge of bankruptcy due to low oil prices when the Covid-19 crisis set in and has been forced to beg Ottawa for emergency assistance. 

National debt problems are real issues facing Premier Ford and Premier Ball.
Ontario's Doug Ford (at left) says $14 billion in further federal hand-outs “Won't cut it”, while Newfoundland and Labrador’s Dwight Ball (at right) is facing provincial bankruptcy.

If these deficits were mere one-time events, the impact of the shutdowns imposed in response to the coronavirus might be considered a difficult but entirely temporary problem. But no one really expects the economy to take off the minute restrictions are eased. A more realistic prediction is that these unprecedented deficits will continue well into the foreseeable future; some economists say Ottawa can expect to add a total of $600 billion in new debt over the next six years. And that was before the OECD released its latest set of economic predictions based on a second wave of Covid-19 sweeping the world; in this case, no recovery is in sight until 2022 at the earliest. If this comes to pass, the additions to our national debt following such a major (perhaps unprecedented) contraction constitute a problem of unforeseen magnitude. 

A common measure of the manageability of any government’s debt load is the ratio of debt to the country’s gross domestic product (GDP). As of last year, the federal government’s accumulated debt amounted to 31 percent of Canada’s annual GDP. Using scenario analysis, Lakehead University economist Livio Di Matteo made a series of estimates for where this ratio might land in a few years, even before all the Covid-inspired deficits come to an end. His medium case, based on the current projection for a $252 billion deficit this fiscal year (which, to repeat, is now regarded as a low estimate), is that the ratio will zoom to around 60 percent as early as 2022-23. A more pessimistic option puts it at 73 percent, a figure which means Canada’s federal government will owe $1.5 trillion dollars.

For context, in 1995 when the Wall Street Journal ran a politically earth-shaking editorial declaring Canada to be “an honorary member of the Third World in the unmanageability of its debt problem,” the federal debt-to-GDP ratio was around 66 percent. The federal debt burden today is thus heading back into danger territory at alarming speed, and the provinces are in equally dire straits. 

With everyone currently focused on ending the various restrictions and wondering when the next category of activities and facilities will reopen, relatively little attention is being paid to the long-term consequences of such a massive increase in government indebtedness. Much of society is still in a “make it go away” state of thinking about the pandemic; many people are hoping the wage subsidies, payment deferrals and aid programs to businesses and organizations will be extended or expanded, or new ones invented. Relatively few seem to be wondering how – or even if – we’ll be able to pay it all back. 

As history and economics reveal, there are only four ways out of our current economic straightjacket. And only one offers a realistic path to renewed prosperity and growth.

Option 1: Just Walk Away 

Let’s start with the worst case. The most calamitous method of dealing with a crushing debt burden is simply not to pay it back. In a “sovereign default” government bond payments are ignored or dishonoured. These are relatively rare events because they are politically, fiscally and economically calamitous. But it has happened in Canada before. 

As revenues collapsed and expenditures soared in the midst of the Great Depression, the provincial government in Alberta found its interest payments gobbling up nearly half of its meagre revenues. Without enough cash to cover its liabilities, on April 1, 1936 the province defaulted on its debt; for the next decade it paid only half its interest obligations to bondholders. In the end, the province had to be bailed out by the federal government. It was perhaps the most humiliating political experience in Alberta’s history.

Ottawa has never defaulted on its debt. But after decades of improvident deficits, by the 1990s its debt charges were also growing at a worrisome rate. When the Wall Street Journal ran its “Bankrupt Canada” editorial in 1995, the federal government’s interest payments comprised a third of all expenditures. That same year Mexico nearly defaulted on its debts, and was only saved by a $50 billion international bailout led by the U.S. government. More recently, during the financial crisis in Greece that began with the Great Recession of 2008-09, the Greek government closed bank branches, froze personal bank accounts and limited ATM withdrawals to less than $70, causing widespread panic and huge lineups. All this before coronavirus was even a figment of anyone’s imagination.

Picture of protestors when Greece's national debt reached crisis levels.
Lineups outside ATMs in Greece when governments closed banks during their financial crisis.
How the bill comes due: Angry Greeks (above) demonstrate against their debt-ridden government’s austerity, while panicked Greeks (below) line up at frozen ATMs when the country’s financial system very nearly collapsed.

Today, with deficits burgeoning in nearly every country, bond rating agency Fitch Ratings has declared that 2020 will likely be a “record year for sovereign defaults.” Already there have been three due to the pandemic: Argentina, Ecuador, and Lebanon. Who will be next? The possibility of more-developed countries defaulting on their coronavirus-inspired debt loads may be slight, but it cannot be ignored. In a recent opinion column for the Wall Street Journal, former Prime Minister Stephen Harper noted that government debt levels “were dangerously high” even before the Covid-19 crisis hit. (The pre-Covid public debt-to-GDP ratio for all countries worldwide was a stunning 83 percent.) It “will be an unholy mess” once it’s over, Harper opined. 

While defaulting may seem like the simplest solution, it is by no means the easy way out. Countries that bear the scarlet letter of default can no longer obtain credit on reasonable terms and inevitably find themselves saddled with perpetually higher interest costs, repeated failed governments − due to internal dissension or simply because austerity imposed by outside forces is almost always politically unpopular − and a dramatically reduced standard of living. It would be a disaster for any country.

Option 2: Undermine the Debt Itself

Future generations will suffer: Jack Carr, professor emeritus of economics at the University of Toronto, cautions that future generations will bear the burden of bad monetary policy.

Then again, countries need not go through the shame of a default to avoid repaying their debt obligations. They can simply inflate their way out of the problem, reducing the relative value of their crushing debts by undermining the value of the currency itself. The prospect of runaway inflation has not been a major public or political preoccupation for well over a generation in Canada, but its potential reappearance presents a serious risk to our national financial health – including the economic well-being of ordinary Canadians. A brief tutorial is in order.

“Ordinary folks like you and me have two ways to finance their expenditures,” says Jack Carr, professor emeritus of economics at the University of Toronto and an expert on monetary policy, in an interview. “We can spend our current earnings, or we can borrow against future earnings. But government has a third way. It can print money.” While governments usually borrow money by selling bonds to private investors, they can also sell those bonds to their nation’s central bank. In this case the Bank of Canada would simply create (“print” in popular usage – although the majority of currency consists of electronic entries rather than paper cash) the money necessary to pay for the bonds and hand that over to Ottawa. 

As with any other item, dramatically increasing the supply of money inevitably cause its value to fall. When the world is awash in crude oil, prices for gasoline and heating oil fall. When wheat farmers produce a bumper crop, grain prices fall. The same holds true for money. When the supply of money created by government exceeds the growth rate of the economy – either by having the central bank print more of it or by keeping interest rates artificially low – the result is inflation.

One solution to national debt problems is for government's to
Picture of Zimbabwe banknote which was inflated in response to the nation's debt crisis.
Always ends badly: Governments can try to “inflate” their way out of debt, as Zimbabwe did in the late 2000s, but this is what happens. The banknote’s market value: 40 U.S. cents.

“Inflation is like a tax,” explains Carr. “If I have $100 and the inflation rate is 10 percent, by the end of the year I will have lost $10. Who benefits from that? The issuer of the money – the government.” The more money a government prints in excess of demand, the faster a currency’s value falls. In extreme cases, inflation can turn to hyperinflation, as occurred in Zimbabwe beginning in 2000 by design of the late dictator Robert Mugabe. Unable to rein in his budget or otherwise improve his country’s economic prospects, Mugabe simply had the central bank print more money for his government to spend. By 2007, Zimbabwe’s year-over-year inflation rate was 2,200 percent as the country turned out ever-larger and more improbable bank notes. At one point, the Reserve Bank of Zimbabwe printed a 100-trillion-dollar bill. It was worth 40 U.S. cents on the open market. 

Perhaps the most infamous case of hyperinflation dates back to the Weimar Republic of Germany in the early 1920s; at one point prices in Germany were doubling every 3.7 days. The value of the official German currency, the Papiermark, declined from 1-to-1 with a 1 mark gold coin in 1918 to 1 trillion-to-1 by 1923, and bank notes of up to 50 trillion marks were printed. The savings of millions of people, as well as businesses and larger investors, found themselves wiped out. Ordinary Germans were, quite literally, taking wheelbarrows full of cash to the grocery stores and going home with barely the same weight in food. People became obsessed with “hard” assets such as land, buildings and gold.

The national debt problems in Weimar-era Germany were so extreme they reached hyperinflation levels.
Inflation levels in Weimar Germany were so extreme prices doubled every 3.7 days.
The faces of inflation: In Weimar-era Germany prices doubled every 3.7 days and people required baskets of cash to buy groceries.

Today Venezuela, under the mismanagement of its “Bolivarian” socialist dictatorship, is experiencing hyperinflation. Among the many horrific effects of hyperinflation are that imports not only of consumer goods but of truly critical items, such as life-saving medications or machine parts to maintain hospital systems or electricity plants, simply stop because they can no longer be paid for with currency of recognized value.

Why would any government willingly go down such a ruinous route? By debasing the value of its currency, the relative cost of a government’s fixed-interest debt becomes less onerous over time as it is gradually inflated away. Plus, inflation causes nominal government tax revenues to soar. Growing revenues and shrinking debt obligations make for a rather attractive proposition, at least in the short-term. But the long-term consequences of government-induced inflation are rather similar to those of a sovereign default. Investors eventually realize their government bonds are worth less and less every year, and demand ever-higher rates of interest. To which governments respond by printing more money. And so a vicious cycle is perpetuated. 

Picture of empty shelves in Venezuela as a consequence of the nations debt, hyperinflation, and price controls.
Venezuelans suffer from the effects of the governments hyperinflation, debt, and official price controls.
Nada: As this is written, Venezuelans are suffering the effects of hyperinflation and official price controls, one of which is that there is nothing left to buy.

While true hyperinflation has never made an appearance in Canada, we did suffer through an era now known as “the Great Inflation” during the 1970s and early 1980s. At its peak in 1981, the inflation rate hit 12 percent and mortgage interest rates reached an all-time high of 21 percent. “Inflation is hugely distortionary,” advises Carr. With Canada having enjoyed several decades of low inflation that continue through to today, he admits tales of double-digit rates now like seem like ancient history. Most Canadians under the age of 40 have no concept of what life was like when prices changed significantly on a monthly, if not daily basis.

A once common sight: Soaring interest rates and inflation in the early 80s meant that many people could not afford to keep their homes.

“Young people have come to expect interest rates of two or three percent,” says Carr. “It is very easy to finance any purchase with rates like that. But when interest rates are always going up and up, it becomes very difficult to borrow or make a budget. Inflation is very problematic, especially for the younger generation.” It requires an enormous leap of faith to take out a loan at double-digit levels even as prices for everything else are also rising continuously. And that leap is frequently unsuccessful. During the 1980s many people simply walked away from their biggest debts because their wages were no longer keeping pace with the increase in their payments. Anyone who has lived through a prolonged period of inflation absolutely hates the very memory of that time. It is to be avoided at all costs, regardless of any short-term political appeal.

End of Part I. 

Coming in Part II: The risks of a new Great Inflation in Canada, the approach governments are most likely to take to grapple with the massive debts they have created, and the right way to tackle Canada’s monumental fiscal challenge – one that has worked before. 

Matthew Lau is a Toronto writer specializing in economic issues. With files from Peter Shawn Taylor.

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