Nearly two decades ago, David Walker went on tour across the United States. Not as a rock star or a travelling preacher, though he did have a sermon to spread. Instead, Mr. Walker was the country’s chief bean-counter, and his message for his fellow Americans was grim: The U.S. was suffering from “a fiscal cancer,” the then comptroller-general told the public on what he called his Fiscal Wakeup Tour. Spiralling deficits and debt would have “catastrophic consequences” if left untreated.
His pleas were ignored.
What followed was year-after-year of unrestrained borrowing, as a potent combination of falling interest rates and entrenched political division allowed spending plans to mushroom even as tax cuts left Washington’s coffers empty.
Large swaths of the rest of the world eagerly joined in the debt-financing party, including Canada, where the Liberal government’s $40-billion-deficit budget this week yet again ramped up spending by tens of billions of dollars. By next year, a generation of Canadians will have been born and become adults since the federal government last balanced its books.
While Canada and the U.S. may seem as if they’re on different planets when it comes to what they owe – just over $1.1-trillion for Canada compared with roughly $40-trillion (in Canadian dollars) for the U.S. – both are now spending as much on interest payments as they do on programs they each hold dear. Canada will fork out $54-billion this year in debt costs – more than Ottawa will send to the provinces in health transfers – while for every dollar the U.S. spends on defence, it will pay that much in interest to its lenders.
All told, by 2028 the gross public debt of advanced economy governments worldwide is forecast to exceed 122 per cent of GDP, the highest level since the Second World War, according to the International Monetary Fund.
“The bottom line is elected officials are addicted to spending, deficits and debt,” Mr. Walker told The Globe and Mail. “But I do think we are approaching an inflection point.”
For one thing, credit rating agencies have begun kicking up more of a fuss about the sustainability of government borrowing. Last fall, Fitch, one of the big three rating agencies, cut the United States’ credit rating from AAA to AA+, while another, Moody’s, later lowered the outlook on its U.S. credit rating to “negative” from “stable.”
At the provincial level in Canada, British Columbia, which is expected to post the largest deficit-to-GDP of all the provinces this fiscal year, had its own credit rating cut by S&P Global Ratings this month – B.C.’s third downgrade in three years of overspending.
In the U.S. there have also been cracks in the long-held assumption that the world’s appetite for American bonds, regarded as the safest investment on the planet, might not be as bottomless as once thought.
As if to drive home that message, this week the IMF took aim at the United States’ US$26-trillion debt load. The United States’ surprisingly strong economic performance is owing in part to “a fiscal stance that is out of line with long-term fiscal sustainability,” the organization’s chief economist, Pierre-Olivier Gourinchas, wrote in a bulletin. “Something will have to give.”
Of course, given the United States’ vast size and role at the centre of global financial markets, even if Canada and other countries transformed into bastions of fiscal virtue, they could still face fallout from Washington’s continuing recklessness. As the IMF also warned this week, runaway debt and loose fiscal policies could push up long-term borrowing costs for other countries and pose “significant risks” to the global economy.
Yet it’s still unclear exactly what unsustainable means when it comes to government debt, both in terms of how much is too much, and when that tipping point might arrive. It’s certainly not the same for every country, experts say. But against a backdrop of higher-for-longer short- and long-term interest rates, after so many years when it seemed as if debt didn’t matter, suddenly it does.
The scale of the United States’ debt burden can be mind-boggling. Here’s one way to think about it: Over the past year, the U.S. has added US$1-trillion in new debt an average of every 150 days. As of this week the federal debt stands at US$34.6-trillion, according to the U.S. Treasury Department. That includes a lot of debt that other arms of the U.S. government hold, and so when that’s excluded, the actual debt held by the public is closer to US$27.8-trillion, which is still a staggering 100 per cent of GDP.
In other words, for every dollar of output by the largest and most powerful economy on the planet, it’s also in hock to someone else for another dollar. And that ratio is only projected to climb – by 2054 the Congressional Budget Office projects debt-to-GDP will top 160 per cent.
Canada’s debt picture is not as grim, provided everything in the economy unfolds as optimistically as this week’s budget forecasts. According to the budget, the federal debt-to-GDP ratio will gradually decline from 41.9 per cent to 39 per cent in 2028-29, while the deficit will drop below 1 per cent of GDP within three years. That’s largely thanks to a $19.4-billion windfall of tax revenue that will come from raising the inclusion rate on capital gains of more than $250,000, from one-half to two-thirds.
While Finance Minister Chrystia Freeland framed the budget as responsible, not everyone agrees, particularly when you consider this budget in the context of all the others that preceded it.
“They’ve dramatically increased spending, doubled the national debt and increased the federal civil service,” said Laurence Booth, a finance professor at University of Toronto’s Rotman School of Management. “That is not a sign of a prudent government.”
Once the provinces are included in Canada’s debt picture, things begin to look even less rosy.
In a recent report, economists at Bank of Montreal estimated that, based on all the red ink featured in provincial budgets this year, total provincial debt will increase more than $65-billion, a record jump equivalent to 2 per cent of GDP and larger than the debt loads they took on during the first year of the pandemic.
Amid rising demands for services, a prolonged era of cheap debt that lasted until 2022 and the churn of election cycles, it is not a surprise that governments for a long time saw little upside to being champions of fiscal discipline.
In the U.S., President Joe Biden isn’t slowing spending, particularly in an election year with so much at stake, while his rival Donald Trump is promising massive tax cuts. Both policies would only leave an even bigger hole in U.S. finances.
Prime Minister Justin Trudeau and Deputy Prime Minister and Minister of Finance Chrystia Freeland are joined by cabinet ministers before the tabling of the federal budget on Parliament Hill in Ottawa, on April 16.Justin Tang/The Canadian Press
Many also see the Trudeau government’s budget as an election gambit as it tries to shore up support among young voters dissatisfied with rising costs.
Mr. Walker reminisces about the United States’ last fiscally responsible president, Bill Clinton. Likewise Tony Fell, the former chief executive officer of RBC Dominion Securities, complains that the last time Canada displayed “fiscal sanity” was under the Liberal government of Jean Chrétien, when Paul Martin was finance minister. “There’s nobody up there even thinking that way now.”
History holds many examples where governments of countries that allowed their finances to deteriorate for too long were suddenly forced to adopt prudence over profligacy, including Canada in the early 1990s when Mr. Chrétien and Mr. Martin wrestled the federal budget under control after 27 straight years of deficits. Their fiscal anchor was not just slightly smaller deficits, but repeated balanced budgets and a rapidly falling debt-to-GDP ratio.
The question is, will this be one of those moments of reckoning for the world’s big public borrowers?
In the lead up to this week’s budget, as economists and investors waited to see if the Trudeau government would hold to its own fiscal anchors of a downward sloping debt-to-GDP ratio and deficits below 1 per cent of GDP in 2026-27 and onwards, Royal Bank of Canada issued a warning that Canada should not take its vaunted AAA credit rating for granted.
“Key metrics indicate its fiscal position is among the more vulnerable relative to other AAA rated economies,” economist Rachel Battaglia wrote. “This suggests Canada is at a greater risk of a downgrade than other top-rated peers.”
As it turned out, Ms. Battaglia said the budget likely met the mark fiscally. But that doesn’t mean rating agencies won’t be keeping a close eye on Ottawa’s books for signs of trouble, since those weaknesses she pointed to still stand.
For instance, while Canada compares favourably when looking at government net debt-to-GDP, which includes the value of financial assets such as the Canada Pension Plan, Canada’s gross debt levels are much higher than other AAA-rated countries – at 107 per cent versus 45 per cent for Germany or 5 per cent for Denmark.
That translates into higher debt servicing costs than other AAA-rated countries, which has a knock-on effect of “trickling down to consumers and businesses who ultimately are paying more to service their mortgages and loans,” she said.
The biggest metric credit rating agencies may be watching in Canada, however, is its productivity performance, which is poor relative to other countries. “Weak productivity can put downward pressure on revenues, which limits the government’s ability to fund its operations without raising taxes or tacking on even more debt,” she said. “The credit rating agencies are definitely watching that.”
Even if that’s the case, Prof. Booth doesn’t think rating agencies are in any rush to downgrade Canada. Even if they did, he doesn’t believe it would make much difference to borrowing costs, since investor demand has remained strong for federal bonds.
That’s more or less what happened in the U.S. after 2011, when S&P Global Ratings slashed America’s AAA rating to AA+. Clearly lenders weren’t scared away.
The bigger worry for any sovereign lender is market sentiment. Investor confidence can be fickle, and herd mentality can easily take hold, much as it does in the case of a bank run when everything seems fine one day, and the next crowds are rushing the exits.
“It all comes down to supply and demand,” Prof. Booth said. “Government’s supply bonds and the question is whether investors want them. If they don’t, you’re into a buyers’ revolt, yields start increasing, and you know you’re reaching the limit.”
Or as Ms. Battaglia puts it: “Debt isn’t a problem, until it is.”
The problem is, it’s virtually impossible to nail down exactly where the tipping point lies between government debt levels that might draw table-thumping from fiscal hawks but otherwise keep swelling, and a debt load that suddenly plunges your country into a fiscal crisis.
Some have tried to identify a hard debt line. One highly touted 2010 academic paper by Harvard University’s Carmen Reinhart and Kenneth Rogoff claimed an analysis of 20 countries showed that once debt rises above 90 per cent of GDP, real economic growth turns slightly negative – an analysis often marshalled to justify austerity crusades in the wake of the Great Recession, until a spreadsheet error in their research was later uncovered that debunked their findings.
For countries such as Portugal, Italy, Ireland, Greece and Spain, a group once offensively derided as PIIGS amid the European sovereign debt crisis from 2009 to 2012, exploding deficits and a surge in debt-to-GDP levels above 100 per cent sent their borrowing costs spiralling higher as investors lost faith in each country’s ability to pay off its debts.
What Canada and the U.S. have that those countries didn’t as members of the euro bloc is control of their own currencies, which means central banks can buy their country’s debt to finance government operations and keep interest rates low, as both the Federal Reserve and the Bank of Canada did on a large scale during the pandemic.
The same can’t be said for Canada’s provinces, and bond markets have already signalled their unhappiness when provincial governments have failed to live up to fiscal guardrails they’ve set for themselves. Quebec’s recent budget, with its historic $11-billion deficit that put its long-term net debt-to-GDP target further out of reach, is a case in point – after the budget’s release, bond markets immediately pushed up the province’s borrowing costs, Ms. Battaglia said.
Yet countries that can print their own money are finding bond investors can lose their patience in abrupt fashion, such as the collapse of Liz Truss’s Conservative government in Britain in September of 2022.
In that instance Ms. Truss touched off a revolt among bond investors when she announced plans to slash corporate taxes while simultaneously ramping up deficit-fuelled spending to boost growth. Almost immediately the value of the British pound and government bonds collapsed. Three weeks later Ms. Truss was forced to scrap the plan and step down, having famously been outlasted by a not-yet-wilted head of lettuce.
That episode continues to lurk in the shadows as the United States’ debt levels surge. Last month Phillip Swagel, the director of the Congressional Budget Office warned the United States’ “unprecedented” debt trajectory could lead to a similar shock. “The danger, of course, is what the U.K. faced,” he told the Financial Times. Such a crisis wasn’t imminent in the U.S., he said, but the risk is there.
There have been some signs that U.S. bond markets may be suffering some indigestion as they try to absorb record levels of treasuries sold at auction – last fall long-term yields jumped amid worries about U.S. deficits and whether they were adding to inflation.
Yet there is no way to know what the breaking point is for U.S. debt – if one even exists – or when it might come. In a recent report the Penn Wharton Budget Model (PWBM), a nonpartisan fiscal policy research group at the University of Pennsylvania, tried to determine what unsustainable U.S. federal debt looked like. The model assumed that at some point drastic fiscal policy action will be taken, but determined the U.S. debt held by the public cannot exceed 200 per cent of GDP, and that a ratio of 175 per cent is more plausible.
It also found the U.S. has roughly 20 years “for corrective action after which no amount of future tax increases or spending cuts could avoid the government defaulting on its debt.”
“Ultimately it comes down to when capital markets stop believing that the government will solve its debt problem,” said Prof. Kent Smetters, the PWBM’s faculty director. “Theoretically it could happen tomorrow.”
The problem is, he said, the U.S. government has become numb to the idea of using debt on a massive scale to get through crises such as the Great Recession and the pandemic. “What happens when the crisis itself is caused by debt?”