A couple of weeks back, Jack Mintz warned Financial Post readers that governments that think low interest rates will let them keep borrowing big are on a dangerous path. As he pointed out, the presumption that deficits are sustainable depends on the rate of growth of the economy exceeding the interest rate. Drilling down, if a government borrows to pay all its interest, its debt will grow at the interest rate. If the economy grows faster than that, the government’s debt-to-GDP ratio can fall even if it also borrows to pay for some of its program spending. But if the interest rate is greater than the rate of economic growth, the government must cover all its program spending with taxes, and then some. Otherwise, its debt grows faster than the economy, and trouble awaits — including the possibility of wrenching adjustment and perhaps even a financing crisis.
Mintz’s warning is timely. Ottawa’s fall economic statement prefigured unprecedented borrowing — not only this fiscal year, but in the next three, as well — with tax revenues nowhere near covering program spending. In the statement’s projections, this is not a problem: rates of economic growth well above interest rates rescue us. On the growth side, a huge rebound gets revenues in fiscal 2021/22 above their pre-pandemic level, and they grow at more than five per cent per year after that. As for interest rates, short-term rates don’t hit one per cent, or bond yields two per cent, until 2024. Amazingly, the statement pencils in $70-$100 billion of additional stimulus borrowing, with no provision for any interest payments on that additional debt!
Back in the real world, however, interest rates have often exceeded growth rates. As Mintz reminded us, they did in the 1990s, when the relentless rise in federal debt and interest costs prompted Paul Martin’s austerity budgets. They did in 2020, too, when COVID hammered the economy. Debt binges by governments can push rates up — especially if bloated central bank balance sheets spark fears of inflation, and lenders begin to worry they’ll be repaid in depreciated currency, or worse. Since the fall statement, long-bond yields have in fact risen faster than projected.
As for economic growth, I would double-down on Mintz’s warning. There are many reasons to expect slow growth ahead. In addition to a sluggish global environment (the subject of Mintz’s comments last week), COVID has strengthened the demographic headwinds that were already slowing the growth of our labour force. A cohort of young workers has been scarred by COVID unemployment, while the immigration we have been depending on to replace retirees seems bound to become more difficult. Both the virus and a resurgence of protectionism are stressing the global supply chains that have supported growth for the past 70 years. Finally, and perhaps most importantly for the sustainability of government debts, borrowing on the current scale undermines growth by turning the saving that finances investment into consumption.
Ordinarily, government deficits, even the chronic ones the federal government has run since 2015, are not that big relative to national saving and investment. Before the pandemic, all levels of government taken together were roughly in balance. With no borrowing drag from the public sector, we could easily finance the $250 billion a year that Canadian businesses spend on capital — adding to the stock of buildings, engineering, machinery, equipment and intellectual property that underpins future growth — from our own saving.
But the fall statement projects some $300 billion in federal borrowing over the next three fiscal years. Add provincial deficits to that and you get serious competition for saving. That stands to crowd out private investment and slow the economic growth we need to make all the debt sustainable.
Although low business investment is not the only reason the Bank of Canada downgraded its estimate of the Canadian economy’s potential growth rate since the pandemic hit, the bank has repeatedly emphasized its importance. Its January Monetary Policy Report presented estimates of potential real growth averaging less than one per cent over the next three years — which implies that after the COVID rebound, the rate of economic growth will be much closer to the interest rate than the minister of finance’s much more optimistic fall economic statement implied.
So the presumption that huge federal deficits do not matter because economic growth rates will easily exceed interest rates is shaky on both fronts. As Jack Mintz warns, interest rates are likely to rise, particularly if Ottawa continues its record borrowing. And economic growth is likely to be slow, particularly if federal borrowing crowds out investment as the economy recovers. Many people, including buyers of government bonds, have taken comfort in the interest-rate-less-than-growth-rate story, which has helped keep bond yields down. If that comfort erodes, a vicious circle looms: fears that the interest rate/growth rate ratio might flip can raise yields on its own.
There is in short no guarantee that interest rates lower than growth rates will see us through our debt dangers. The more we rely on that presumption and keep borrowing heavily, the greater the chance interest rates higher than growth rates will lead to another wrenching turn toward austerity, if not an outright financial crisis.
William Robson is CEO of the C.D. Howe Institute.