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Government Deficit Financing: How Do They Do It?

Government deficit financing is a hot topic among taxpayers everywhere. It seems like no matter how much we pay in taxes, our governments are never able to run a balanced budget, at least where I'm from (remember from my post about moving to the big city that I grew up in rural New Brunswick).

Canada in general is known for high levels of government debt, particularly at the provincial level. According to this article from the Financial Post, Ontario is now the world's most indebted sub-sovereign borrower. The Province has twice the debt of California, which is the largest American State. Amazing!

Luckily, not all the publicity about Canadian government debt is bad news. According to the Huffington Post, the Federal government is planning on running a $29.4-billion deficit for the coming fiscal year, which the conservative party has called a "nightmare". I don't agree with that statement - after all, perspective is everything. Consider this: in the 1980s, the Federal government ran much larger deficits, including a high of $51.6-billion (which would actually be much larger in today's dollars due to inflation). Along with the relatively low federal deficits we are currently running, many provinces have also committed to running balanced budgets. Quebec leads the pack, largely due to the Quebec Balanced Budget Act.

Obviously there's a ton of buzz around government budget deficits, so it's surprising how many people don't' actually understand the dynamics behind government deficit financing. Do you understand who the provinces are actually borrowing money from when they run a deficit? Is it the Bank of Canada? Is it a retail bank, like TD or RBC? Read on to find out!

Why Should We Care?

First of all, it's important to realize that pretty much all of the Canadian provinces (along with the federal government) are in massive amounts of debt. There is a lot of variability between provincial debt levels, particularly if you consider the absolute numbers (rather than the per-capita or per-GDP numbers). This is due to variance in the population sizes of the provinces. In this section I'm going to briefly present some data that will show the current indebtedness of the Canadian governments, then later I'll explain the mechanics behind how they work.

First I'm going to show net debt by province, so you can see how much the absolute debt varies between provinces:

Source: RBC Economics

Next, the same data in a pie chart so you can see the contributions of each province to the total provincial debt level of ~$560 billion. As you can see, Ontario's net provincial debt makes up roughly half of the country's total, and Quebec and Ontario together have more than 75% of the pie:

Source: RBC Economics

Up next is a bar chart to compare the aggregate Canadian provincial debt to the total federal net debt outstanding. You'll see that even though our provinces are in a frightening amount of absolute debt, it still pales in comparison to that of the federal government:

Source: RBC Economics

The ratio of net debt to GDP is one that is commonly used to measure how effectively a government can use their outstanding debt to generate productivity. This graph compares net debt to GDP for the 10 Canadian provinces, with Quebec leading the pack in this instance:

Source: RBC EconomicsSource: RBC Economics

The last metric we're going to look at (I promise!) is net debt per capita. As the name implies, this is simply each citizen's share of the province's net debt. I find this graph to be the most interesting of them all, and Quebec again holds the lead:

Source: RBC Economics

Now that we have a sense of the severity of our current provincial and federal debt situations, I'll move on to explain how this debt is actually financed.

Government Deficit Financing: Made Possible Through the Issuance of Bonds

The title says it all here. Governments borrow money not from the Canadian central bank, not from retail banks, not from other governments, but from everyday individual investors like you and I. They do this through issuing bonds.

Bonds are simply a contract between a borrower and an investor.

If you're not familiar with what bonds are or how they work, then I'll explain it a bit here. Essentially a bond is a lending contract between an issuing entity and an investor. In the case of government deficit financing, the issuing entity is the government (federal or provincial). The government receives a certain amount of money from you when you purchase the bond, called the "principle", and in return for the ability to use this capital they will make semiannual payments to you (called the coupon payments). At the maturity of the bond (which are most typically 2, 5, 10, 20 or 30 years), the government pays you a final interest payment along with the repayment of principal.

Notice that debt and deficit to not mean the same thing, though they are definitely related. Debt refers to a point in time, a snapshot of a person's (or in the case, government's) financial indebtedness. Deficit is different because it considers a time period. If expenses exceed revenues for a given time period, then the government is said to run a budget deficit over that period. The opposite to this is a budget surplus, when a government's revenues exceed their expenses.

Though unlikely, it is possible to run a budget deficit and still not be in debt. For example, if a government had no net debt and $1,000,000 in cash and ran a budget deficit of $500,000, then they would still have cash of $500,000 at the end of this budget period. Thus, they ran a deficit but still didn't have any debt.

Government Deficit Financing

Budget surpluses are reducers of government debt.

The way that I tend to think of it is like this: budget surpluses are times of government savings while budget deficits are times of government spending. Every day that goes by in a budget deficit increases the government's debt, while time spent in budget surplus reduces the government's debt (or builds their assets, if no debt was present at the beginning of the surplus).

Controversy and Economic Benefits

Government budget deficits have long been a source of controversy to the taxpayers. As debt service charges increase, less of the citizen's tax money is being used on government-related expenditures but is instead being paid to bondholders in the form of coupon payments.

On a high level, though, economists generally agree that deficit spending is healthy for an overall economy as long as two criteria are met.

First, there should be cyclical deficits but not structural deficits. What this means is that the government is running a budget deficit intentionally during times of economic recession to make up for the lack of overall consumer demand. This is referred to as a cyclical deficit. Times of economic boom should result in budget surpluses of roughly the same magnitude, so theoretically there should be no net deficit over the course of a full economic cycle. A structural deficit, on the other hand, should be avoided - with structural deficit meaning permanent deficit.

The second stipulation that economists have agreed upon for the execution of a successful budget deficit is that during times of economic boom, the budget surplus that is naturally generated should be used to pay down debt. There are a variety of ways this has manifested itself in modern fiscal policy.

The Generations Fund is based on the premise that investment returns are likely to outperform the cost of debt in the immediate future.

The Generations Fund is based on the premise that investment returns are likely to outperform the cost of debt in the immediate future. The wider the spread, the bigger the benefit.

For example, the Province of Quebec has instituted an interesting debt reduction technique in the form of the Generations Fund. This is a trust fund that was created by the Province in 2006 with the intention of paying down debt. Essentially, the Province has mandated that surpluses generated by certain provincial activities will be deposited to this fund. According to the Province of Quebec's website, these designated funds will include all mining revenues, a particular tax on alcohols, and $215 million coming from Hydro Quebec (starting in the 2017-2018 fiscal year).

Once deposited, the money in the Generations fund is invested to create a return. The idea here is that the Fund is likely able to generate a higher return than Quebec's debt service charges, so it makes more sense invest in the fund rather than buy back their own provincial bonds. It all comes back to leverage, as I discussed in my post Pay Down Debt or Invest?

And how have their returns been? I was able to find this chart about the activity in the Generations Fund for the 2015-2016 fiscal year:

Source: Website of the Quebec Minister of Finance

Source: Website of the Quebec Minister of Finance

My interpretation of this is that Quebec was able to generate an investment income of $347 million off of a book value of $6 938 million (or more appropriately $6.94 billion). Some simple math tells me that this is a return of 5.00%. It's hard to say whether this is a good return or not given I don't know what asset class they are investing in - for example, this would be a poor payoff for the risk assumed when investing in global equities. Given that this is a provincial fund, though, I would imagine that they are investing in some sort of low-risk securities like bonds. And one thing can be certain - given today's extremely low interest rate environment, this is most likely a higher return than the cost on their debt. So at least in this fiscal year, the Generation Fund was a sound economic decision.

Takeaways

In this post, there were three things that I wanted to highlight for my readers.

First, I showed you a few charts and other metrics to demonstrate the level of debt that the federal and provincial governments have incurred to this point. By doing this I wanted you to have a sense of why it is important to understand government deficit financing.

Next, I explained the mechanics behind government deficit financing so you could see exactly how it works and what happens behind the scenes to engineer these deficits. Hopefully after reading that section, you have a better idea of the purpose of federal and provincial bonds and why they are a necessary component to our current Canadian economy.

Third, I highlighted some of the controversy behind government deficits and used Quebec's Generations Fund as an example of exotic methods used to reduce government debt. Hopefully you learned something fomr this section, as well!

Thanks for reading!

Readers, before reading this post did you have any sort of understanding of government deficit financing? Did you know that bonds are the weapon that engineers it all? Do you think our current levels of government debt are sustainable, or should we be worried about what will happen going forward? Let me know in the comments section!