Monday, June 21, 2010

Debt Myths

Myth 1: Government spending under Trudeau and Pearson accounts for most of Canada's debt

The notion that the Trudeau and Pearson spent Canada into debt is laughable. Leaving aside the fact that Most of Canada's debt accumulated under Brian Mulroney, when Trudeau left office Canada's debt to GDP ratio was slightly less than it was under Diefenbaker and for most of 60s and 70s debt to GDP ratios were well below what they were in 1960. Moreover, it was only Trudeau's last term in office that deficits to GDP reached troubling levels and that had nothing to do with new government spending.

At the beginning of the 1980s, the US Fed and other Western countries declared a war on inflation. The war was won, but it came at a terrible cost. Sky rocketing interest rates meant sky rocketing deficits in both Canada and the US. An example should put things into perspective. In September 1980 interest rates stood at already ridiculously high 13%; three months later the US Fed had raised them to 20%.

Monetary policy and not government largeness explains Canada's debt crisis in the 1990s.

It was also helps to explain why Martin was able to tackle the deficit. The last of those ridicously high yeild bonds had run out by 1993 and by 1992 new bonds were issued at a much lower rate. Lower interest rates also drove demand here at the same time as they helped lower the Canadian dollar against US dollar.

Myth 2: Canadian government spending is out of control

Using the mid 1990s as a reference pundits such as Andrew Coyne like to point out that government spending has grown by leaps and bounds. Indeed, it has. The problem is government spending in the mid 1990s was lower than it was at any point since the 1950s and given the demands of a modern economy, such low levels of spending were unsustainable. In other words, what we have witnessed in the last 10 years is not a spike in government spending but an inevitable and needed rebound. The amount of government spending in Canada as percentage of GDP is lower than most Western countries and is even lower then what it is in the States.

Furthermore, what is true for other countries in recent years is also true for Canada. What accounts for most of the deficit is a massive decline in revenues and not "Canada's Action plan".

Myth 3: The debt crisis in Europe is a result of government largeness

The acronym PIGS make it seem that Europe's debt crisis is a result of government spending. This is simply not true. Prior to the Lehman Brothers bankruptcy Portugal, Ireland, and Spain, had debt levels that were either comparable to Canada's or lower. Moreover, none of these countries were running huge deficits prior to the crash. Indeed, Spain was running surpluses. The huge deficits these countries are running now are a consequence of a massive decline in government revenues and the massive increase in debt levels is a consequence of large amount of private debt being transferred to the government books in the face of crisis brought on by a US private debt crisis and huge spike in oil prices in the summer of 2008. The UK is perhaps the best example of the later

Italy and Greece, of course, had higher debt levels. However, even here this has arguably more to do with with the revenue side than the spending side. This is especially true in Italy's case. Tax evasion is widespread in both countries. The situation is Italy is so bad that the former government proposed that every Italian's income be made public so that people could rat out tax evaders.

The origins of the debt crisis matter. If the cause of crisis is massive reduction in revenues, fiscal stimulus may be the only way out. Getting on with the business of reducing the debt in the face of 20% unemployment in Spain's case, is likely to make things worse. First there is the question of there being a liquidity trap. Then there is this. However big the real estate bubble was in the States it was far bigger in many European countries and where there real estate bubbles there are high consummer debt levels and most cases highly leveraged banks. Slashing services, rising interest rates, raising taxes that will in turn lead to increased financial burden for households will only serve to bring various European economy closer to the edge. It will lead to defaults which will in turn lead to bank failures. The consumer debt problem and public debt problem are actually one problem.

There is no easy answers and things only stand to get more complicated. For one, the true European debt crisis lies in wait. While there is nothing to suggest that the timing of the current crisis was consequence of government largeness, a rapidly aging population endangers every major European economy. Europe's "implicit debt", most notably generous but uncosted public pensions, will become more of a problem as Europe ages. This is especially true for the PIGS. Italy is Europe's oldest country and, if memory serves, Greece has its lowest birth rate. Many Europeans have been loath to embrace immigration for fears that it would erode national identity. Europe must now embrace higher immigration if it wants to maintain its current way of life.

To further complicate matters, there is the Euro. Greece has been in and out of default for a good portion of the last hundred years. What makes this most recent crisis different is that should it default the future of the Euro would be in called into question. As Paul Krugman et al, have suggested default may be impossible to head off default. The problem is that countries in Greece's position have tradionally devalued their currency in order to get back on their feet again. (To very real extent that is exactly what Canada did in the 1990s.) So long as Greece uses the Euro, that option is not open to them though. In order for Greece business to complete with their German counterparts, for example, there most be real reduction in Greek wages. If Greece was not a Euro member, it could accomplish the same by devaluing its currency.

Myth 4: This is 1995 all over again

Canada is also vulnerable. Sure are banks are better shape, but this is no small measure do to the fact that Canadian housing corporation and not the banks and AIGs of the world are on hook should the real estate bubble burst in Canada's biggest cities.

You see, one of the first things the Conservatives did upon taking office was to extend the mortgage amortization period from 25 years to 30 years in February 2006, extend it to 35 years in July of 2006 and extend it yet again to 40 years in November 2006 During this period they also reduced the needed down payment on second properties from 20% to 5% and allowed for 0 down on one's primary residence.

Such actions allowed Canadians to take on mountains more debt, house prices went through the roof and so has the Canadian housing corporation liabilities. It was 100 billion in 2006. It is expected to reach $500 billion by the end of the year. A sharp increase in defaults will add billions and billions and billions to Canada's net debt.

The slash and burn policies of the 1990s will only make a bad situation worse. Indeed, with Canadian consumer debt growing at amazing 7% a year, slashing services that will in turn lead to increased financial burden will, here too, only serve to bring the Canadian economy closer to the edge. Canada needs to take action least a private debt problem become a public debt one. That means above all insuring that real estate does not continue to rise and to lessen the financial burden of young families in particular. A national day care program is great place to start. The type of services that Canada should be cutting -- if not gutting -- are the ones that offer no direct financial benefit to Canadians. Military spending and the Conservatives daft get tough on crime policies are great place to start.

5 comments:

WesternGrit said...

Great post.

RuralSandi said...

Well done. That's more like it. We need more "truths" and reminders out there.

Keep it up.

Anonymous said...

It's fairly simple math: we're spending more than we're taking in. And what's more, unless we increase revenues or decrease spending it is going to stay that way. We're in what is called a structural deficit, and this so called history lesson doesn't change that. Since neither the Liberals nor the Conservatives want to raise taxes it means we need to have a serious debate about what services we want to cut.

Koby said...

"We're in what is called a structural deficit, and this so called history lesson doesn't change that."


It is very debatable whether the deficit is structural.

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