What you should know about Canada’s deficit #CanadaFinance

By the end of the 2024-25 fiscal year, Canada’s total market debt is expected to surpass $1.4 trillion. Every day, this debt grows by more than $100 million, and every second, Canada pays more than $1,200 in interest.

Many Canadians are concerned about the growing deficit, raising concerns that Canada could, once again, be called “an honorary member of the Third World” or see its dollar be called the “Northern Peso.”

Fifty-five per cent of Canadians think the federal government’s spending is too high. In spite of this, Chrystia Freeland, Deputy Prime Minister and Minister of Finance, postponed debt-reduction goals multiple times, and anticipates that the debt-to-Gross Domestic Product (GPD) ratio will keep growing for at least the next two years. For now, it seems the debt burden is here to stay, although the future of the Liberal government is uncertain with the end of the NDP-Liberal supply-and-confidence agreement.

In the meantime, Canada is in a GDP-per-capita recession, a tsunami of mortgage renewals are about to crush in, and the interest rate has just been cut again, to 4.25 per cent, to keep the economy afloat.

The financial ‘soup’

Understanding national debt is crucial to grasping the gravity of the situation. National debt represents the amount of money a government owes its creditors. Every time a government runs a deficit, it needs to borrow to cover it. Canada runs deficits more often than not.

National debt is measured as a percentage of GDP or on a per capita base. National debt can be measured in different ways, including gross debt, net debt and public deficit. Some measures include just the federal government, while others include the provincial governments.

To illustrate a country’s financial system, it’s helpful to imagine it as a pot of meatball soup. At the bottom of the pot, various factors — social, economic, political and environmental — act as the heat source. Above the pot are the regulatory and oversight authorities.

Inside the pot, the meatballs represent different financial markets, including the stock, real estate, commodities, currency and bond markets. The soup’s liquid serves as a connective medium that allows these markets to interact. If a meatball (representing a financial market) becomes problematic, it can spoil the entire soup. If the soup is too hot, it burns; if it’s too cold, it’s unappetizing.

The role of financial oversight institutions is to maintain the soup’s quality. Too much public debt limits their ability to manage and prevent financial crises effectively. Citizens only become concerned about national debt when it starts affecting the quality of the soup.

Debt accumulation

National debt can be beneficial, but only if its managed properly. Governments collect revenue from different sources and get more money if the economy is growing.

Borrowing money is reasonable when investing and facing economic downturns, but mismanagement can cause problems. At some point, too much debt becomes burdensome and economic growth and private investments slow down.

Periods of debt accumulation are common around the world, with more than 500 episodes occurring since 1970. Around half of these episodes were associated with financial crises.

During these crisis periods, output per capita was typically six to 10 per cent lower and investments were 15 to 22 per cent weaker. A rapid buildup of debt increases the likelihood of a financial crisis occurring, as does a larger share of short-term external debt, higher debt service and lower reserves.

Tackling national debt

Governments have several tools at their disposal to manage fiscal deficits and debt, though each comes with its own set of challenges.

1. Governments aim to eliminate fiscal deficits by growing the economy continuously, but this is easier said than done.

2. Raising taxes is another option, but economic contraction, high unemployment rates, the costs of implementing fiscal consolidation, debt burdens and an increasing debt-to-GDP ratio can make this approach challenging.

3. Financial repression involves government policies that control financial markets. These can include directed lending to the government from domestic institutions like pension funds or banks, explicit or implicit caps on interest rates, regulating cross-border capital flow, and strengthening ties between governments and banks.

4. Inflation can be an effective tool because even if creditors are repaid, the value of the goods and services they purchase is significantly lower than when the loan was originally extended.

5. Cost cutting can also be a possibility, but governments are often reluctant to do so because it can lead to significant changes in policy, operations and administration which, in turn, may undermine long-term goals.

6. Other financial strategies include transferring loans, postponing and reimbursing restrictive debt withdrawal rights, leasing or revising interest rates as authorized in the debt market, domestic financial sector transfers, fiscal consolidation and debt restructuring.

National debt around the world

The past offers us a stark example of the dangers of unsustainable financial policies. In the wake of the 2008 financial crisis, Portugal, Italy, Ireland, Greece and Spain all saw their national debts downgraded to “junk status” after being burdered with enormous sovereign debt, real estate bubbles and unreported fiscal deficits.

In response, they were forced to implement harsh austerity measures, tax increases and spending cuts. These actions, in turn, sparked widespread social unrest.

In the present day, Argentina’s President Javier Milei is taking a bold approach to address the country’s rampant inflation, which has reached 211 per cent year over year. Milei has brutally cut expenses and public deficit in an effort to curb the spiral.

The United States presents a different case altogether. It holds all its debt in U.S. dollars, meaning it will always be able to pay them. Japan, on the other hand, is the most indebted country in the world, and faces serious challenges because of it.

Around the globe, other countries face their own unique challenges: Zambia has borrowed too much to afford infrastructure, Ecuador is burdened by excessive subsidies, El Salvador’s adoption of Bitcoin has led to its long-term debt being traded at a 70 per cent discount, and about 30 per cent of Kenya’s revenues go to interest.

Canada versus the world

If anything distinguishes Canadian finances from its G7 peers, it is it’s pervasive ambivalence. As the senior director of Canadian economics at Desjardins Group notes: “Canada still remains the cleanest dirty fiscal shirt in the closet.”

Canada typically focuses more on net debt — a measure that looks at gross debt minus the government’s financial assets — because it presents a less alarming picture. Canada’s net debt-to-GDP ratio is around 13.28 per cent, significantly lower than the G7 average of 95 per cent.

However, Canada’s gross debt-to-GDP ratio stood at about 104.7 per cent in April — higher than Germany or the United Kingdom. Canada is more fiscally vulnerable than the U.S. or Germany, as its economy is smaller and its currency not a reserve currency.

In the typical Canadian duality, the country has a growing economy, but a recession per capita. National debt looks favourable in net terms, but is alarmingly high in gross terms. Canada’s leaders need to resolve these dualities — before its currency gets called the “Northern Peso” again, like it did in the mid-90s.