Debt Accumulation, Debt Reduction, and Debt Spillovers in Canada, *

Transcription

1 Deb Accumulaion, Deb Reducion, and Deb Spillovers in Canada, * Ron Kneebone Deparmen of Economics Universiy of Calgary John Leach Deparmen of Economics McMaser Universiy Ocober, 2000 Absrac Wha have been he causes of he accumulaion of governmen deb in Canada? How large have been he respecive conribuions of high ineres raes, low growh raes, he business cycle, and changes o ax raes and program expendiures? To wha exen have he fiscal choices of members of he Canadian economic union impaced upon one anoher? This paper invesigaes hese quesions and finds ha he causes of deb accumulaion a he federal level differ subsanially from he causes of provincial governmen deb accumulaion. Wha s more, we find ha he fiscal policy choices of he federal governmen have had a negaive impac on he effors of he provinces o conrol heir accumulaion of deb. This paper was presened a he Fiscal Federalism: Working Ou he Fuure conference, Regina, Ocober 12 and 13, The conference was sponsored by Saskachewan Finance and Saskachewan Insiue of Public Policy. * We should like o hank Peer DeVries and Janine Robbins, boh of he Deparmen of Finance, for assising us wih he daa. The views expressed in his paper are hose of he auhors. 1

2 1. Inroducion Wha have been he causes of he accumulaion of governmen deb in Canada? How large have been he respecive conribuions of high ineres raes, low growh raes, he business cycle, and changes o ax raes and program expendiures? To wha exen have he fiscal choices of members of he Canadian economic union impaced upon one anoher? These are quesions his paper addresses. Figure 1 graphs raios of ne deb-o-oupu for Canadian governmen secors. 2 This picure is a familiar one. Deb-o-oupu raios reached a minimum in 1974 following a long and seady decline from pos-war highs. Afer 1974, deb-o-oupu raios climbed upward, wih he occasional slowdown during periods of srong growh, before reaching peaks in Since 1995, srong fiscal measures and very srong economic growh have combined o pu deb raios on a downward rajecory. Figure 1: Ne Deb-o-Oupu Raios Toal Governmen Federal Provincial/Local Undersanding he reasons for he rise in deb-o-oupu raios is imporan for undersanding wha can be done o preven such occurrences in he fuure. Was deb 2 Ne deb is measured as direc liabiliies less financial asses as defined in he Naional Balance Shee Accouns. Ne deb is divided by GDP a facor cos. Daa provided o us by he Deparmen of Finance (and discussed below) were generaed using GDP a facor cos. For consisency, we use his measure of GDP hroughou. Toal Governmen includes he federal, provincial, and local governmens, public hospials, and he CPP and QPP accouns. Public hospial accouns are subsumed in he provincial/local governmen secor. The fac he CPP and QPP were in ne asse posiions hroughou his period explains why oal governmen deb is a imes less han he sum of federal and provincial/local deb. See he Appendix for daa sources. 2

3 accumulaion due o inappropriae seings of ax raes and spending propensiies or because of an unforunae and unique urn of evens? If he former, serious quesions mus be raised abou fiscal policy seings. If he laer, such quesions may no be appropriae. I is also useful o gain some undersanding of he relevance of deb spillovers: deb induced exernaliies imposed by one member of a moneary union on ohers in he form of higher ineres raes and/or slower economic growh raes. Concern over such spillovers was behind he European Moneary Union s imposiion of defici and deb resricions. Canada provides a very useful laboraory for examining he imporance of such spillover effecs in a moneary union. 2. The Deb Dynamics Ideniy The change in he deb-o-oupu raio from one year o he nex is given by he ideniy; D Y D PDEF ( R G ) D 1 1 = + (1) Y 1 Y Y where D is public ne deb a he end of calendar year and Y and G are naional oupu and he growh rae of naional oupu over he same calendar year. R is he average ineres rae on exising deb during he calendar year, and PDEF is ha year s primary defici. 3 The primary defici changes wih he srucure of governmen programs and wih changes in he level of oupu. The former reflec changes in fiscal policy while he laer reflec he affecs of auomaic sabilizers. To separae hese wo ypes of changes in he primary defici, we follow a procedure suggesed by Forin (1996) and re-wrie he deb dynamics equaion as: D Y D PDEF PDEF PDEF * * 1 1 = + ( R G ) * * Y 1 Y + Y Y (2) Y D where PDEF * and Y * are he cyclically-adjused primary defici and poenial oupu in calendar year. The cyclically-adjused primary defici measures wha he primary defici would be if acual oupu was equal o poenial oupu. Equaion (2) divides each year s change in he deb-o-oupu raio ino hree componens. The firs erm on he righ hand side is he srucural componen. I measures he increase in he deb-o-oupu raio ha is aribuable o he srucure of he governmen s spending and axaion programs. If he design of hese programs leads o a primary defici even under he mos favourable circumsances an economy operaing a poenial oupu heir design is conribuing o a rise in he deb-o-oupu raio. The second erm is he cyclical componen, which measures he increase in he raio ha occurs because he economy is no operaing a poenial oupu, so ha spending is inordinaely high and revenues are inordinaely low. The hird erm is he rae componen. If he primary defici were zero, so ha all of he ineres on he exising 3 See he Appendix for deails on definiions and daa sources. 3

4 deb were paid by issuing new deb, he growh rae of he deb would be equal o he ineres rae. The growh rae of he deb-o-oupu raio would hen be equal o he difference beween he growh rae of he deb (R ) and he growh rae of oupu (G ). The rae componen measures he increase in he deb-o-oupu raio ha occurs because here is a gap beween hese wo raes. Using his approach, Forin (1996) concluded ha he cyclical componen was responsible for 60% of he accumulaion of oal governmen deb beween 1981 and The remaining 40% was due o he rae componen wih he srucural componen conribuing virually nohing o he accumulaion of deb. Forin s resuls have been cied by hose wishing o argue ha spending on social programs in he 1970s and 1980s was no responsible for deb accumulaion and, by implicaion, should no be par of he effor a deb reducion (McQuaig 1996). Forin himself has used his resuls o poin he finger a he Bank of Canada (who he suggess is on he hook for he rae componen) and unforunae world economic evens (on he hook for he cyclical componen) as being responsible for deb accumulaion. Forin s resuls are conroversial. They have promped a rebual from Freedman and Macklem (1998) who argue Forin s definiion of poenial oupu biases his resuls and who emphasize he imporan role of he level of deb, and he direcion of change in he level of deb, in affecing ineres raes. They argue ha by ignoring his linkage, Forin places oo much blame on he rae componen, and hence he Bank of Canada, for he accumulaion of governmen deb. In he following secion, we begin our sudy of deb accumulaion in Canada using hese hree componens. Alhough we follow Forin s basic approach, we inroduce four significan changes. Firs, we add 5 more years of observaions ( ) no available o Forin, and we include 7 more years of observaions ( ) ha Forin chose o exclude. Second, we use differen, and we hink more appropriae, definiions of poenial oupu (Y * ) and he cyclically adjused primary defici (PDEF * ) han Forin employed. Third, we correc a measuremen error in Forin s calculaions. Finally, whereas Forin examined he accumulaion of he oal governmen secor, we consider separaely he accumulaion of deb by hree sub-secors of he oal governmen secor: he federal governmen, he provincial/local governmen secor, and he public pension plan (CPP/QPP) secor. 4

5 3. The Accumulaion of Deb In decomposing he sources of deb accumulaion ino he srucural and cyclical rae componens, he definiions of poenial oupu and he cyclically adjused primary defici are criical. The srucural componen implicily defines fiscal reciude. Programs should be designed so ha he primary defici is in balance a poenial oupu. If observed oupu is below poenial, here will be a endency for he deb-o-oupu raio o rise, bu his is due o he business cycle. If poenial oupu means maximum susainable oupu, so ha observed oupu falls shor of poenial in recessions and surpasses i in booms, programs srucured in his fashion will push up he deb-o-oupu raio in recessions and drive i down in booms. They will have no longer-erm effec on he deb-o-oupu raio and hence are appropriaely designed. By conras, if poenial oupu means maximum possible oupu, programs designed in his fashion will have no effec on he deb-o-oupu raio in a booming economy, push i up a lile in a so-so economy, and push i up a grea deal in a falering economy. I is difficul o argue ha a fiscally responsible governmen should se ax raes and spending propensiies in his fashion. Forin measures poenial oupu wih a peak-o-peak mehod. Tha is, he idenifies years in which he believes he economy was a poenial oupu. He hen assumes poenial oupu grows linearly beween peaks. Thus observed oupu is occasionally equal o poenial bu is oherwise below. The cyclically adjused primary defici is calculaed on he basis of he esimae of poenial oupu. His approach, hen, is consisen wih he means maximum possible oupu definiion of Y *. As a resul, he cyclical componen will be larger han i would be if he maximum susainable oupu measure is used. Raher han follow Forin s approach, we employ esimaes of poenial oupu and he cyclically adjused primary defici consruced by he Deparmen of Finance. These are more conservaive measures. In paricular, poenial oupu is now consisen wih maximum susainable oupu. Similarly, he cyclically adjused primary defici moves ino surplus in a booming economy. A second modificaion o Forin s basic approach is o recify a problem in he daa in an unbiased way. Daa on he governmen s financial asses and liabiliies is conained in he Naional Balance Shee Accouns. Daa on revenues and expendiures is conained in he Naional Economic and Financial Accouns. In heory, hese accouns should mach in he sense ha daa drawn from he laer should explain all of he annual changes in he former. In pracice, hey do no mach, and he discrepancies are summarized by reconciliaions conained in he Naional Balance Shee Accouns. 4 Forin s approach was o calculae he srucural and cyclical componens direcly and o calculae he rae componen as a residual. This approach causes he reconciliaions o be included in he rae componen. We have insead chosen o rea he reconciliaions as a separae facor, as a fourh erm on he righ hand side of he deb dynamics equaion. 4 For more deail, see he Appendix. 5

6 Table 1: Explaining he Accumulaion of Toal Governmen Deb, Toal Governmen Change in Deb-o-Oupu Raio due o: o Srucural Componen o Cyclical Componen o Rae Componen o Daa Reconciliaion Table 1 presens calculaions for oal governmen over wo periods. Forin examined he period. Here we see ha using more conservaive measures of poenial oupu and he cyclically adjused primary defici changes Forin s conclusions. Whereas Forin concluded he srucural componen had virually no role in deb accumulaion, here we noe ha i accouns for 30% of he explainable increase in he deb-o-oupu raio. The cyclical and rae componens now explain 47% and 24% of he explainable increase, down from Forin s esimaes of 60% and 40% respecively. During his period, he deb-o-oupu raio increased dramaically. I is noable ha during his period, he rae componen was posiive. Also imporan is ha fiscal policy choices, as refleced in he srucural componen, added over 16 percenage poins o he federal deb-o-oupu raio. The decision o begin an examinaion of he deerminans of deb accumulaion in 1981 is misleading. As we saw in Figure 1, he deb-o-oupu raio for oal governmen sopped shrinking and began increasing a he end of Beween 1974 and 1981, he deb-o-oupu raio increased by almos nine percenage poins. While i is rue ha he raio began is mos precipious climb in 1981, he reason for he increase in deb in he earlier period can help explain he rise in he laer. The firs column of Table 1 looks a he period. Key here is he negaive rae componen. During his early period of deb accumulaion, he imporan ineres-rae growh-rae differenial was such o cause he deb-o-oupu raio o fall, ceeris paribus. The effec of he business cycle almos exacly offses his favourable influence. During his period, he deb-o-oupu raio need no have increased a all bu for he srucural componen ha added 10 percenage poins o he raio. Adding daa from he period o he calculaions shows ha over he whole period, which closely corresponds o he period of deb accumulaion, he rae componen conribued virually nohing o he increase in he deb-o-oupu raio. The srucural componen added over 26 percenage poins o he raio 40% of he oal idenifiable increase. So far, we have looked only a he oal governmen secor; he sum of he federal, provincial, and local governmens plus he accouns for he Canada and Quebec Pension Plans. I would be surprising if he evoluion of deb did no differ across secors of governmen. The CPP/QPP accouns have a rhyhm quie disinc from he accouns for he res of he governmen secor, more generaional han cyclical. Wha s more, i seems inappropriae o accoun for wha was a large ne asse posiion in hese accouns for he pas 25 years bu no accoun for he large unfunded pension liabiliy. For hese reasons, 6

7 we removed he pension plan accouns from furher consideraion. Forunaely, he Deparmen of Finance was able o provide separae esimaes of he cyclically-adjused primary defici for he federal governmen and for he provincial/local governmen secor. Table 2 presens resuls for he federal governmen and for he provincial/local governmen secor. Calculaions for wo sub-periods are presened. The period corresponds o he period of deb accumulaion while he period corresponds o he recen period of budge rerenchmens and deb reducion. Ineresingly, during he period, he sources of deb accumulaion differed significanly beween he federal governmen and he sub-naional governmens. The rae componen was roughly he same size for he wo levels of governmen bu was opposie in sign. For he sub-naional governmens, he ne ineres rae was much lower han for he federal governmen owing o he large ne asse posiions of Albera, Briish Columbia and Saskachewan during par of ha period and he relaively small ne deb of he larges province, Onario. As a resul, even hough he rae of oupu growh was he same for he sub-naional as he federal secor, he rae componen conribued o deb reducion for he sub-naional secor while i conribued o deb accumulaion for he federal governmen. On he oher hand, he cyclical componen was much larger for he sub-naional governmens han for he federal governmen. Undoubedly his was due o he fac he sub-naional governmens each have a far less diversified ax base han he federal governmen and hence are subjec o wider flucuaions in revenues and expendiures. Clearly, he sub-naional secor as a whole was saved from experiencing a rapid accumulaion of deb only because of he ne asse posiion of some of is members. Table 2: Explaining he Accumulaion of Deb by Level of Governmen Federal Governmen Change in Deb-o-Oupu Raio due o: o Srucural Componen o Cyclical Componen o Rae Componen o Daa Reconciliaion Provincial/Local Governmen Secor Change in Deb-o-Oupu Raio due o: o Srucural Componen o Cyclical Componen o Rae Componen o Daa Reconciliaion A sriking difference beween he wo governmen secors is wih respec o he srucural componen. One-hird of he increase in he deb-o-oupu raio experienced by he federal governmen was due o he srucural componen; he seing of ax raes and spending propensiies a levels ha would yield a primary defici even under he mos favourable circumsances. Virually none of he increase in he deb-o-oupu raio for he sub-naional secor was due o his reason. 7

8 In he period of fiscal rerenchmen, boh he federal and he sub-naional governmen secors inroduced changes in ax raes and spending propensiies ha have reduced heir srucural componens. The urnaround in he federal governmen s fiscal choices was really quie remarkable. Faced wih punishing high deb service coss and a raings downgrade on is deb in 1993, he federal governmen was able o reduce is deb-o-oupu raio even in he face of a sluggish economy ha coninued o produce a posiive cyclical componen. Jus as impressive was he performance by he provincial/local governmen secor. Despie an economy sill operaing below poenial, and despie a federal governmen ha was busily cuing ransfers o he provinces, his secor inroduced changes o ax raes and spending propensiies ha resuled in a -6.7 percenage poin reducion in he srucural componen. Figure 2 shows he srucural, rae, and cyclical componens conribuing o he growh in he federal deb-o-oupu raio from 1974 o Figure 3 shows he same for he provincial/local governmen secor. Noe ha he rae componen for he subnaional secor coninued o work o reduce he sub-naional governmen secor s deb-ooupu raio well pas 1981 when i sopped doing so for he federal deb. Due o he smaller sub-naional deb, he rae componen for ha secor in he early 1990s was much smaller han for he federal governmen. Finally, i is ineresing o noe ha he srucural componen was a very minor conribuor o he rise in he sub-naional deb-ooupu raio up unil Given he size of he Onario economy, i seems safe o speculae ha he large conribuions o he sub-naional srucural componen in he early 1990s was largely due o he expansionary policy choices made by he Peerson and Rae governmens in ha province. 8

9 Figure 2: The Decomposiion of he Federal Deb-o-Oupu Raio Srucural Componen Rae Componen Cyclical Componen Figure 3: The Decomposiion of Provincial/Local Deb-o-Oupu Raio Srucural Componen Cyclical Componen Rae Componen

10 4. Deb Spillover To he exen ha increases in deb increase ineres raes and decrease growh raes, he deb of one governmen in a moneary union will have spillover effecs on ohers. Concern over he possibiliy of such spillovers is wha moivaed he designers of he EMU o place resricions on he size of member s deficis and debs. In his secion, we discuss he possibiliy of such spillovers in Canada. Fillion (1996) esimaes ha each percenage poin increase in he public secor deb-o-oupu raio causes real long-erm ineres raes in Canada o rise by 5 basis poins. This esimae is almos idenical o he sensiiviy for Canada repored by Correia-Nunes and Semisiois (1995). Macklem, Rose and Telow (1995) simulae he Bank of Canada s QPM model using he assumpion ha each percenage poin increase in he public secor deb-o-oupu raio causes real long-erm ineres raes in Canada o rise by a more modes 1.7 basis poins and his only when he deb-o-gdp raio is high (defined as > 50%). However, hey also allow for a 6.6 basis poin response o each one percenage poin change in he deb-o-oupu raio during periods of ransiion beween seady saes. During periods of deb accumulaion, hen, he affec on he real ineres rae is quie large. Alhough all of he sudies cied above assume a linear relaionship, he risk premium likely increases a an increasing rae wih he deb-o-oupu raio. Table 3 presens calculaions measuring how changes in he srucural componen of each level of governmen affeced he real ineres rae. By focussing on he ineres rae effecs induced by deb accumulaed due only o he srucural componen we are seeking o idenify he effec on ineres raes due o ax and spending policies ha generae deficis even under he mos favourable of economic circumsances. Thus we are seeking o idenify ineres rae affecs resuling from inappropriae fiscal choices. The calculaions in he able are based on he esimae ha each percenage poin increase in he public secor deb-o-oupu raio causes real long-erm ineres raes in Canada o rise by 5 basis poins. Table 3: Change in he Real Ineres Rae Due o he Srucural Componen* Federal Provincial/Local *Percenage poins The able shows ha over he period , he deb accumulaed due o he federal srucural componen caused he real ineres rae o be higher han i was a he end of 1973 by an average of 0.77 percenage poins. By he end of 1995, he real ineres rae was 0.95 percenage poins higher han a he end of 1973 as a resul of he federal srucural componen. The dramaic reducion in he federal srucural componen afer 1995 exered a srong reducion in he ineres rae. During , he real ineres rae was on average 0.45 percenage poins lower han i was a he end of The srucural componen of he provincial/local governmen secor had very lile influence 10

11 on he ineres rae during he period of deb accumulaion. The reducion in he size of he sub-naional srucural componen afer 1995 had a much larger impac on he ineres rae, causing i o be an average of 0.22 percenage poins lower han a he end of The relaive effecs on he ineres rae of federal and sub-naional srucural componens are, of course, due o he much larger role played by he federal srucural componen in explaining he accumulaion of federal deb. Using he esimaes of he sensiiviy of he ineres rae o changes in he srucural componen, we can shif some of he responsibiliy for changes in he deb-ooupu raio from he rae componen o he srucural componen. For each year, we calculaed he increase in he ineres rae due o he srucural componen and muliplied his by he deb-o-oupu raio a he beginning of he year. The resul is an esimae of he change in he rae componen due o he ineres rae change caused by he srucural componen. Over he period his amouned o jus over 7 percenage poins of deb-o-oupu for he federal governmen. In oher words, jus over 7 percenage poins of he federal deb-o-oupu raio idenified in Table 2 as being due o he rae componen should be reallocaed o he srucural componen. By pushing up ineres raes, he federal srucural componen also impaced he budge of he sub-naional governmen secor. Using he same mehod described above, he federal srucural componen is calculaed o have increased he sub-naional secor s deb-o-oupu raio by jus over 2 percenage poins an amoun equal o $16 billion in The same calculaions show a small negaive spillover from he sub-naional secor o he federal governmen indicaing he sub-naional srucural componen had conribued o a small reducion in he federal deb-o-oupu raio over he period I needs o be sressed ha he esimae of a $16 billion spillover effec from he federal srucural componen o he provincial/local governmen secor s deb is based on a very simple calculaion and is a conservaive measure. I is based on he assumpion ha he induced increase in he ineres rae has no effec on he oal amoun of deb or he primary defici -- i only increases he cos of carrying he amoun of deb. In realiy, of course, because he increased cos of carrying he deb mus be financed somehow -- eiher by an increase in deb or by a reducion in he primary defici he real cos of he deb spillover will be higher han our simple measure suggess. The $16 billion esimae is also based on he assumpion ha only he ineres rae is effeced. Increases in he deb-o-oupu raio will also impac upon he rae of growh of oupu. This is so because higher levels of deb require higher ax raes hereby driving a wedge beween he price sellers receive and buyers pay. To he exen ha higher governmen deb effecs ineres raes on privae borrowing, higher deb can also be expeced o raise he cos of capial and hereby reduce producive capaciy. Given he non-linear relaionship beween ax raes and excess burden, and he non-linear relaionship beween credi raings and he level of deb, i is mos likely ha here exiss a non-linear relaionship beween he debo-oupu raio and he ineres and growh raes. For all hese reasons hen, our esimae of he spillover effec is conservaive. 5 Bu even by our conservaive assumpion, i is he case ha during he period of deb 5 Robson and Scarh (1997) use a simulaion model o show he effecs of federal governmen deb on oher economic variables. While hey assume a smaller sensiiviy of he ineres rae o changes in he deb-ooupu raio han we do here, hey also allow for changes in he level of deb o affec he rae of observed 11

12 accumulaion, he federal srucural componen was responsible for a larger increase in he sub-naional deb-o-oupu raio (1.7 percenage poins) han was he sub-naional secor s own srucural componen (1.1 percenage poins). 5. Limiaions In our analysis we have aggregaed he budges of he provinces and local governmens ino a provincial/local governmen secor. This consrain was forced on us because he Deparmen of Finance calculaes he cyclically adjused primary defici only for ha level of aggregaion. This is unforunae because he budgeary experiences of individual governmens wihin he sub-naional secor differ significanly. In paricular, he negaive rae componen for his secor noed in Table 2 is mainly due o he large ne asse posiions of Albera, Briish Columbia, and Saskachewan for pars of he period For hese provinces, hen, he ne ineres rae was negaive producing a very favourable ineres-rae growh-rae gap. No all provinces, however, enjoyed his favourable gap. The Alanic provinces in paricular carried large debs and paid large ineres rae premiums. Thus he rae componens for hose provinces were conribuing o deb accumulaion raher han acing as an offse o oher componens. If we speculae ha he risk premium imposed on a governmen s deb grows a an increasing rae as he deb-o-oupu raio grows, hen he spillover from he federal srucural componen was larger han average for he more heavily indebed provinces. Anoher ype of spillover is due o cus o inergovernmenal grans by he federal governmen. These cus are hidden wihin he esimaes of PDEF* and, o he exen hese cus were o cyclically sensiive areas of provincial spending, PDEF. If we had esimaes of cyclically adjused grans, we could idenify hese separae componens. Finally, our calculaion of he deb spillover is based on arihmeic. To go furher, we need a simulaion model ha allows changes in he deb-o-oupu raio o affec ineres raes as well as observed and poenial growh raes. We would also need o make some bold assumpions abou how he Bank of Canada and he federal and provincial governmens migh have behaved differenly under alernaive levels of deb. Everyhing becomes speculaive. and poenial economic growh, and he size of he primary defici. In heir simulaions, hey assume he federal governmen arges a deb-o-oupu raio and makes adjusmens o is primary balance so as o mee is deb arges. The differences in he simulaions generaed wih and wihou he endogenous responses of economic variables o changes in he deb are noiceable bu no overwhelmingly large. This suggess ha our simple calculaion of he deb spillover, while conservaive, is in he ballpark. 12

13 6. Conclusions To a cerain degree he amoun of deb a governmen accumulaes is beyond is conrol. Recessions mean a loss of ax revenue, an increase in cerain expendiures and increase in deb. Deb accumulaion from his source should, however, be of limied duraion. A fiscally responsible governmen should plan o mainain a more or less consan deb-ooupu raio over he course of a business cycle. A change in long-run rends in growh raes and ineres raes can cause a deb-o-oupu raio o grow even in he absence of a primary defici. A fiscally responsible governmen should respond o changes in he rend rae of growh and ineres rae rends. Surely a lag mus be expeced beween changes in such rends and he realizaion ha hey have occurred. For ha reason, his source of change in he deb-o-oupu raio shows a endency o cause a more prolonged deviaion from wha migh be considered a desirable deb-o-oupu raio. One source of change in he deb-o-oupu raio is no ouside he conrol of he fiscal policy-maker. This is wha we have called he srucural componen. By seing ax raes and spending propensiies, a governmen is able o deermine he rae of growh in he deb-o-oupu raio when he economy is operaing a maximum susainable oupu. The srucural componen should no conribue o deb accumulaion. Wih respec o he quesion of deb accumulaion, he sub-naional level of governmen in Canada was, o a large exen, a vicim of circumsance. Lile responsibiliy for he increase in he deb-o-oupu raio a he sub-naional level can be levied a he fiscal choices made by hose governmens. These governmens were he vicims of a cyclical componen and were only saved by a favourable rae componen. 6 The same canno be said of he federal governmen. The federal governmen s srucural componen was responsible for a large fracion of he increase in he federal deb-ooupu raio. Especially damaging was he accumulaion of deb due o he srucural componen beween 1974 and This se he sage for even more rapid deb accumulaion afer 1981 when he ineres-rae growh-rae gap urned posiive. While i is cerainly rue ha economic downurns and periodic run-ups in ineres raes caused by igh moneary policy conribued o he federal governmen s budgeing woes, i is also rue ha he sub-naional secor, despie dealing wih a less diversified, and hence more volaile revenue base, largely avoided such poor choices. Thus suggess ha he federal governmen was by no means a vicim of some sor of unavoidable confluence of evens. The idea ha in a currency union one governmen migh, wih profligae spending or unsusainable ax raes, impose coss on oher members of he union by forcing up ineres raes and slowing economic growh is behind he resricions on he budgeary choices of member saes of he EMU. We have provided conservaive esimaes of such spillover coss in he conex of he Canadian currency union. Even our conservaive measures show ha profligae spending and/or unsusainable ax rae seings a he federal level, as evidence by he large federal srucural componen, impose a large cos on he sub-naional secor in relaion o ha secor s own srucural componen. Unforunae circumsances in he form of deep recessions and slow recoveries were he main reasons for increases in he deb-o-oupu raio a he sub-naional level. Federal 6 Bu again, i is imporan o sress ha no all governmens a he sub-naional level were saved. 13

14 fiscal choices caused he sub-naional deb in 1998 o be higher by a minimum of wo percenage poins of GDP or $16 billion. To ha exen, he provinces were vicims no only of circumsance, bu also of he federal srucural componen. 14

15 References Correia-Nunes, J., and L. Semisiois. Budge Defici and Ineres Raes: Is here a Link? Inernaional Evidence, Oxford Bullein of Economics and Saisics, Vol. 54, No. 4 (1995): Fillion, J-F. L endeemen du Canada e ses effes sur les aux d inérê reels de long erme, Bank of Canada Working Paper (1996): Forin, P. The Canadian fiscal problem: he macroeconomic connecion, in Pierre Forin and Lars Osberg, eds., Unnecessary Debs (Torono, Lorimer, 1996). Freedman, C. and T. Macklem A Commen on The Grea Canadian Slump, Canadian Journal of Economics, Vol. 31, No. 3 (1998): Macklem, T., D. Rose, R. Telow Governmen Deb and Deficis in Canada: A Macro Simulaion Analysis, Bank of Canada Working Paper (1995): McQuaig, L. Shooing he Hippo, (Torono, Penguin Books, 1996). Robson, W. and W. Scarh Ou Fron on Federal Deb Reducion, C.D. Howe Insiue Commenary, No. 100, (November, 1997). 15

16 Appendix Daa on governmen expendiures, revenues, and capial and financial accouns are from Tables 31 hrough 43 of he Fiscal Reference Tables (Deparmen of Finance, Sepember 1999). These are calendar year daa and are aken from he Naional Economic and Financial Accouns (NEFA). "Toal Governmen" comprises he federal governmen secor, he provincial and erriorial governmens secor (including public hospials), he local governmen secor, and he Canada Pension Plan and Quebec Pension Plan secor. The basic conceps are defined as follows: defici oal expendiures oal revenues + non-financial capial acquisiions ne capial ransfers capial consumpion allowances ne ineres paymens ineres paid on he public deb invesmen income primary defici (PDEF) defici ne ineres paymens Daa on nominal GDP a facor cos (Y) is from CANSIM series D Our variable G measures he rae of growh of Y. The nominal rae of ineres (R) is he raio of ne ineres paymens o ne deb. The rae of ineres is hus specific o each secor or aggregaion of governmen. Ne deb (D) is direc liabiliies less financial asses, as defined in he Naional Balance Shee Accouns (NBSA). These daa are from CANSIM marices 0782 (for he federal governmen), 0783 (for he provinces, local governmens and hospials), 0788 (for he CPP) and 0789 (for he QPP). These are calendar year daa and refer o he value of asses and liabiliies a he end of he year. The change in he value of ne deb from year o year, calculaed using daa on ne deb as defined in he NBSA, should in heory mach he value of he defici for he same year, as defined in he NEFA. However, as described in Naional Balance Shee Accouns, , he operaional erm here is "in heory." The difference beween he flow measure provided by he NEFA and he change in he sock measure provided by he NBSA is explained by concepual differences, revaluaions, and classificaion changes. The reconciliaion erms saisfy he condiion: (Ne Deb from NBSA) +1 (Ne Deb from NBSA) + (Defici from NEFA) +l + (Reconciliaion) +l The Deparmen of Finance very kindly provided us wih heir unpublished esimaes of he cyclically adjused primary defici (PDEF*) for he oal governmen, he federal governmen, he CPP/QPP, and he provincial/local governmen secors. They also generously provided us wih he Deparmen's esimaes of poenial GDP a facor cos (Y*). 16