The Incredible Shrinking Federal Government

The Federal government will be releasing their fall economic update today and so this is as good a time as any to review Canadian federal government finances.  Contrary to my earlier expectations, I guess the Federal government may indeed be about to balance its budget by 2015/16 judging by early press reports regarding today’s Federal fall economic statement that will be released in Edmonton. 

My earlier pessimism regarding the ability of the spring 2013 federal budget to balance the books by 2015/16 was rooted primarily in the expectations of revenue growth being as optimistic as the federal government seemed to be predicting.  However, while revenue growth is likely to still be soft, the federal government has been quite aggressive on the cost side.  The last few years have seen a real steep drop in the program expenditure to GDP ratio after the surge in 2009. 

The program expenditure to GDP ratio surged from 12.9 percent in 2008/09 to 15.8 percent in 2009/10 as GDP growth slowed and stimulus spending rose in the wake of the 2009 recession.  However, by 2012/13, the program expenditure to GDP ratio was down to 13.5 percent.  The federal revenue to GDP ratio also fell during this time period but more gradually, from 14.4 percent in 2008/09 to 14.1 percent by 2013/13.  After a few years of stablity, the revenue to GDP ratio begins its drop in 2006/07 prior to the 2009 recession – coinciding with the second GST rate cut. 

 There is a primary surplus with revenues exceeding program spending.  The rest of the deficit is due to debt charges and even those have been dropping as a share of GDP as the accompanying figure shows.  Three things strike me here.  First, the federal government is indeed on the road to fiscal sustainability as taken over the long term (going back to the 1990s), the expenditure to GDP ratio has been falling faster than the revenue to GDP ratio – most of this in the wake of the federal fiscal restructuring of the 1990s. Second, without the two GST tax rate cuts and all other things given,  the federal budget might be balanced already.  Third, it would appear that the federal government does indeed now have a smaller footprint and is back to the size it had in the mid 1960s.  With tax cuts on the horizon in the run-up to the next federal election, the question is how much lower will it go?

Comments

[RPLong]

We sure could use a dose of that Canadian good-sense down here south of the border.

[Ralph Musgrave]

I don’t agree with the suggestion that a surplus equals “fiscal sustainability”. Reason is thus.

Assuming the 2% inflation target, and assuming to keep things simple that the national debt plus monetary base stay constant at say 50% of GDP in the long term, that means the real value of the debt and base will shrink in real terms. And that means they’ll have to be topped up which can only be done via a deficit. Plus if there is real growth of say 2%, then even more “topping up” is needed. In fact taking the above figures, the deficit would need to be (2+2)x50% of GDP which is 2% of GDP. And that would be perfectly “sustainable” in the long run.

[RPLong]

Ralph - I don't know about you, but I'd be tickled pink if the value of my debts shrank in real terms. I'm not sure I'd be inclined to top them up. I might think about topping up my consumption or investments instead.

But maybe I don't understand what you're getting at.

[Nick Rowe]

Ralph is right that if deficit=(NGDP growth rate)x(debt/GDP ratio) then the debt/GDP ratio will be constant over time, and sustainable in that sense. But maybe we want to bring down our debt/GDP ratio back to what it was before the crisis (just in case there's another crisis). Plus, the demographics don't look good, and we might want to bring down the debt/GDP ratio before the worst of the demographic effects of aging boomers hits.

[Jacques René Giguère]

So we will decrease the public debt to let us have a higher private debt? Unless,as Nick points out, we deleverage? And so provoke the very recession we need to avoid if we want to pay the boomers retirement?

[RPLong]

I don't understand. This all sounds too clever by half to me. The idea that eliminating government debt will precipitate a recession or prove fiscally unsustainable doesn't appear to make sense, or I am just majorly dense (probably the latter). There is a difference between public and private debt in that public debt is economy-wide and constrains future economic growth via tax liabilities, while private debt just cancels itself out since one man's accounts payable is another man's accounts receivable.

I know I'm missing something, but I can't see it. Can someone help me?

[Ralph Musgrave]

R.P.Long,

National debt is an asset as viewed by the private sector holders of that debt. And it’s an asset (at least at low interest rates) that is little different to money itself – or monetary base to be exact. I.e. monetary base is a liability of a sort of the government / central bank machine, and so too is national debt.

So if the monetary base or debt are reduced too far, the private sector might regard itself as holding too little by way of paper assets. So the private sector might then start trying to save, and that produces Keynes’s famous “paradox of thrift” unemployment.

There is then the question as to whether those paper assets should consist of debt and base, or just base. Warren Mosler and Milton Friedman have argued for the 2nd option. Though if we retain a national debt and keep the interest rate below the rate of inflation, then government makes a profit out of its creditors, which is an option I’d be happy with.

[The Keystone Garter]

Observing the past few years, in a recession private debt is worse as little guys are first to be wiped out in a flight to quality. In booming growth, federal public debt is worse as interest rates rise. The debt i at an all time high. I think Livio and the CPC are delusional to expect we will see near zero interest rates for the next three years. Contrarily to the lies of the Speaker of the House, the CPC ran deficits in boom times and deficits in plateaued growth or recession. I expect unexpected costs to the federal gvmt without unexpected tax increases.
The alternative would be testing negative interest rates in this fractional banking system. It is clear to me AGW will reverse the development of major Asian seaboard cities via typhoons. We are destroying our own future commodities market yet still racking up debt and transfer wealth to the savings accounts of CEOs much dumber (in Canada) than are MPs.

[JW Mason]

So what do we think is the optimal debt-GDP ratio?

[Nick Rowe]

JW: There is very little theory on that question, AFAIK.

There is the Barro-Pigou tax-smoothing hypothesis, which basically says "keep the debt/GDP ratio at whatever it is right now".

I did a paper once with Vivek Dehejia, where we added uncertainty and a Laffer curve to the Barro model, and found you should plan to slowly reduce the debt/GDP ratio over time (to what level???).

In Canada, the theory seems to be: "25%!"

[Livio Di Matteo]

Re:Keystone Garter
Delusional? Moi? Why? Because I pointed out empirically that debt service costs as a share of GDP have declined? Who said anything about expecting near zero interest rates for the next three years? Have I missed something.? Am I using too many interrogatives?

[rsj]

How about increasing the debt if r < g until r = g, and decrease the debt if r > g until r = g ?

[The Keystone Garter]

I like your chart, Livio. It is the balanced budget forecast; even if the budget is temporarily balanced, it won't last. Far from it with corporate tax rates set to fall more. Our public debt was about $450B in 2007 and is about $600B now. What were debt servicing interest rates in 2006, 4%. What are they now? 1%. Someone published a paper that 90% debt/GDP ratio triggered runs where the debt itself lead to default or crippling public service cuts. I'd guessed about 105%. Our major trade partner is there this year...rsj, that sounds great below the 90% boundary. Once you get to 75% I'd pay it off regardless, the EU thinktank figure would be +/- 14%.
I'm frustrated by the stupidity. Non-financial cdn corporate cash was at about $525B early in 2012. It was about $375B in 2009. If all we get for these tax cuts and misinformation about a carbon tax, is cash in corporate accounts, the gvmt should be undoing its worst tax cuts: no pragmatism. We should not elect leaders from nor hold shares of companies from, places whose 0.5% Ph.D graduation rate is below the 8.5% national avg. Prolly just missing 1.5 yrs of key core courses.

[RPLong]

Ralph - Thanks for the reply. That helps. I remain skeptical, but you've pinpointed the concept I wasn't giving proper consideration. I'll have to think through this some more.

[Andrew F]

Any thoughts on replacing some or all public debt with Shiller's 'trill'? Then, to my mind, the face value of the debt is less important than what share of GDP is spoken for by debt service costs.

[The Keystone Garter]

Part of the automatic stabilizer built into the present system is the flight to quality. It permits Keysensian spending in a recession at hardly any interest charges. On the flipside, when the economy is humming and inflation threatens, you are forced to pay down debt rather than espouse the false "don't break the momentum" rhetoric. When interests rose for Mediterranea, that was it; their economies broke. They didn't pay down debt in the late 1990s like Chretein suggested. Up until 2006 on that chart, we were paying down debt. After 2006, the fall in debt charges is from lower cdn interest rates. If interest rates go to 5%, the debt charges will shoot up to 10% and unless we have a gvmt raising taxes to Chretein levels, we will experience Mediterranea without the ability to laze on the warm beach. Andrew, the debt servicing costs are far more volatile than is total public debt. Maybe we are entering a new economic milieu where interests stay flat for generations or where they go negative sometimes, but I'd guess not and that they will rise. Eventually, rich people will pull their money out of cdn federal instruments. I hope into future WMD sensors and regenerative medicine. I think the trouble with Trills is they are hyperinflationary. Debt isn't a part of GDP measures. A bad leader leading dumb people would just run a massive deficit and keep financing it with Trills. Maybe a better balance sheet measure (Green GDP and such forth) and account for Stimulus spending needs. If the USA doesn't increase food stamps in their recession they probably double their prison population.