What Caused the Build-Up of Canada s Public Debt?

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1 What caused the Build-Up of canada s Public Debt? 1 What Caused the Build-Up of Canada s Public Debt? In Chapter 32 we discuss government debt and deficits and why these matter, not only for the conduct of macroeconomic policy but also how they affect the long-run living standards of consumers and taxpayers. In a box on page 818 we use simple algebra to derive an equation showing how the debt-to-gdp ratio changes over time. In this web-based section, we use a slightly modified version of this equation to explain the various components in the build-up of Canada s federal public debt over the past three decades. The Evolution of the Debt-to-GDP Ratio As we show in the textbook, the change in the debt-to-gdp ratio can be shown with a simple equation: d = x + (r g)d (1) where d is the debt-to-gdp ratio at the end of the previous period (usually the year), x is the primary deficit as a share of GDP during the period, r is the real interest rate, g is the growth rate of real GDP, and d is the change in the debt-to-gdp ratio during the current period. As we explain at length in Chapter 32, the primary budget deficit is the excess of program expenditures (discretionary spending) over tax revenues, and this can change for two quite different reasons. First, it can change because of a change in the government s fiscal policy a decision to change the level of program spending or the level of tax revenues. Second, it can change because the level of real GDP changes, thus influencing the government s level of tax collection or transfer payments, even in the absence of a change in fiscal policy. To separate these two distinct effects on the size of the debt-to- GDP ratio, we modify the right-hand-side of equation (1) slightly by adding and subtracting x*, the primary budget deficit when the economy is operating at its capacity level of output potential output. d = x* + (x x*) + (r g)d (2) This modified equation shows three distinct forces acting on the debt-to-gdp ratio. First, the structural component (x*) is the primary deficit when the economy is operating at potential output. Other things being equal, an increase in x* leads to an increase in the rate of debt accumulation. Second, the cyclical component is the difference between the actual primary budget deficit (x) and x*. Other things being equal, a reduction in real GDP created by a slowdown in growth will lead to an increase of x above x* and thus to an increase in the rate of debt accumulation. Third, the rate component is the difference in the real interest rate and the GDP growth rate, all multiplied by the current debt-to-gdp ratio. Other things being equal, an increase in the real interest rate or a decline in the GDP growth rate will lead to an increase in the rate of debt accumulation. To see how this decomposition is useful in the analysis of real-world government debt, we apply this equation to the Canadian federal debt beginning in These data and analysis are based on that by Ronald Kneebone and Jennifer Chung from the University of Calgary and is found in their excellent paper Where Did the Debt Come From? 1 1 See Is the Debt War Over?, edited by Christopher Ragan and William Watson, published by the Institute for Research on Public Policy, 2004.

2 2 What caused the Build-Up of canada s Public Debt? The Evolution of Canadian Federal Debt, The application of equation (2) to actual data requires some assumptions in order to construct a measure of x*. Two different sets of assumptions or estimates are needed. First, the potential level of GDP is not directly observed and must therefore be estimated. The federal Department of Finance, the Bank of Canada, and several private forecasters provide different estimates. The various estimates are not identical, and there is some disagreement over the path of potential output during specific intervals, but there is broad agreement over the general path of potential output. Second, some assumption must be made regarding the sensitivity of the primary budget deficit to changes in the value of real GDP in other words, it is necessary to estimate the slope of the (primary) budget deficit function (recall the discussion in the textbook on pages 815 and 816). Kneebone and Chung estimate that a one-percentage-point increase in real GDP reduces the primary deficit by 0.23 percentage points of GDP. With these estimates in hand, Kneebone and Chung are able to construct a time series for x* for the Canadian federal government. Figure 1 shows the annual contributions to the change in the debt-to-gdp ratio coming from the three distinct components, each component represented by the vertical bars of different shading. The continuous line simply connects the cyclical contributions and thus gives a quick impression of the business cycle during this 30-year period. (Periods when the cyclical contributions to the debt ratio are negative are periods when real GDP exceeds potential GDP; periods when the cyclical components are positive are periods when real GDP is less than potential GDP.) FIGURE 1 Annual Contributions to the Federal Debt-to-GDP Ratio Percentage Points of GDP Structural Component Cyclical Component Rate Component

3 What caused the Build-Up of canada s Public Debt? 3 We begin with the cyclical component, the green vertical bars. We see that in times when the economy is operating above potential output, such as the mid-to-late 1970s and the late 1980s, the cyclical component is negative, acting to reduce the debt ratio. This is sensible since during such boom periods tax revenues tend to be high and government transfers tend to be low. In contrast, in periods when the economy is operating below potential output, such as immediately after the recessions in the early 1980s and 1990s, the cyclical component is positive, acting to increase the debt ratio. Not surprisingly, however, the cyclical component tends to cancel itself out over a period of many years; the debt-reducing years of economic booms are offset by the debtincreasing years of economic slumps. Next consider the rate component, as shown by the blue vertical bars. During the 1970s real interest rates were low (negative in the mid 1970s!) and GDP growth rates were relatively high; the result was that the rate component was negative, acting to reduce the debt-to-gdp ratio. Indeed, the magnitude of this separate component was significant, especially in the early 1970s and early 1980s. From the mid 1980s to the mid 1990s, however, real interest rates had increased and GDP growth rates had declined (both partly because of the disinflation policies in place at the beginning of each decade). The result was that the rate component turned positive, and sharply so in the early 1990s. Only by the late 1990s had the rate component fallen from its very high levels at the beginning of that decade. Now consider the structural component, clearly the largest contributor to changes in the debt-to-gdp ratio over the three decades shown in the figure. The vertical red bars show the annual contributions to the debt ratio due to the structural component the decisions by the federal government to change program spending or total tax revenues. As is clear in the figure, the structural contribution to the debt ratio rises from below 1 percentage point in the early 1970s to between 3 and 4 percentage points from the mid 1970s to the mid 1980s. Only in the mid 1980s, under the Conservative government of Brian Mulroney, does the structural component begin to fall. Only under the subsequent Liberal government of Jean Chrétien is there success in turning this component around into significant negative values indicating that the structural component is then reducing the debt-to-gdp ratio. Figure 1 shows the annual contributions to the debt-to-gdp ratio but does not add them up to show the cumulative effect over time. This cumulative effect is shown in Figure 2, where the three continuous lines show the cumulative effect of the three separate components, whereas the vertical bars show the path of the overall federal debt-to- GDP ratio. In other words, the height of the vertical bar in any period (the debt ratio in that year) is given by the sum of the three values as shown by the three lines. Note that in 1970 the federal debt-to-gdp ratio was very close to 20 percent. It is important to keep in mind that the values shown in Figure 2 are relative to that base of 20 percent. Thus, in 1988, for example, the height of the vertical bar is 30 percent, indicating that the cumulative effect of the three components since 1970 has been to increase the debt ratio by 30 percentage points to a total of 50 percent of GDP. The structural component begins a substantial increase in the mid 1970s, as government tax revenues fall further and further behind growing program spending. But during this same period, the effect on the overall debt is muted because the rate component is negative (real interest rates below the growth rate of real GDP). Thus the structural increases in the government s debt ratio were largely hidden by the favourable rate component at the time. The problem, however, is that the rate component can change quickly, whereas the structural component, being much more entrenched in established policies, is harder to change. The early 1980s witnessed precisely this kind of turnaround in the rate component. As real growth rates dropped and real interest rates increased, the negative contribu-

4 4 What caused the Build-Up of canada s Public Debt? FIGURE 2 Cumulative Contributions to the Federal Debt-to-GDP Ratio Net Debt Structural Component Cyclical Component Rate Component Percentage Points of GDP tions from the rate components turned into large positive contributions (see Figure 1). In Figure 2 we therefore see the cumulative rate component start to increase. But there is no significant change in the structural component during this period, so the overall debt ratio continues climbing, reaching 30 percentage points by 1989 (above the base of 20 percent from 1970). And then, in the early 1990s, the rate component rises very sharply and, even though the structural component is roughly stable, the overall debt ratio climbs even higher, to about 48 percent in 1996 (above the 20 percent base from 1970). At this point, many economic observers viewed Canada as being against the debt wall. Following the dramatic deficit-reduction policies instituted by the Liberal government of Jean Chrétien, especially following the 1995 federal budget, the structural component continued its sharp downward trajectory (which had begun under the Conservatives in the late 1980s). Despite the tendency of the rate component to remain at significant levels throughout the 1990s, the combined effect was to sharply reduce the overall debt ratio, from its high of 68 percent in 1996 to about 49 percent in 2001, and it continued to fall to about 44 percent by the time of the 2004 federal budget. Some Simple Lessons? The first lesson that can be drawn from this exercise is that the three distinct components all influence the overall debt ratio but their changes are caused by different things. A full

5 What caused the Build-Up of canada s Public Debt? 5 understanding of where the debt comes from must therefore recognize this distinction and understand the movements of the three separate components. The government has the most direct influence on the structural component its spending and taxing policies determine whether the primary budget will be in deficit or surplus when the economy is operating at potential output. In contrast, the government only has an indirect influence on the cyclical and rate components. Changes in the government s fiscal (and monetary) policies will lead to changes in the growth rate of real GDP and thus to changes in the cyclical component, but these effects may be small relative to the other, non-policy sources of economic fluctuation. In addition, the government s policies will surely have an influence on real interest rates and GDP growth rates, at least in the short run, but other factors are also very important in driving changes in the rate component. Nonetheless, governments must recognize that their policies will have some effect on both the cyclical and rate components. The second lesson that should be drawn from this exercise is for policy analysis; the rate component is prone to sudden and significant swings, whereas the structural component, being based on policies that tend to be entrenched and with considerable political inertia, is difficult to change over short periods of time. As Figure 2 shows so clearly, the increase in the overall debt ratio was very modest until 1983, and until then there was no clear debt problem. But in fact the structural component at that time had increased markedly from a decade earlier but was being hidden by a favourable rate component. When the rate component turned around suddenly in the early 1980s, and then sharply increased again in the early 1990s, the effect on the overall debt ratio was dramatic. But it took considerable time and effort and political consensus to reduce the structural component, which did not begin its significant fall until the late 1980s. By that time the overall federal debt was well on its way to its high of 68 percent of GDP. If this exercise in debt decomposition had been done in the late 1970s or 1980s, the government of the day may have seen the truth that the un-alarming overall debt picture of the mid 1970s or even early 1980s was based largely on a very favourable rate component hiding an unfavourable structural component. Reasoning that the rate component might change quickly, a strong case could have been made at that time to reduce the large and growing structural component. There would naturally have been some political opposition to such a change (as there usually is to spending cuts and/or tax increases), but at least it would be clear from the overall decomposition exercise that the structural component was adding significantly to overall debt.

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