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High borrowing costs make deficits harder to defend

One in every 10 dollars spent by federal government now goes to servicing debt
Finance Minister Chrystia Freeland and Prime Minister Justin Trudeau have defended deficit spending

In her first budget in 2021, federal Finance Minister Chrystia Freeland defended her government’s deficit spending by pointing to low borrowing costs.

“In today's low interest rate environment, not only can we afford these investments, it would be short-sighted of us not to make them,” she said.

Jock Finlayson, chief economist for the Independent Contractors and Business Association (ICBA), clearly recalls Freeland making the statement, which has not aged well.

Two and a half years later, the overnight and prime lending rates are at 20-year highs – five and 7.2 per cent, respectively – the federal deficit is $40 billion, the federal debt approaching $1.2 trillion, and servicing that debt has become a major expenditure.

The public debt charges for the 2023-24 budget is $46.5 billion, and will rise to $52.4 billion in 2024-25.

“Next year, for the first time, we will spend more on debt interest than on health care,” Conservative Leader Pierre Poilievre said last week, in response to Freeland’s Fall economic statement, which included roughly $20 billion in additional funding, much of which is targeted to addressing Canada’s housing crisis.

“With the Bank of Canada still pushing to get inflation back to target, arguably this is not a good time for any additional spending over and above what was already included in the budgets that were tabled back in the spring,” Finlayson said. “I would make that comment for Ottawa, but also the provinces.”

For two decades now, governments have gotten used to cheap borrowing costs, which made it easier to justify debt and deficits. Between 2009 and 2022, central bank overnight rates were below two per cent, and were as low as 0.25 per cent. 

But the era of cheap borrowing is over. Thanks to inflation – partly fanned by government spending – interest rates have been pushed to highs not seen for more than two decades.

Conservative think-tanks like the Fraser Institute and Montreal Economic Institute (MEI) have been ringing alarm bells over the Trudeau government’s deficit spending, which, in the current economic climate, can fan inflation, prompting interest rate hikes, which results in higher debt servicing costs for the federal government, leaving less money for program spending.

The Trudeau government has never tabled a balanced budget since taking office in 2015. Freeland’s fall economic update shows the federal deficit to be $40 billion for 2023-24, with public debt charges of $46.5 billion, rising to $60.7 billion by 2028-29.

The Fraser Institute notes that debt interest costs now represent 9.6 per cent of total revenues for 2023-24. 

“This means roughly one in every 10 dollars Ottawa collects from Canadian taxpayers this year will go towards debt interest costs, rather than government services or tax relief.”

The Fraser Institute notes that the interest payments on debt in Canada for both federal and provincial governments in 2022-23 was $68.6 billion.

“The federal government will spend $34.7 billion on debt servicing charges in 2022/23, which is more than what the government expects to spend on child-care benefits ($29.4 billion) and employment insurance benefits ($24.8 billion),” the Fraser Institute noted in a recent research bulletin.

It is estimated that inflation would have been two per cent lower, in the absence of federal deficit spending.

“With the Bank of Canada asking it for help to tame inflation, the Trudeau government is adding fuel to the fire,” said Gabriel Giguère, public policy analyst at the MEI. “Ultimately, Canadians are seeing the effects in the high prices they’re paying at the grocery store and in their rapidly rising mortgage payments.”

Canadians have seen this movie before: An energy crisis contributing to inflation, rising interest rates leading to a wave of mortgage defaults, recession, crippling government debt and, inevitably, painful government austerity measures. 

This is what occurred between the mid 1970s and 1990s, albeit on a much greater scale, and absent a pandemic.

The Jean Chretien Liberal government was forced to implement severe austerity measures in the 1990s to whittle down Canada’s debt and balance the federal budget. Canada is in better shape now than it was in 1980s and 1990s, Finlayson noted.

“Although interest rates are a lot higher than they were two years, they’re nowhere near as high as they were back in the early 90s, when we were looking at double-digit rates,” Finlayson said. “But I do think this government, in particular, is too complacent about both the economic outlook and the financial imperatives. 

“They have no plan to ever bring the deficit down to zero. That speaks volumes itself. It’s kind of signalling by the politicians in charge that they don’t care very much about deficits.

“It’s pretty eye-catching that the cost of servicing the debt is going to double between 2022 and the end of the decade. And that’s because of both the build up of debt and the fact that it costs more to borrow.”

Freeland defended her government’s deficit spending last week, saying that “Canada maintains both the lowest deficit and lowest debt-to-GDP ratios in the G7.”

Finlayson agreed that, compared to some of its G7 peers, Canada is in comparatively better shape, in terms of government debt-to-GDP.

“There’s a lot of debt being issued by a lot of governments, not just ours,” he said. “The U.S. government is running a budget deficit that’s six per cent of GDP. Here our national government is running something closer to 1.5 per cent of GDP. So by U.S. standards we’re relatively prudent here. But the U.S. is a bad example because they’re particularly irresponsible, I think, at the moment, in terms of the fiscal policy they’re running.”

Ultimately, the risk for any government carrying too much debt – especially in a high interest rate environment -- is that they won’t have the cushioning to deal with future shocks to the economy.

“They’ve weakened the balance sheet so that increases the risk, going forward, that if we’re hit by another shock, or if the cost of money ends up being higher than they’re assuming, the national government will be less capable of responding to the shock,” Finlayson said. “They will have less money to spend on programs and services because more money has to be diverted to cover debt servicing costs.”