Good debt versus bad debt – what is the difference?
April 2, 2019
In some economic circles, it has become fashionable to suggest that mounting government debt and deficits don’t matter a whole lot. Take for example the International Monetary Fund (IMF) study put forward last year suggesting that for governments in good standing, debt capacities are infinite with low risk of default.
Closer to home, studies from the University of Calgary’s School of Public Policy suggest that Alberta still ranks more favourably than all other provinces in debt to GDP ratio. However, the province does risk negative repercussions should a debt and deficit reduction plan not be followed in a reasonable amount of time. Many economists worry the trend by successive Alberta governments of pinning their hopes to fluctuating royalty revenues will continue and result in a systemic failure to balance the province’s books. University of Calgary economist Trevor Tombe provides a good primer on debt here.
Taking on debt can be a good thing in the short-term – especially to stimulate infrastructure spending during times of recession – it can also be detrimental if it is allowed to continue to grow or if governments take on debt to fund operating budgets.
Before the 2008 economic crisis, taking on debt as a government varied from country to country, based on unique economic situations. Once the global economic downturn took hold, major economies started to increase their debt loads as a tool to boost economic activity.
Borrowing by governments can result in three upsides for economies:
1) It provides governments with extra funds to invest in economic growth,
2) It allows a safer alternative for foreign investors, as government bonds are a safer alternative to direct investments, and
3) It standard of living during tough economic times, by building infrastructure and supporting social services.
Canadians and Albertans have seen spin-off benefits of these during the last economic downturn. Both provincially and federally, this has come in the form of investments in infrastructure projects which have created jobs and funding for education programs that encourage students to learn essential skills in evolving sectors like science and technology. However, most economists state that economic growth, increased investments and improving or maintaining standards of living that come from taking on debt are limited to the short-term and are often outweighed by long-term risks. This does not mean that governments should never take on debt. Most budgets are generally split into two portions, an operating budget and a capital budget. An operating budget refers to the costs that governments take on year after year in the operation and maintenance of public services. A capital budget is spending on fixed assets such as infrastructure.
If governments are to consider taking on debt, they should explore using this option on the capital side as it offers more long-term benefits to the taxpayers and avoid taking on debt to fund annual operating expenditures that become difficult to sustain year over year.
The negative effects of public debt
Debt accumulation in the long-term hurts economic growth in several ways. Most importantly, carrying debt for an extended period increases the debt to GDP ratio. Usually written as a per cent, the ratio compares a country’s public debt to its gross domestic product (GDP). The lower a jurisdiction’s debt to GDP ratio is, the healthier its fiscal position.
A high debt to GDP ratio is a red flag for investors looking to move capital into a market. Investors look to the debt to GDP ratio as an indicator of a jurisdiction’s capacity to pay off its debt. As the ratio grows, so does the chance of default on loans.
With increasing debt, the portion of a budget that must be dedicated to repaying that debt also increases. This limits what any given government can spend on the services that citizens demand while stifling its ability respond to emergencies that may come up. Increased interest rates because of long-term deficits leave governments with less to invest in its own future. Furthermore, an increasing debt burden exposes businesses and taxpayers to growing risk that the government will raise taxes to generate revenue in order to keep servicing its debt.
Future investments from the private sector are also at risk when a government chooses to stay in debt. With a rising debt trajectory, investor confidence is eroded by the combination of the two effects above leading to a crowding out of investments. A drop in private investments doesn’t only stifle economic growth, it also decreases wages for households.
In 2019/2020, Alberta is projected to reach over $70 billion in public debt. The good news is that Alberta’s debt to GDP ratio remains the lowest among Canadian provinces. However, in recent years we have seen the overall debt load increase significantly and there are a variety of factors that could impact future debt levels. For instance, by 2040, an aging population in the province is expected to increase government spending to keep services at a necessary level to maintain quality of life for its citizens. During this time, it is also expected that the tax revenues will fail to keep pace. This puts our province in a critical situation where the focus needs to be on reducing its debt and returning to a balanced budget as soon as possible.
By creating stability though fiscal responsibility and returning to balanced operating budgets, the government of Alberta can help lift the current chill on investment. A balanced budget would also allow the province to avoid the long-term negative effects that are associated with accumulating debt.
Public Debt & Municipalities
Legislation around debts and surpluses for municipalities vary from province to province. In Alberta, municipalities are bound by legislation to have a balanced operating budget. This inability to operate under a budget deficit drastically limits the amount of debt that a municipality can carry. In addition, there are often provincially-legislated debt limits to how much debt a city can take on. This protects cities from the adverse effects of public debt in two ways. First, it greatly limits a city’s risk exposure. Second, it ensures that there is a backstop provided by the provincial government in the debt that is carried by cities.
Alberta’s Municipal Government Act (MGA) limits total municipal debt to two times municipal revenues with debt servicing costs limited to 35 per cent of revenue for all cities in the province. Currently, the City of Calgary is utilizing 9.6 per cent of its 10 per cent debt servicing cost limit it has imposed on itself. This is well below the provincial limit. Edmonton is currently projected to be below its self imposed 22 per cent debt servicing limit. This is using roughly half of the debt limit allotted to the city under the MGA. This shows that both major cities in Alberta are maintaining a healthy debt burden and are borrowing money for capital projects that benefit citizens in the long-term.
Public debt is a slippery slope that offers short-term benefits at the risk of long-term downfalls. Economists, political commentators, and central banks across the world believe that despite short-term benefits, carrying public debt for an extended period hinders economic growth, limiting a government’s ability to respond to emergencies, and drives away investment.
In the Calgary Chamber’s advocacy work, the importance of government’s working towards balanced budgets is featured as a principle of fiscal responsibility in the 2019 Alberta Election Platform.