Debt-Financed Government Spending Imposes ‘Real Economic Costs’ on Canadians: Study

Deputy Prime Minister and Finance Minister Chrystia Freeland responds to questions from the opposition after delivering the federal budget in the House of Commons in Ottawa on April 7, 2022. The Canadian Press/Adrian Wyld

The notion that debt-financed government spending has a “low fiscal cost” is not only misleading, but also hides the fact that it has real economic costs, even when the interest rates are very low, a recent study says.

“There is no free lunch when it comes to debt-financed government spending. Even with record low interest rates, there are real costs imposed on the economy and Canadians,” said study co-author Bev Dahlby, a senior fellow with the Fraser Institute, in a press release on July 7.

The study, titled “The Fiscal Costs of Debt-Financed Government Spending,” is a review of fiscal policies made based on favouring debt-financed spending due to “very low interest rates on government debt over the past decades.”

“The persistently low interest rates on government debt over past decades has prompted some leading economists to question the wisdom of fiscal policies that restrict the use of deficits to finance government spending,” the report said.

“This position is based on a simple model of public debt dynamics which implies that when the real interest rate on public debt, r, is less than the growth rate of the economy, g, the ratio of the government debt to GDP can be stabilized even if the government has a primary deficit, i.e. with current revenues less than current program expenditures.”

The study says this notion has led some policymakers to believe that tax revenues never have to equal program expenditures if the real interest rate on government debt is less than the growth rate of the economy.

According to several econometric studies cited in the report, when governments accumulate debt, it will lead to higher real interest rates and lower economic growth rates.

“A more recent study by Jiang et al. (2022) found that a one percentage point increase in a government deficit to GDP ratio increased the interest rate on government debt by about 10 basis points for nine EU countries from 2002 to 2020,” said the authors, citing a study published in SSRN, a repository for preprints devoted to the rapid dissemination of scholarly research.

The adverse effect of public debt on growth was also documented in several studies included in the report.

“Perhaps the most comprehensive of these studies is by Woo and Kumar (2015) which concluded that a 10 percentage point increase in an advanced economy’s debt ratio reduces the annual economic growth rate by 0.15 percentage points,” the report said.

Study co-author Ergete Ferede, also a senior fellow with the Fraser Institute, said “the evidence is clear” that the notion that debt-financed spending has a low fiscal cost is “misleading.”

“Policymakers would be wise to re-examine their fiscal policies in light of the substantial increases in government debt due to the pandemic and the environment of rising interest rates,” he said.

Value Gap

The authors stressed that government borrowing can crowd out and displace private sector investment, lower the economy’s productive potential, which eventually results in lower incomes for Canadians.

In addition, with growing government debt, the value of the “r - g” gap increases as interest rates rise relative to declining economic growth rates.

“[A] one percentage point increase in the debt to GDP ratio of the federal, provincial, territorial, and local government sector is associated with a 6.7 basis point increase in the Canadian r – g gap,” the report noted.

The rising of the “r - g” gap means that the governments will either have to resort to significant spending cuts and/or increase taxes to stabilize their debt levels, according to the authors.

“These costs are not theoretical as Canadians have already endured them during periods like the late 1980s and early 1990s, which necessitated large fiscal reforms,” Dalhby said.