National Debt Explained

Dear Reader,

Canada’s Covid-19 Economic Response Plan is in full swing.  Those eligible can apply to receive the Canada Emergency Response Benefit (CERB), an increase to the Canada Child Benefit (CCB), deferral of income taxes owing (Sept 1), mortgage deferrals, wage top-ups for essential workers, a Special HST Tax Credit Payment, a one-time tax-free payment for holders of the Disability Tax Credit, Canada Emergency Student Benefit (CESB), Canada Student Service Grant (CSSG), assistance to student loan borrowers, support for student researchers and post doctoral fellows, support for international students working in an essential service, a one-time tax-free payment for Old Age Security (OAS) and Guaranteed Income Supplement (GIS) holders, support for indigenous communities and post secondary students, a boost to the On-Reserve Income Assistance Program (ORIAP), the Canadian Emergency Wage Subsidy (CEWS) for businesses, a temporary 10% wage subsidy, the Canada Emergency Business Account (CEBA – interest free loan), Regional Relief and Recovery Fund (RRRF), Canada Emergency Commercial Rent Assistance (CECRA), Large Employer Emergency Financing Facility (LEEFF), Industrial Research Assistance Program (IRAP), and more including a number of targeted relief for sectors such as Agriculture, Aquaculture, Heritage and Sport, Air Transportation, Tourism, Energy, Infrastructure…

How can the country afford all this???  Where is all this money coming from???

It is apparent that funding for these programs comes from money the government does not have (otherwise, they would have been offering these benefits already).  As such, the government has undertaken an extensive borrowing effort to ensure its citizens do not experience the full brunt of an economic depression. 

And sure, this is a temporary fix, but what are the long-lasting implications? Will the debt ever be paid back? If so, how do we pay it back? What does this mean in terms of the value of our money and in terms of the overall economy?

So to start, why do we even need to borrow in the first place? In a perfect world, everyone would just buy things that they could afford as opposed to going on that $10,000 vacation when you only have $2,000 in your bank account. When someone buys something frivolously that they can’t afford, it’s easy to label that person as irresponsible. Is national debt ay different?

The fact is, running a country does not work this way; a country is run like a business. Countries have a measure called the Gross Domestic Product (GDP) – the entire market value of all the goods and services produced in the country.

The reason we measure GDP is to gage the economic output of our country to see if we are growing as a society. If that number goes up, it tells us that spending is increasing and incomes are increasing. More on this later.

Alongside the GDP is all the other revenue the country earns to keep itself running – roads need to be built, etc. Much of these services are paid through our tax dollars.

Now, there will be times when tax revenues are not high enough to pay for all the services we need. When this happens, the need to borrow (debt) arises.

Typically this is done through issuing bonds and treasury bills to the public, which is a fancy way of saying that the government will pay you interest if you lend it money, and this loan is guaranteed by the country (the chances of it not paying you back on time is not likely).

So, who owns this debt?

1) Canada’s own citizens - Canadian Citizens buy bonds and earn interest (money). The more money they make, the more they spend and circulate back into the economy.

2) The Bank of Canada and Federal Government – These entities essentially lend money to themselves. How this works is some government departments have surplus savings and so they invest the extra money back into the government and get paid interest. When they need the money in the future, they cash out their bond/treasuries and get paid back.

3) Foreign investors – Investors in other countries who might view Canada as a stable and safe guaranteed return for investment.

This type of borrowing is quite unlike the notion of a credit card with a balance that needs to be paid back as soon as possible.

In a way, holding debt can be a good thing.

Here’s an example:

You have $1M and you want to buy a $1M house. A lender offers to lend you $1M and will only charge you 1% annually in interest - and you don’t have to pay it back anytime soon. Anyone would take that deal knowing full well that they can take their $1M and instead make more interest elsewhere; and they can profit on the difference by not paying back the loan. 

Not to mention, if inflation is 2% annually and you’re only paying 1% in interest, then every single year, that debt becomes cheaper and cheaper the longer you don’t pay it off.

In this example, your outstanding loan balance declines by 1% each year - meaning you owe less money in the future than you do right now.

A government works the same way. With interest at almost 0%, the government pays virtually no interest on that debt. That said, inflation has a worry of going negative (deflation) over the short term, but when inflation is 2% annually over the long-term, that debt becomes less intimidating each year. All things being equal, if we held onto that debt for 100 years, the amount owing would be a fraction of what it is today.

Some facts and figures:

The Gross Domestic Product (GDP) in Canada was worth $1.74Trillion US dollars in 2019, according to official data from World Bank and projections from Trading Economics. The GDP value of Canada represents 1.44 percent of the world economy. (source: https://tradingeconomics.com/canada/gdp)

Government Debt in Canada is expected to reach $683.92Billion CAD by the end of 2020, according to Trading Economics global macro models and analysts’ expectations. In the long-term, the Canada Government Debt is projected to trend around $705.05Billion CAD in 2021 and $715.52Billion CAD in 2022 (source: https://tradingeconomics.com/canada/government-debt).

When you take a step back, it seems holding onto over $700B of debt is not as bad as it seems when you look at the whole picture; it is relative to what is owned and how much is being produced.

If I told you I was $15M in debt, but then also revealed that I had a substantial portfolio of rental properties totalling $50M and that this portfolio produces $2.5M per year of rental income, then the $15M in debt might not seem like that much.

Our national debt is measured against the GDP – how much revenue our country produces. 

Government Debt to GDP in Canada is expected to reach 97 percent by the end of 2020, according to Trading Economics global macro models and analysts’ expectations. In the long-term, the Canada Government Gross Debt to GDP is projected to trend around 95 percent in 2021 and 90 percent in 2022 (source: https://tradingeconomics.com/canada/government-debt-to-gdp).

To use the same analogy with real estate, this means that Canada receives the $2.5M in rental income per year, and the overhead costs to manage the properties is a little less than $2.5M per year.  Each year, the mortgages get whittled away due to inflation, and each year Canada raises rents due to inflation.

Issues with this notion arise when the appetite for debt gets out of control. In the last 50 years, the amount of debt we’ve been taking on relative to how much money the country makes has exceeded 100% - in other words, the country has previously been in positions where it was spending more money than it was making.

Here are a few concerns: if interest rates rise, the cost of holding all that debt becomes more expensive.  At low interest rates, owing $700B is not that much of a concern. If anything, it might even be a good thing. But if interest rates start rise to say 4%, then holding all that debt would start costing a lot more money and would drain funding from other sources.

So, Canada has all this debt. With low interest rates and mild inflation, this is totally harmless – if anything, it helps our economy in the short-term. But if interest rates go up and inflation rates go down, then where is all that extra money supposed to come from to service the debt?  When Canada needs more money to service its needs and has already borrowed what it can, it will have no choice but to raise taxes to make up the difference.

Another concern is that Canada will defer paying back debt and put it off to future generations – more taxes, less public infrastructure, or maybe they will keep kicking that can down further and further so our future great-great-grandkids can worry about dealing with it.

The real issue here is likely a bit more nuanced. It’s assumed that the plan is likely to keep interests rates low and let inflation rise. As long as our economy continues to grow and innovate, the debt can sit there and whittle away through inflation – assuming we do not keep adding to it (!).

Another big issue here is if global investors stop seeing Canada as a safe and stable place for investment, then we might have to raise interest rates to entice people to lend us money. And that would likely mean higher taxes in the future.

In summary, yes the national debt is going up, yes it is concerning, and yes it can have some serious repercussions.  But as of right now, it isn’t a major concern, but it can be if interest rates go up, or if the debt goes higher and higher above our GDP.

This type of debt is necessary to continue to invest in the infrastructure of our economy. We have operated on debt since the early 1960’s, it’s not as bad as it seems, but it’s certainly something to keep an eye on and be aware of.

The take-home here is to ensure you have a framework for long-term investing, and to ensure your emotions (excitement when markets are up, fear when markets are down) don’t cloud your judgment in sticking to that framework.

If you have any questions about your financial plan, would like our opinion on what this current financial landscape means for long-term investors, or would like a refresh on the framework we have in place for times like these, please never hesitate to reach out. 

Be well and be safe,

Adam