In the Financial Post, MLI senior fellow Philip Cross writes that municipal and provincial borrowing have pushed government debt to dangerous levels in Canada. "Canada's gross government debt is higher than in either the United States or the EU", Cross writes. "Much of the favourable perception of the state of government finances in Canada comes from considering only federal government debt". A longer version of this article first appeared in C2C Journal. Cross was also interviewed on the subject on BNN. Click here to watch.

Philip Cross, December 4, 2013

Canadians have followed the unfolding government debt crisis in the United States and the European Union (EU) with a sense of detachment. After all, a government debt crisis could never happen in Canada, right?

Wrong. It happened with the federal government in the mid-1990s and it could easily happen again in the not-too-distant future, this time originating with the provinces.

Canada's gross government debt is higher than in either the United States or the EU.

Much of the favourable perception of the state of government finances in Canada comes from considering only federal government debt. Government debt in Canada now originates mostly at the provincial and local levels of government. Combined, they have been more indebted than the feds every year since 2002. They made little headway in reducing their debt during the extended economic boom of the last two decades. The recession made things worse as revenue plunged and Keynesian pump-priming came into vogue, then their debt levels rose further even as the economy began to recover. As a result, provincial and local government debt as a share of the GDP was higher in 2012 than it was in 1995, the last time Canada faced a debt crisis.

For the moment, record-low interest rates are delaying the problem. The share of GDP spent on interest payments for government debt fell below 4% in 2012. This is lower than it was before the recession and well below its record high of nearly 20% in 1995. However, interest rates that go down must come up eventually.

Combine rapidly aging population on lower economic growth and higher health care costs, a return to more-normal levels of interest rates and the dependence of some provinces on volatile natural resourcerevenue, and precarious is certainly the word.

Already, the worrisome fiscal outlook is forcing unpopular choices onto provincial governments. Quebec's Finance Minister Nicolas Marceau declared, "Eliminating Québec's deficit is non-negotiable." Bond ratings agencies downgraded Ontario last summer, citing its $15-billion deficit and high spending. British Columbia received notice of a possible downgrade. Canada's governments will soon have to take decisive 1990s style action on debt.

What is different now is the record deficit run by local governments. Last year, local governments posted a deficit of $9.2-billion, by far the largest ever. Before 2000, it was rare for local governments to run a deficit of more than $1-billion, but it jumped to $6.3-billion during the recession in 2008 and has widened since (the deficit is tracking above $10-billion so far in 2013). The source of this growing deficit is easy to pinpoint: The increasing fiscal prudence among provincial governments has already resulted in lower transfers to local governments since 2010, totalling more than $2-billion. Meanwhile, capital spending has more than doubled to $28.4-billion in the last decade alone, most of it for aging infrastructure.

In the mid-1990s, governments in Canada showed that with decisive action the debt time bomb could be defused in a very short period without triggering a recession. And unlike the mid-1990s, when an upturn in interest rates helped precipitate the debt crisis, the current period of record-low interest rates will alleviate rather than aggravate the problem if governments act before rates start rising.

Still, difficult decisions about spending cuts are required. The provinces must address rapidly growing education and health care spending, which together account for more than half of their expenditure. A major overhaul of policy-making in these two sectors is long overdue.

Governments continue to pour money into education, particularly universities, even while their most noticeable output seems to be a nation-wide skills mismatch. Health care expenditures are among the highest in the world, even before the Boomer generation begins to tax the system. Nevertheless, the performance of our health care system consistently ranked as well below average.

Politicians will always try to put off making hard choices, but there are precedents for overhauling major social programs to make them more efficient in achieving their social goals. Canada's welfare system was reformed as part of government belt-tightening in the mid-1990s that cut the number of beneficiaries by half without any major consequence for poverty rates. As well, the Canada Pension Plan was put on a more-stable footing in 1999. The alternative is American-style denial, to always deal with the problem next quarter, then the next.

Facing up to government debt problems is a matter of "arithmetic," not ideology, in the words of former finance minister Paul Martin. Increasingly, for Canada's provinces and municipalities, the numbers just do not add up. With Canadians already showing signs of tax fatigue, and many having to save more as their retirement approaches, the only politically sustainable solution is lower government spending.

Philip Cross is a Senior Fellow at the Macdonald-Laurier Institute and former Chief Economic Analyst at Statistics Canada. 

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