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Pour en finir avec la dette…

The previous post reflects a general mood about the Québec election and its perennial debates, constitutional and otherwise. Nonetheless, for all the talk about Québec’s specificity, many economic discussions bear striking resemblance to what is happening in the rest of North America. Worry about the public debt is one of them, one that has taken centre stage, amidst speculations of Québec’s future as a petro-province (or state) and the rush to tap northern mineral resource. I know it has been over 25 years since the whole thing began (under Mulroney, if I recall), but that still baffles me.

Jim Stanford, a little more than a month ago, wrote a post about the debt situation in Canada, rightly stating that debt levels were fine. Some of the comments that followed questioned that there would even be limits on government borrowing. This is true as long as Canadian debt is denominated in Canadian dollars, which it by and large is. As long as the government retains the power to print its payment, its solvency would be hard to question.

What of the provinces, though, since they don’t have control over money creation (leaving aside that the federal government could back them up, given that the debt is largely in Canadian dollars) ? Well, another aspect of the issue for Canada is that the debt is, by and large (over 85%), owed domestically, to Canadian people and entities, over which the government has a power of taxation. This is also true for a province like Québec, as l’Institut économique de Montréal, one of the strong voices claiming the provincial debt to ba a major challenge of our time, itself acknowledges. In short, we owe it to each other and, currency aside, debt servicing and tax payments are an internal redistributive device, with the government establishing who pays whom.

So here we have a useful financial asset, which is still in high demand (some of the rates at which Épargne Placement Québec borrows these days are some times even below inflation), without much of a repayment issue. And yet it dominates the economic side of the campaign. The whole thing becomes farcical when leaders, such as François Legault, urge the others to think of their grand kids and address the debt issue. At any point in time, some living quebeckers [through taxes] will be paying other living beings, likely Québec individuals and institutions.

This leads me to a question with which I have been struggling for years : How to explain that public debt in Canada is essentially a non-issue ? Is there any strong image that could do what the fallacious mortgage metaphor has done for the other side ?

Enjoy and share:


Comment from Purple Library Guy
Time: August 25, 2012, 9:00 am

Hmmm . . . you could say that internal debt is like when you’ve got multiple accounts at your credit union and you move some from your holiday savings fund into your day-to-day checking, intending to put it back later. You don’t actually have less money.
Or maybe like when you and your spouse have an arrangement where normally you cover different kinds of expenses, like you handle some of the bills and he/she deals with the groceries, and then something comes up so you borrow some money from him/her. The household as a whole still has the same money, right?
Or maybe it’s like if your dad has a lot of savings that aren’t making him much, so you took out your mortgage with him instead of the bank so you both get a better interest rate. And then he moved into the house with you. He’s not that likely to foreclose on you while he’s living under your roof. Even if he does, the house is still in the family.

Comment from Mike
Time: August 26, 2012, 10:46 am

The real issue is it shouldn’t have been called debt in the first place since the government (in theory) is the master of the economy because it ISSUES the currency.

i.e. you can’t have an economy without an agency to enforce the law and prevent fraud

Comment from Keith Newman
Time: August 27, 2012, 7:16 am

Of course our federal government cannot become insolvent since it issues its own free-floating fiat currency. It can run fiscal deficits that allow for near full employment, ultimately constrained by inflation.

It is very dificult for people to get their heads around that since it is very counter-intuitive and I believe in a political debate the point is impossible to make convincingly. Better to avoid it altogether and talk about the need to invest in our future, our young people, our environment, our infrastructure, the need for fairness so for public services, etc.

I think you’re being too dimissive of the financial problems faced by the provinces. The problems of the eurozone demonstrate the serious problems that can occur for non currency issuers. The provinces do face a real solvency issue. Consequently their interest rates will normally be higher than the feds, and could increase explosively if solvency becomes problematic.

While a Canadian province can indeed tax its residents, some one half of taxes go to the federal government. So provincial taxation will not resolve the financial arithmetic. Additionally the stimulus provided by provincial deficit spending and interest payments on the debt leak out of the province in considerable amounts.

The Canadian federation works because of various mechanisms paid for by the federal government – federal government jobs, equalization, EI, subsidies to various health and welfare programs. In the absence of full employment and/or an offsetting trade surplus providing these will require a fiscal deficit which the feds can run it at whatever level is required. (Note there are other sectoral balance issues here as well).
Due to its strategic fiscal and financial role the Canadian government should pay for more things within the Canadian federation (eg pharmacare, daycare, buiding rail infrastructure, etc)

Comment from Mathieu Dufour
Time: August 27, 2012, 11:29 am

I like the parent metaphor, though I agree that it is inherently hard to make the case, partly because of the terminology.

As for being dismissive, I don’t mean to say that provincial debt would never be problematic. To me, public debt can become problematic if (a) it is denominated in a currency that the government does not issue and, if so, (2) it is owed to people outside its jurisdiction (and have enough leverage to induce reimbursement). The Canadian government suffers from neither problem and I would argue that a provincial government like that of Québec suffers mostly from the first one.

The comparison with the Euro zone crisis is only partially fair. The Greek government, for example, owes a large share of its debt to entities over which it has no control whatsoever… entities whose governments are by and large intent on repayment. There are various proposal to internalise the issue by formalising fiscal transfer mechanisms (and addressing internal trade imbalances along the way), but desires to preserve national sovereignty stand in the way…

Québec, by contrast, largely owes its debt to its own residents (the government does not seem to publish numbers, but the Institut économique de Montréal (quoted above) estimates the Québec-owned portion at around 85%), and the vast majority to Canadian residents (over 98% of the provincial debt is denominated in canadian dollars). The portion owed to Québec residents presumably does not give rise to a leakage. The interests on that portion could even technically be taxed back in various ways, making the debt self financing, with just enough targetting to maintain the incentive to own the debt securities.

For the part owed outside the province but in Canada, then I agree the issue has to be worked out with the federal government (or in coordination with all the other provinces). But that’s the major difference with the Eurozone – Canada has fiscal transfers in place and the constitutional makeup to build other ones if necessary. To the extent that debt does not really give rise to leakages outside of the country, resources can be transferred around. Of course, if provinces are instead made to compete with each other, that’s another issue.

As for the nominal rates, just looking at fixed term “obligations d’épargne”, for example, they are currently below or roughly equal to inflation for obligations up to four years (1.3%, 1.5%, 1.7%, and 2%, for 1-year, 2-years, 3-years, and four-years securities respectively). Rates can of course flare up, but currently, it looks like the government feels it can borrow almost for free. So the discussion above aside, it is hard to see it as the crisis that it is made to be in the current provincial elections.

Comment from Darwin O’Connor
Time: August 27, 2012, 12:06 pm

If the big 5 banks are “too big the fail” and are protected by an implied Federal government guarantee, surly the provincial governments would be too.

Comment from Purple Library Guy
Time: August 27, 2012, 7:26 pm

I do think that, all old Harper talk about firewalls aside, Canada’s provinces are knit together a bit more firmly than countries in the EU, and the mere existence of a fairly strong federal government voted for by the populations of the provinces makes the kind of politics the EU is having over austerity much less likely. Whatever party did to a province what Germany and co. are doing to Greece could kiss all votes in that province goodbye for a generation. So I can’t see us letting a province default on its debts and go bankrupt.

The only time Quebec would have to worry about that would be if they actually did separate–and if they did, they would be issuing their own currency so they still wouldn’t have a problem.

Comment from circuit
Time: August 29, 2012, 3:08 pm

To respond to your question, we could start by pointing out that the provinces with lowest debt-to-GDP levels are also those with the most financially vulnerable households.

Debt and deficit reduction are hardly harmless objectives to Canadians.

Comment from Keith Newman
Time: August 29, 2012, 7:59 pm

Re Martin’s comment @ 11:29am.

My concern re provincial debt is related to the fact provinces do not issue the currency and could potentially face insolvency. If this were to occur interest rates would rise considerably on the debt as has been the case in Europe. This is not to say Quebec is the next Greece by any means, just that the European catastrophe illustrates varying degrees of problems stemming from the inability to issue your own free-floating currency.

With respect to Quebeckers owing the money to themselves, the government cannot realistically tax back all its interest expense, even setting aside the money owed to non-Quebec residents. A holder of Quebec debt pays taxes to the federal government as well as to the Quebec government. And the highest marginal rate of combined Quebec and federal tax is about 50% with each level of government getting about 25%. So even at the highest tax rate Quebec would only get back about one quarter of the interest expense. If Quebec were to raise special taxes on its own debt within Quebec, no Quebecker would buy the debt in the first place.

A good part of the original spending, as well as interest expense, also leaks out of the Quebec economy through the purchase of non-Quebec produced goods and services. The part of this spending put into savings in the form of financial assets (personal savings, pension funds) is also lost to the Quebec macro economy. I don’t know what the interprovincial and foreign net flows are so perhaps this is less of a problem than I think. Or perhaps not.

The role of the federal government is to offset these leakages through its programs I alluded to above. However this still doesn not mean Quebec cannot face solvency issues if its debt servicing burden reaches excessive levels. It’s not there yet but it could happen. The current level of debt is 55% of GDP. Whenever a true recovery occurs interest rates will rise and interest payments could become quite burdensome.

Of course the federal government could devise a special program to bail out a province and the Bank of Canada has the ability to lend money to provinces. Still, these are unusual measures and I suspect would be fraught with all kinds of political problems.

The best way to avoid excessive provincial debt levels is for the federal government to spend more on infrastructure and services and run higher fiscal deficits. This is precisely what the Harper government does not want to do. It’s very clever from a Conservative point of view because if it balances its budget it can claim to be responsible even though its balanced budget will force the provinces (and/or households) to run deficits, in the absence of an offsetting foreign surplus. So the feds seem responsible, the provinces irresponsible, and our social programs are cut back because the provinces can’t afford them. Then they are privatized. And while it all seems to be the fault of the provinces it is in reality the fault of the federal government. Quite brilliant in an evil, Conservative, sort of way!

Comment from Mathieu Dufour
Time: August 29, 2012, 9:59 pm

Good point, Circuit. This deserves more publicity…

I agree with the last bit of Keith’s comment: It is indeed pretty clever on the part of the federal government, especially given the current state of the discussion on debt. I’m not really sure that the provincial governments are entirely innocent, however – one might recall, for example, the speed at which Philippe Couillard, a former Liberal health minister, jumped on the privatisation bandwagon when given half a chance.

I still don’t see the leakages issue, though. Unless we assume that the recipient of interest payment have a greater propensity to spend/invest outside the province than those who pay taxes, whether the income is taxed and handed back as interest payment before it is spent – rather than being spent right away – does not induce a particular leakage. This propensity may not be entirely the same, but how large can the difference be ? And in any event, this is linked to a political decision regarding the way the burden of taxation is determined.

The one leakage I see is in the tax paid to the federal government. If I make 100% of my income in interest payments, some of it will be taxed by the feds, say 15%. That leaves only 85% to be mobilised by the provincial government to give it to me. In that sense, there is a cap in terms of marshallable money. Presumably, the feds would send some money back in one form or another, but they don’t have to. Otherwise, in terms of money spent outside, the issue exists regardless of the debt. If one year the province imports more from the rest of Canada than it exports (with balanced financial flows), money will flow out (but also, prices may change, etc.). If debt obligations are nominal, then money to execute the transfer between taxpayers and securities holder may become scarce, but that seems like a minor issue in an overall unsustainable setup. Or maybe I am missing the point altogether.

As for linking a tax with debt, I agree that offering a deal where all the interest are re-taxed is likely to decrease demand for these securities. The problem is lessened if the targetting is broadened. For example, if the top X% of income earners own Y% of the debt, they could be taxed for an overall amount equal to Y% of the interest. this would not remove the individual incentive to own debt securities. More generally, taxing financial markets (instead of abolishing the capital gains tax as Premier Charest did), where a fair share of the securities are held, could accomplish a similar goal.

So sure, at the top marginal rate, the government gets about 25% of any dollar earned, and so of any interest dollar earned. However, it also gets 25% of any other income earned (rate specifities aside). Let’s say that 2% of the income of the people paying the top rate comes from interest, and let’s assume that 24.5% of that income is deemed enough government revenue for other spending. Raise the marginal tax rate to about 26.5% and the whole debt servicing will now be included, while other spending can be maintained. How well or finely the targetting could be accomplished ultimately depends on various factors, but some targetting could certainly be done.

In any event my point is that to the extent that tax paid and interest received don’t match, there is an income transfer on any given year. Through its taxation powers, the provincial government can shape this transfer, at least on the portion held in Québec.

Comment from Keith Newman
Time: August 30, 2012, 9:01 am

Re Mathieu @ 9:59 pm:

Circuit’s point is very à propos, illustrated by the student protests in Quebec. It was about who carries the cost of education – society as a whole or students (or recent graduates). It’s clearly fairer that society as a whole carry the debt since educated young people are a benefit to society. Conservatives do not see it that way of course.

The point about Philippe Couillard is spot on. Perhaps even worse is the revolving door between the health ministry and the pharmaceutical drug industry, shown in the Quebec documentary of a few years ago partially on that topic.

My point about leakage is a general one. Since Quebec is not a closed circuit financial outflows are a loss to Quebec, are not controlled by the government and can be problematic if they are substantial and not adequately offset. Since I don’t think we know their magnitude further discussion on that is probably pointless.

I take your point about raising the top marginal tax rate to cover interest expenditures but there must be some limit to this. It may well be a political limit – lots of money and other support for politicians who predict catastrophe, but it’d still be real.

My concern is for the longer term. Currently interest rates are very low. The retail rate today for Quebec government 10 year bonds is about 2.8%, according to TDWaterhouse. However the average rate paid on Quebec gross debt is about 5% (9.5 billion/183 billion) due to debt incurred in an earlier period. You could argue this is the time to load up on long term debt. However you are then supposing economic growth will be strong enough to enable easy payment in the future – a risky assumption. Also interest rates have nowhere to go but up now although it may be some time before that happens. Not long ago interest rates for provinces were quite a bit higher, about 3 % higher 10 years ago, 2% 5 years ago. Granted economic growth would probably be higher as well. So while there is no imminent catastrophe, my point is that as the share of debt versus gdp rises the risks rise for a non-issuer of the currency and can become constraining if circumstances turn bad. And in Europe they did turn very bad indeed for some countries.

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