THE COVID DEBT TRAP
Our fearless leaders are absolutely loving low interest rates which they think gives them the ability to borrow unlimited amounts of money using the pandemic as the excuse. Our new Finance Minister sees it as a “fabulous opportunity for our country”, to rebuild the country along more equitable, greener lines – a chance “to get through the pandemic in a way that gives everyone a real and fair chance at success, not just the wealthiest one per cent.” Canadian federal debt has gone from $685 billion to around $1.2 trillion this year. Let’s be clear, using debt to support households is not a bad thing during desperate times such as a pandemic. However, what is concerning is that politicians are not being honest nor transparent on who will be paying for all this accumulated debt: future generations. There is no free lunch. The top 1% in Canada cannot shoulder all the burden. The government must have a plan and discipline to pay down that debt during times when there is no crisis – something politicians have been dismal at in the past, entering each crisis with evermore debt. Fitch Ratings is the first rating agency to have now downgraded Canada’s triple A status. This is the foundation for our ability to borrow at the lowest prices.
The Canadian deficit (the annual budget shortfall) was estimated to be at $343 billion in July, but the government has since announced fresh spending bringing this number closer to $400 billion, which puts the debt to gross domestic product (GDP) ratio at around 50%. It is likely to hit 60% in the next couple of years. To put it into context, during the painful debt burdened years of the mid 90s, it was at 66.8% so it is not like we have not been at these levels before, and back then there wasn’t a pandemic to blame.
The only way to be able to effectively manage our way out of this is for interest rates to remain lower than the actual growth rate of the economy; so that the government’s revenue growth rate (i.e. as the economy grows so too does their tax collection) exceeds the growth of their interest expenses. This of course assumes no additional debt is being added. To put things into perspective, in the mid 1990s, because of higher rates, the government was spending $0.36 of every dollar in revenue on debt servicing, while today that number is around $0.09. Low rates therefore incentivizes our leaders into justifying more spending. Debt that can produce growth by generating future income, providing excess income even after the debt is repaid, is a productive form of debt. Spending on research and development, on training, on digitalization of the economy, those are all great ways to produce future growth in an economy. According to the Economic Policy Institute, on average $100 billion spent on infrastructure generates one million new jobs. And a study by the Business Roundtable claims that every dollar spent on infrastructure returns $3.70 in additional economic growth. Unfortunately, we see little evidence of spending on these types of projects. It appears the preference is to simply hand out money without expectation of any return for the economy overall, to those that they think will get them the most votes.
To date, at least half of the money that Trudeau has spent has been wasted, while our deficit (the annual budget shortfall) is heading to $400bln. The recent speech from the throne where the Liberals claim to spend “whatever it takes, using whatever fiscal firepower is needed” to get Canadians through the COVID-19 crisis should be of huge concern to everyone because of the lack of a major plan to ensure that this is done in the most productive way possible.
Their focus on “extreme wealth inequality” is particularly concerning in an era where the most privileged are those working for the government themselves. According to the Fraser Institute, government workers have been found on average to enjoy a 9.7% wage premium over their private sector counterparts. The majority of public sector workers are the only workers on the planet that are not held accountable to those that pay their salaries: the taxpayers. Most importantly, the public sector is entitled to pensions, at the expense of all other Canadians, that average $30,000-$40,0000 per year and are indexed to boot.
To put this into perspective, private workers today do not have any such pension benefits. Somebody making the average Canadian salary of around $55,000 per year pays taxes to cover the pension for a public worker that probably makes more than he/she does. Certainly, at that average salary, there will be no funds left over for them to fund their own pension.
What is this pension worth? With today’s interest rates at 0.58% on a ten-year treasury bond, a person working in the private sector would need to have $5,000,000 in the bank to generate the average government pension. To put this into perspective, around 2% of all Canadians have wealth of between US$1.0million and US$5.0million (around $6.5 million Canadian) and only 0.25% have over US$5 million. That is around 764,000 individuals in Canada that have between US$1.0-5.0 million! Less than 100,000 Canadians have over US $5 million.
Those working for the government have become the elite in today’s Canadian society. No plan has ever been presented by making this more equitable: perhaps by reducing public pensions to the benefit of those in the private sector or, at the very least, allow a level playing field so that private sector employees have the same ability to save for retirement as the public sector. The only tax-free savings vehicles available are the TFSA and RRSP, which have capped annual contributions. Instead, all talk is of simply going after those in the top 1%, who cannot possible have enough to cover all the frivolous government spending.
The reality is that by taking on all that debt, without ensuring it is ultimately used for productive purposes, what the government is ensuring is that future generations will be poorer. Too much debt means money has to go to service that debt that would otherwise be available to invest in growth. Fiscal policies that are financed by debt only boost growth in the short run because that money ultimately has to be paid off, regardless of how low the interest rate is to borrow it in the first place.
In the US a similar problem is underway. Total public and private debt jumped from 167% of GDP in 1980 to 364% in 2019 and it is expected to breach 400% by year end. Gross government debt as a percent of GDP was under 33% in 1980 and 107% at the end of last year. This year it is expected to end closer to the 130% mark. What is most important however, is that each additional dollar of debt has generated a lower increase in GDP. Back in 1980 every incremental dollar of debt increased GDP by $0.60. Today it only increases it by $0.27. This is because today’s incremental debt is going towards non-productive use. This is another consequence of lower rates. Investment decisions are made based on whether an expected return exceeds a specified hurdle rate which is based off of today’s interest rates. A lower interest rate translates into a lower investment hurdle rate, meaning less productive projects or investments now appear worthwhile when they would not be profitable with slightly higher rates. This is a recipe for disaster and is the reason the productivity of Canada’s economy has been in a constant decline.
Canada, the U.S., Japan and Europe are now all in the same boat: too much debt with the resulting anemic growth. Using debt to service unproductive expenses such as Medicare and Social Security in the US is necessary, but hardly productive for the economy overall. When unproductive debt is used, it is primarily those that are the most productive that end up paying for it. Look no further than the “antitrust” laws taking place in the US; targeting their most successful innovative companies. You can bet that there will be hefty fines eventually imposed resulting in a transfer of wealth from the productive to the unproductive.
In Canada, according to the Fraser Institute, as of April 2019 our Liberal Prime Minister’s legacy was that of being the largest accumulator of federal debt per person (5.6%), among all prime ministers who did not fight a world war or experience an economic downturn during their tenure. Then COVID came along, giving him even more license to spend with reckless abandon, but the path was already well set in stone. One can only hope that at some point a new leader with fiscal prudence can be successful in convincing the nation that this is not the road to prosperity.
Debt can be critical for economic growth. It finances innovation and adds to an economy’s productive capacity. But too much of it takes away from investment in growth and therefore the quality of life that this growth supports, diminishes. This is why the majority in Canada, the US, Europe and Japan are now struggling to get ahead. Today, low rates are not necessarily a benefit to the economy, but clearly simply the result of too much debt. Ultimately you have to stop growing this debt or the system comes crashing down but Japan, at 260% debt to GDP, shows that this can go on for a long time. Nevertheless, interest rates being very low should not be necessarily seen as a positive thing, a reason for our governments to spend more and to fall into an eternal debt trap. In the end what they are doing is buying votes today, at the expense of our children, and even grandchildren’s future.
The Summerhill Team
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