A country does not have to hit the debt wall to be taking on too much fiscal risk

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Just how bad is Canada’s fiscal situation? Is it, as the (interim) Parliamentary Budget Officer says, “alarming, “shocking,” “unsustainable,” even “stupefying?” Or, is it, as the Prime Minister insists, pretty near perfect: “strongest credit rating in the world…lowest deficit in the G7 … lowest net debt-to-GDP in the G7...”

Ummmm, both? It’s true that the government of Canada enjoys a triple-A credit rating from two of the three major bond rating agencies (S&P and Moody’s; Fitch has marked us down to AA+), though that hardly makes us the “strongest in the world.” Australia, Denmark, Germany, Luxembourg, the Netherlands, Norway, Singapore, Sweden, and Switzerland all have triple-A ratings from all three.

And yes, it’s true that our deficit and debt, in proportion to GDP, are the lowest in the G7. But it’s also true that the situation is rapidly deteriorating. The PBO’s latest report puts the deficit for the current fiscal year, 2025-26, at $69-billion, almost twice what was forecast in the last budget. (In fairness, that was nearly 16 months ago.) Moreover, the PBO shows the deficit remaining in the $60-billion range for the next several years.

Worse yet, it projects that the ratio of federal debt-to-GDP, far from falling, as the Liberal government has repeatedly promised, will continue to rise, from 41.1 per cent in fiscal 2023 to 43.7 per cent by fiscal 2029. The cost of interest on the debt, which had fallen to as low as seven per cent of revenues, is projected to hit 14 per cent.

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Which would be sobering enough, were these not almost certainly substantial underestimates. The PBO acknowledges as much. “Due to limited information provided,” it says, “the outlook does not fully reflect the Government’s North Atlantic Treaty Organization (NATO) commitment to increase defence expenditures to 3.5 per cent of GDP by 2035 and the additional 1.5 per cent of GDP spending commitment toward critical defence and security-related expenditures.”

Neither does it include, as the PBO’s director of fiscal analysis Kristina Grinshpoon told a Commons committee the other day, $20-billion of proposed spending included in the Liberals’ spring election platform.

What does the picture look like when these are included? The economist Trevor Tombe calculates the deficit is on track to come in not at the $30-billion-plus projected in the 2024 budget, nor the $60-billion-plus in the PBO report, but more than $90-billion – not just this year, but every year for the next several years. This is strikingly close to the estimate published in July by the C.D. Howe Institute. Should the economy continue to weaken, as it has in recent months, it is not hard to see the debt-to-GDP ratio approaching 50 per cent.

International comparisons, then, are not necessarily relevant. If our debts look less daunting than our G7 comparators, it may only be because they’re in even more of a mess than we are. Which, as Prof. Tombe notes, may in fact make our situation even more perilous: if every country is borrowing massive amounts from the same pool of global capital, it makes it that much harder to sell your bonds. To say nothing of the risk of contagion, as fears about one sovereign creditor spread to the others.

A final note: Canada’s debts look a lot less comforting next to other countries’ when gross debt, rather than net debt figures, are used. Net debt is gross debt minus assets, which in Canada’s case includes the $732-billion squirrelled away in the Canada Pension Plan. But these are needed to finance the pensions the CPP is legally obliged to pay its beneficiaries. Focusing on net debt, rather than gross debt, as a measure of how sustainable our debts are assumes that, in a crunch, the government could just stiff the country’s roughly seven million pensioners (that’s CPP only: it’s approximately nine million, if you include the Quebec Pension Plan). That’s unlikely, to say the least.

Fiscal hawks can take a certain grim satisfaction from these numbers. For years, as the federal government racked up big deficit after big deficit, well before the pandemic and years after it, we were told that “historically low interest rates” made concerns about the debt irrelevant. Those who suggested that at some point perhaps interest rates would no longer be so historically low were told they were stuck in the 1990s, that by any measure our debts were nothing like what they were then.

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Which of course was true. But you know what they say about “events.” And events began to crop up, one after another, with distressing frequency. The pandemic. War in Ukraine. A spike in commodity prices, followed by a spike in inflation, followed by a spike in interest rates. War in the Middle East. And through it all federal spending, and federal borrowing, continued to rise.

Then Donald Trump returned to power, and soon after began tearing apart the world economy, not to say bankrupting his own. Emboldened, Russia began to menace, not just Ukraine, but other countries in the region. Canada found itself having to rethink its foreign, trade and defence policies from the ground up. And through it all, federal spending and borrowing continued to rise.

Which is how we got to our present pass, with a debt-to-GDP ratio that will soon be half-again as high as it was just five years ago. Yet even today, it’s easy to be complacent. You say debt-to-GDP is nearing 45 per cent? That’s still barely two-thirds what it was at its early 1990s peak. Yawn.

In truth it is the what-me-worry camp that is stuck in the 1990s. The implication is that as long as the wolf is not actually at the door – as long as our debts have not reached the point where we might not be able to sell our bonds, as was very nearly the case then – we have nothing to worry about.

But if there is anything the last few years should have taught us – if there is anything the 1980s and 1990s should have taught us – it is that things happen you cannot predict, and numbers change in ways you would not have thought possible. As late as 1977, the federal debt-to-GDP ratio was just 20 per cent, less than half what it is today. But by 1985 it had doubled, and by 1993 it had tripled. Things can change, fast.

Risks of this kind are not of the binary, on-off, safe-unsafe variety. The tendency to think of them in this way is an example of what might be called Micawberian economics. You will recall Mr. Micawber’s advice to David Copperfield: “Annual income twenty pounds, annual expenditure nineteen nineteen six, result happiness. Annual income twenty pounds, annual expenditure twenty pounds nought and six, result misery.”

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But in the real world, results tend to fall somewhere in between happiness and misery; risks, likewise, are measured more in increments, at the margin. Fiscal policy involves a series of choices – a little more risk, a little less – that may each seem individually too small to worry much about. But they compound over time, and it is over time that their effects are most likely to be felt. All the same, they remain risks, not certainties. Which makes it hard for human beings, obsessed as we are with the here and now, to focus on them.

What we know is that the larger our debts relative to our income, and the longer we leave them there, the more exposed we are to the risk of “events.” Does that mean we should take on no debt whatever, or devote all of our income to paying debt down to zero? No. A certain amount of additional debt is worth a certain amount of additional risk. Debt can even improve a country’s finances, as it can with individuals, if it funds investments that pay lasting dividends, to the economy and the treasury. But obviously there is such a thing as too much debt.

How much is too much? Frustratingly, there are no firm rules we can turn to. There have been attempts to calculate “threshold” values of debt-to-GDP – for example, Carmen Reinhart and Kenneth Rogoff’s famous 90-per-cent estimate – beyond which a country is likely to run into trouble. But even if we attach much significance to that number, that obviously doesn’t mean a country can rocket all the way up to 90 per cent without undue risk. By that point you might have built up so much momentum as to be unable to stop from crashing through the barrier.

So somewhere short of that, to be safe? But how much short? And whatever the level of debt, what about the trend? How fast, for how long, can the debt-to-GDP ratio be allowed to grow? I’m afraid these are all judgment calls. We are condemned to use our heads.

Could we not nevertheless set some sort of rough-and-ready rule, as a guide – and to keep us from the temptation to run up debts today that future generations will have to pay? Yes. Rules are in bad odour at the moment. The Trudeau government kept setting fiscal rules for itself that it failed to obey. The last and least binding of these, a constantly declining debt-to-GDP ratio, is the one we are now waving goodbye to.

Balanced budget laws, similarly, are generally held to be useless. In the crunch, a government that is desperate enough will simply override them. Short of entrenching fiscal rules in the constitution – and good luck with that – it seems governments will always find a way around them.

But just because rules are not perfectly binding does not mean they can’t be helpful. To be sure, a rule is only as solid as the underlying political culture: unless there is a consensus against deficits, as there was in Canada for two decades after the 1990s fiscal crisis, vote-seeking politicians will run them, rule or no rule.

But if rules are downstream from culture, it is equally true that culture is downstream from rules. Sensibly drawn rules can help to shape and cement the necessary popular consensus. The mere discussion – what sort of rule – can be helpful in itself. That’s the sort of discussion we might start having now.