Public Debt: Common 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.

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

At the beginning of the 1980s, the US Fed and other Western countries declared a war on inflation. They purposely drove the economy into a deep recession by greatly increasing interest rates. An example should put things into perspective. In April 1980 interest rates stood at already ridiculously high 13%; three months later the US Fed had raised them to 20%. The war was won, but it came at a terrible cost. Sky rocketing interest rates meant that the amount of money used to finance the debt went through the roof, the spike in unemployment greatly reduced government revenues and the unemployment insurance claims put further stress on government coffers.

By the way, the last of those ridiculously high yield bonds had run out by 1993 and by 1992 new bonds were issued at a much lower rate just in time for Paul Martin. Lower interest rates also drove demand and 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 down turn, Spain, Ireland and UK were in fine fiscal shape. All had gross debt levels that were lower -- in the UK's case much lower, than they are here and Spain and Ireland were running surpluses.

However, Europe was vulnerable in the same way that the US was vulnerable. The Europeans had allowed real estate bubbles to develop. Once real estate bubbles started deflating all over the western world, the UK and Ireland pumped huge sums of money to prop up their banks and furthermore took responsibility for enormous private debts incurred by their banks. As a result, their debt to GDP ratios sky rocked. In the less than a year Ireland's debt to GDP ratio doubled!

At the same time as governments everywhere were busy saving their banker's bacon, government revenues collapsed as unemployment rose and governments were saddled with higher bills for things like unemployment Insurance. This was certainly the case in Spain. A 10% plus jump in unemployment meant the government revenues tanked just as unemployment claims spiked.

Meanwhile, Italy and Greece already had higher debt levels and huge problems especially on the revenue side. Tax evasion is widespread in both countries. This is especially true in Italy's case. 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 back drop to Europe's debt crisis is questions about the feasibility of the Euro and worries that the true European debt crisis lies in wait.

Debt: 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 --- at least outside of Scandinavia. 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. Ironically, Europe must now embrace higher immigration if it wants to maintain its current way of life.

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 traditionally 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. What holds true for Greece also holds true for Ireland, Spain and Portugal.

Myth 4: This is 1995 all over again

No it much more likely that it will be 2007 all over again. Canadian consumer debt, most it related to spike in housing costs, is almost as high as American consumer debt was prior to the crash and in Vancouver it is higher. And again the crisis in Europe and US was brought on by a private debt crisis, associated with various real estate booms and helped along by a spike in oil prices in the summer of 2008, that in turn created a public debt crisis. As for our much lauded banking system, Spain's banks are no less conservative in their lending practices than Canadian banks, but a real estate bubble in Spain inflated and burst nonetheless. And why has the cost of housing gone through the roof since 2006? Well, the Conservative government decided pour fuel on an already red hot real estate market. The Conservatives extended the mortgage amortization period from 25 years to 30 years in February 2006, extended it to 35 years in July of 2006 and extended 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. Ever since the down turn, Jim Flaherty has been scrabbling to undo the damage his past actions have done. Flaherty first reduced amortization period from 40 years to 35 and again mandated a 20% down payment on secondary properties and 5% on primary properties in October 2008 and on March 18th he reduced the maximum amortization period to 30 years. Never once acknowledging that it was he who raised the amortization period to begin with, Jim Flaherty has repeatedly over the course of the last 2 and half years that reducing the amortization and increasing the minimum downplayment was the right thing to do. "In 2008 and again in 2010, our government acted to protect and strengthen the Canadian housing market," The problem is it is too little too late. The best Flaherty and Conservatives can do is prevent further damage. Weather it be Bloomberg, Paul Krugman and, if you read between the lines, Mark Carney many are worried that Canada is headed for a crash that would drive Canada deep into debt. For one thing, since 2006 Canadian mortgage and housing corporations liabilities have gone from 100 billion to 500 hundred billion. If the housing bubble bursts and Canadians start defaulting on their mortgages, the Canadian tax payer will be picking up the tab. The Canadian government guarantees all that debt.