Charting the structural economic effects of the deficit and the debt

Robert Crozier

Robert Crozier, now retired, is the former Director, National Accounts Division, Statistics Canada, the former Head of Forecasting and Economic Analysis at the Department of Trade and Commerce, and former Senior Economist at both the Economic Council of Canada and the Conference Board in Canada.-Note.

This essay represents part of a larger paper presented to the Minister of Finance as he prepared the federal budget for 1994-95. The first part of the paper, omitted here, was concerned with the significant challenge the minister faced. It showed how much the deficit would have to be cut in order to get ahead of the avalanche of spending, accelerated by the force of compound interest interacting with the significant projected deficits that will persist for the next several years in spite of the spending cuts and tax increases in the current budget.

The second part of the paper, presented here, concerns the effect that the fiscal activities of government are having on the structure of the economy and on its ability to grow out of the current bleak circumstances. We have assembled a number of charts which, with very little additional comment, show how the Canadian economy has been affected by so much public sector borrowing. That the economy is functioning poorly is a highly visible fact of life. What is not so visible is that this borrowing has created major dislocations in the balance and structure of the economy, and that these dislocations are affecting the economy's performance in a number of important ways.

THERE ARE MANY REASONS advanced for doing something about the debt and deficit problem. I agree with most of them. The main reason I am concerned about the situation, however, is the fundamental damage which is being done to the structure of the economy by current fiscal practises. There has been too little focus on this.

The deficits (charts l and 2)

At the root of the economy's disorders are the public sector deficits shown in charts l and 2. Note that the federal government has been in deficit in every year since 1960 with one single exception (chart l). The beginning of the 1970s marked the start of a steep slide into deficit financing by the federal government, culminating in an all-time high deficit of 8.6 percent of GDP in 1984. Following this, the Mulroney government was successful in working the deficit down to about 4.5 percent of GDP, but since 1989 it has risen again, to around 6 percent.

Click here to view Chart 1: Federal Government Deficit as a Percent of GDP (1960-1993)

Click here to view Chart 2: All-Government Deficit (-) or Surplus (+) as a Percent of GDP (1960-1993)

Chart 2 shows the all-government deficit position over the same time, on a national accounts basis. (This is the more comprehensive measure of the public sector deficit.) The configuration is much the same, with the exception of the 1965-1974 period. Since 1974, the all-government position has plunged steeply into deficit, reaching over 6.5 percent of GDP in 1992. Provincial government deficits have risen sharply, although collectively they are still considerably lower than the federal deficit. The perverse effect of these deficits has reached into every area of the Canadian economy, as will be seen in the charts that follow.

Net domestic saving (chart 3)

Canada's rate of net domestic saving has undergone an unprecedented decline since 1974, the last year in which all governments collectively ran a surplus. As chart 3 shows, net domestic saving, which was at 12.5 percent of GDP in 1974, had virtually collapsed by 1992, barely reaching 0.5 percent of GDP in that year. The scale of this decline in the nation's saving can only be described as calamitous, unmatched in any period since World War II.

Click here to view Chart 3: Net Domestic Saving as a Percent of GDP (1960-1993)

Table 1 shows how the composition of the nation's saving has changed over this period. The savings of the private sector are now being almost wholly absorbed by the huge deficits in the government sector, leaving little available for domestic needs. The shortage of funds at home has driven borrowers to seek financing in foreign markets, and this in turn has played a major role in the earlier rise in the Canadian dollar exchange rate and in the deficits which have emerged in Canada's balance of payments on current account.

Click here to view Table 1: Net Domestic Savings

Net Private Saving (chart 4)

The record of net private saving over the past 30 years is shown in chart 4. Savings of persons and unincorporated business plus corporate and government business enterprises. After a long 24-year uptrend, the rate of net private savings turned down in 1985 and the fall has continued right through to 1992. This drop in the private savings rate comes at a time when government deficits are already soaking up the major part of our net saving; the decline in private saving is thus contributing to the shortage of saving that already exists.

Click here to view Chart 4: Net Private Savings as a Percent of GDP (1960-1993)

Why are private savings declining? And why did the decline begin around the mid 1980s and take such a decisive turn downward? Chart 5 reveals part of the answer. The rate of personal saving stopped rising and moved sharply downwards in the early 1980s. This decline was clearly associated with an unprecedented rise in taxes on personal incomes, as the chart shows.

Click here to view Chart 5: Personal Savings and Personal Taxes as a Percent of Personal Disposable Income (1970-1993)

From an average of around 23 percent of disposable income in the 1970s, personal taxes rose steeply in the 1980s, to over 30 percent of disposable income by 1992.

Governments facing rising deficits and pressed for new sources of revenue have been piling on tax after tax (including employer-employee contributions to Unemployment Insurance that show up in the budget, and those to the Canada Pension Plan that do not) to the point where persons and unincorporated businesses are now carrying an unprecedented load of taxation. They have cut their saving rate in large measure as a response to these steep tax increases.

Thus, net domestic saving (chart 3) is being hit twice--not just by the deficit itself, but also by the decline in private saving brought on by higher taxes.

The other main element in the private saving mix is undistributed corporation profits (chart 6). These have declined for four years in a row and were negative in 1991 and in 1992. Corporation profits as a percent of GDP are at their lowest level in 20 years, a fact which undoubtedly accounts for a good deal of the "down-sizing" which is still going on in the economy (chart 7). This weakness in the corporate sector has also played a role in the decline of private saving.

Click here to view Chart 6: Undistributed Corporation Profits as a Percent of Net Domestic Income (1970-1993)

Click here to view Chart 7: Corporation Profits Before Taxes and Dividends as a Percent of GDP (1970-1993)

Net Domestic Investment (chart 8)

It is an observed fact that high growth, high performance economies with strong competitive capabilities are generally those with high rates of saving and investment. The growth of productivity, which makes possible advances in a nation's living standards, is closely tied to the rate at which a country invests in its physical stock of capital assets. The equipping of the work-force with modern, technologically advanced plant and equipment is thus one of the principal ways in which countries can raise their living standards, promote economic growth, and successfully compete in global markets. These conclusions are supported by studies comparing the performances of various economies around the world.

Instead, Canada appears to be well on the way to becoming a low-savings, low-investment economy. Chart 3 showed how deficits and other factors have devastated the nation's level of domestic saving, which has been declining for 20 years. Chart 8 gives the other side of the picture--what has been happening to net investment expenditures for new capital structures and machinery and equipment over this same period of time.

Click here to view Chart 8: Net Domestic Investment as a Percent of GDP (1960-1993)

As the charts show, the 20-year decline in the domestic savings rate has been matched by a 20-year decline in the rate at which Canada has been investing in new capital facilities. In both cases, the declines began from a peak in 1974. The fall-off of investment has been less catastrophic than that of saving, reflecting the fact that borrowers have been able to draw on funds from foreign markets to support their programs. Nevertheless, the investment decline has been severe, from 15 percent of GDP when the decline began to less than 7 percent in 1992.

No one can look at these declines in rates of investment in Canada and not be troubled by what they imply for the future. Canada has been under-investing in its basic capital structure for a very long time. We have been "eating the seed corn rather than planting it," using our savings to increase our consumption rather than investing in our collective future.

In the period 1979-90, Canada's productivity growth rate fell to 1.5 percent per year from 2.1 percent in the period 1973-79.

How Ottawa Spends, 1993, p. 328, from an article by Bruce Wilkinson.-Note.

Spending for consumption (chart 9)

The counterpart to the fall in the nation's saving has been the steep rise in the share of output going to consumption. Chart 9 tells the story. Beginning in the mid-1970s, the share of consumption spending in the economy shifted sharply upward to new levels, as money borrowed by governments was spent for consumption purposes. This consumption includes the money borrowed to finance transfers to persons and other welfare and entitlement programs, which end up in personal consumption expenditures, and also borrowing to finance government administered programs, which show up as government current expenditures on goods and services. Whatever form the spending takes initially, it serves almost exclusively to support current consumption. An exception would be where governments borrow funds to finance capital outlay (which in total amount to only 2.5 percent of GDP). Such capital investment outlays are not part of "consumption" expenditures shown in Chart 6.-Note.

Click here to view Chart 9: Spending on Consumption as a Percent of GDP (1960-1993)

A country which chooses to put "consumption" ahead of "investment," as Canada has been doing, is a country which is jeopardizing its economic future. Canada has been borrowing huge sums of money to raise the consumption levels of its citizens beyond those which would be attainable if financed out of income. This is the meaning of the federal deficit now running at $40 to $45 billion a year. The borrowed funds are spent, not for any production-enhancing purpose that confers a flow of future benefits, but for pure consumption. The same process is occurring at the level of the provinces, which are jointly running deficits of $20 billion a year.

Out of this "under-investing" and "over-consuming" economy, we must somehow fashion the arrangements to carry the payments on a $700 billion federal-provincial debt (payments that at the moment are being covered by more borrowing) and eventually to generate the wealth with which to repay the debt. At the moment, we are having a problem just reducing the deficit. It is obvious that there will have to be a fundamental re-arrangement of the way we conduct our economic affairs in Canada if we are ever to work our way out of this dangerous morass.

Federal interest on the public debt (chart 10)

Chart 10 shows the extraordinary rise of federal debt interest as a percent of federal revenues since 1974. As is the case for the public sector's plunge into deficit, the fall in domestic saving, the decline in investment, and the rise in consumption, 1974 is the point of departure for most of the basic changes in direction in the economy that are being discussed here.

Click here to view Chart 10: Federal Interest on the Public Debt as a Percent of Federal Revenue (1960-1993)

In 1974, interest on the federal public debt was 10 percent of federal revenues. By 1992, it had risen to 32 percent, on a budgetary basis. (On a national accounts basis the figures are 12 percent and 29 percent). Whichever series is used, the ratio of debt interest to total revenue is now of the order of one to three.

As table 2 indicates, interest on the federal debt in 1992-93 was $39 billion, about the same size as the deficit for that year ($40.5 billion). We are now borrowing money simply to meet interest payments on past borrowing. Debt interest is now the largest single item in federal expenditures, and, as a continuing contractual obligation, it is placing a major squeeze on the availability of funds for program spending.

Click here to view Table 2: Federal Revenues and Expenditures, 1992-93

Moreover, it is growing at a compounding rate, since each year's deficit brings an increase in the size of the debt, and each increase in the debt brings an increase in interest payments. And this will continue as long as there is a deficit.

It should be noted that chart 10 concerns only interest on the federal public debt. Provincial payments of debt interest are now running in the neighbourhood of $20 to $25 billion a year, which brings the all-government total to $60 to $65 billion--8 or 9 percent of GDP. This is a huge dead-weight drag on the economy which must be paid year after year--half of it to non-residents.

The borrowed funds on which this interest is paid have already been spent, almost wholly on consumption. We have received no permanent benefit from this spending, but the distorting effects of the deficits have inflicted much harm on the economy, as the charts have shown.

Canada's balance of international payments (chart 11)

As chart 11 indicates, Canada has run a deficit on its current international balance of payments in 27 of the past 33 years. To finance these deficits, Canadians have borrowed heavily in foreign markets. Canada's net indebtedness to nonresidents now stands at an estimated $330 billion, equivalent to about 50 percent of Gross Domestic Product.

Click here to view Chart 11: Canada's Deficit or Surplus on Current Transactions with Non-Residents (1960-1993) as a Percent of GDP

Governments facing heavy deficits in the 1980s and 1990s have been large borrowers in international markets. At the same time, Canadian interest rates have until recently been maintained at comparatively high levels, attracting foreign investors seeking high rates of return. The large inflow of foreign funds through this period was reflected in a rise in the exchange value of the Canadian dollar, which moved from $US 0.715 in the fourth quarter of 1985 to $US 0.883 in the third quarter of 1991, the highest level in over a decade. The increase in the exchange rate significantly eroded Canada's competitive position and contributed to a drop in the traditional surplus in merchandise trade between 1985 and 1992. The services account deteriorated as well, mainly as a result of an increase in travel and tourism outside the country. And finally, net payments of debt interest rose from $12.7 billion in 1985, to $24.5 billion in 1992, reflecting the higher levels of international indebtedness. These changes broadly account for the increase in the deficit on current account, which rose from $3.1 billion in 1985 to $28.6 billion in 1992. The figures are shown in table 3.

Click here to view Table 3: Canada's current account balance of international payments

The view has been advanced by some economists that the public sector deficit and the deficit in the international account are intimately connected. The linkages run as follows. The deficit in the government sector causes a fall in the nation's rate of saving. The shortage of saving leads to a competition for the remaining funds, driving up interest rates at home and forcing borrowers to turn to foreign markets. The rise in interest rates produces a heavy inflow of capital from foreign investors seeking a better return on their money. If the capital inflow is excessive and beyond the levels required to satisfy investment demand, it will drive up the exchange value of the currency. This in turn will erode the country's competitiveness in world markets, leading to a deficit in the international balance of payments (or causing it to become larger if a deficit already exists). This "twin deficit" theory was first proposed by Martin Feldstein, former Chairman of the President's Council of Economic Advisers in the United States. It has been the subject of some controversy.-Note.

This scenario does seem to fit the recent Canadian experience. Certainly the public sector deficit produced a huge decline in the rate of saving as has been shown. Certainly interest rates were at very high levels, with a large spread existing between Canadian and U.S. rates. Certainly the capital inflow drove up the exchange value of the Canadian dollar, which rose by 25 percent between 1985 and 1991. And it is clear that the increase in the exchange rate did major damage to Canada's international competitive position, leading to a decline in the trade surplus (as well as an increase in travel outlays). That the capital inflow was indeed excessive in this period is evidenced by the fact that Canada's foreign exchange reserves rose by $14 billion in 1987 and 1988.

It is important to note that almost half of the $25 billion increase in the foreign account deficit between 1985 and 1992 was due to the increase in interest payments on the debt which we owe to non-residents (table 3). The cost of servicing this foreign debt now amounts to 3.5 percent of Canada's GDP. Thus we must now, in effect, transfer 3.5 percent of our production each year to non-residents simply to meet the carrying charges on the money we owe them. As long as we are running a deficit in the balance of payments, our indebtedness to non-residents will continue to rise. And so will the carrying charges against our GDP.

There are risks involved in becoming so heavily dependent on foreign sources of funds. First, there may well be a limit beyond which non-residents no longer wish to hold large amounts of Canadian debt instruments or other forms of investment. Their absorptive capacity is not unlimited. And secondly, the greater the dependency, the more vulnerable Canada becomes to instabilities in international financial markets or to factors affecting investor confidence.

Running deficits in the balance of international payments is another form of "living beyond one's means." We are consuming more than we earn. In effect, we are importing physical resources from other countries to supplement the resources available from our own production. Put another way, Canadian demand is exceeding Canadian supply, and the difference, equivalent to 4 percent of GDP, is made up by importing foreign resources.

Running in place

If these notes have an apocalyptic tone, it is only because the figures look so appallingly grim. "Running in place" may not be a wholly appropriate title for an end-note, but it conveys a sense of the extent to which we are now made captive by debt, deficits, interest payments, and taxes.

The economy has been weakened by a long regime of deficit financing. Our rate of net investment today is less than half of what it was twenty years ago. Net domestic saving has all but collapsed. Our balance of payments is deeply in deficit. And we have other encumbrances, including huge debts and interest payments which will not go away but which are rising fast.

The underlying source of the economy's problems is the huge and chronic deficit in the public sector, as described in the preceding analysis and charts. The deficit is growing at a compound rate, and so are the debt and the interest payments associated with it. The orders of magnitude are now so large that they are threatening to defeat discretionary efforts at deficit reduction unless these efforts are very substantial. The longer action is deferred, the greater the difficulty, for compounding effects do not wait upon the pleasure of governments.

The most compelling message that this analysis provides is how critically important it is that the deficit be eliminated, and quickly. The economy must be relieved of the gross distortions and imbalances imposed on it by two decades of public sector borrowing. And time is of the essence, for if action is not soon taken, the escalating power of the deficit, debt and interest payments will have pushed the numbers beyond any reasonable possibility of our gaining control over the process.

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Last Modified: Wednesday, October 20, 1999.