Interest on Federal Debt, the “Double Whammy” Hypothesis, and Putting My Money Where My Mouth Is

As always, the TL;DR version:

TL;DR: While we should worry about the possibility that the interest rate the federal government pays on debt will rise substantially (tail risk is important!), the medium-term probability of an interest rate spike causing ballooning debt servicing costs is quite low. Here’s why… and I’m putting my money where my mouth is on this one.

Earliest this year, the Canadian Tax Foundation (a research group, not to be confused with the Canadian Taxpayers Federation, which is something else entirely) released the Finances of the Nation website. It’s a fantastic resource, with data going back to 1867. For example, here’s the nominal dollar cost each year, going back to Confederation, of financing the federal debt:

Last year, the federal government spent just over $23 billion on debt service costs (a.k.a. interest payments), or roughly $625 per Canadian. In inflation adjusted terms, this $625 is much lower than most years in my lifetime and is at levels experienced in the early 1970s.

We can think of total debt servicing charges as a function of two components:

• The total amount of debt
• The average interest rate paid on that debt

There are very real, very legitimate concerns that debt servicing costs will skyrocket in the coming years, thanks to the increase in debt during COVID-19 crisis (and debts that may follow).

It’s inarguable that the total amount of debt has risen, and will continue to rise which, all else being equal, will cause debt servicing costs to increase.

But there are also fears of what I call the “double whammy” hypothesis, that the average interest rate that the federal government pays will also rise, and rise significantly. A substantial increase in both right-hand side components of the formula would cause debt servicing costs to skyrocket.

This is certainly possible and is a scenario we should be concerned about and plan for. But it’s not one that is particularly likely over the next decade or so.

Because this will get lost, I want to repeat this. Although it’s not particularly likely, it is still a scenario we should be concerned about and plan for. Tail risk is a thing. We’re currently living through a tail risk event. Low probability does not equal zero probability.

Why isn’t it particularly likely? A few reasons:

• The Bank of Canada has shown the ability to keep inflation at or near 2% in a variety of economic conditions and I believe they will be able to do so.
• Given stagnant global economic growth and an aging global population demanding fixed-income assets, high real (inflation adjusted) interest rates are unlikely.
• The federal government's debt management plan is sound and involves “locking-in” at currently low rates. Nominal yields on 10-year bonds are currently just over 0.5%.
• Over the next few years, a number of high-interest rate bonds mature, and will be rolled-over into lower interest rate debt. These include 11 billion of bonds with a coupon rate of 3.25% which mature on June 1, 2021 and 2.3 billion of bonds with a coupon rate of 8% which mature the year after.

So what is the effective interest rate that the federal government is currently paying on debt? Well, it depends on which measure of debt you use. The Institute of Fiscal Studies and Democracy breaks down three common definitions:

The broadest measure of debt in Canada is “gross” debt, which includes all outstanding liabilities…

Then, to obtain net debt, financial assets are removed. The rationale is that, in theory, financial assets could be used to pay back debt, should the need arise. The Government of Canada’s financial assets are mainly composed of taxes receivable (29%), investment in enterprise Crown corporations (26%), foreign exchange accounts (26%), and cash and/or cash equivalents (10%). Finally, removing non-financial assets — mainly composed of tangible capital assets (81%), inventories (8%), and prepaid expenses and other (7%) — renders the accumulated deficits. Put differently, assuming full restatement or no major changes in accounting practices, the sum of every fiscal year’s budgetary balance (surplus or deficit) since inception would equal the current accumulated deficit (or surplus).

The Finances of the Nation site has data on gross debt and real debt going back to 1867, which, along with the data on debt servicing costs, allows us to calculate an implied interest rate on debt:

Unfortunately, they do not have data on accumulated deficit, but we can obtain these from the RBC fiscal tables going back to the 1981–82 fiscal year:

In the last fiscal year we have data for, the ratio of debt servicing costs to total accumulated deficit is 3.4%.

For the reasons outlined earlier in the piece, this ratio should continue to decline in the short-to-medium term. On this, I’m willing to put my money where my mouth is. I have made the following wager with the National Post’s John Ivison:

In fiscal year 2023–24, the ratio of debt servicing costs to accumulated deficit will be lower than 3.3%.

If I’m right, John will pay $100 to the charity of my choice (Ausome Ottawa). If John’s right, I will pay $100 to the charity of his choice.

Concluding thoughts: This is simply a prediction of what the government’s debt servicing costs will look like in a few years. Nothing in this piece (so far) should be taken as advice of how large the federal government should be willing to allow the debt to grow.

When it comes to taking on more debt (or reducing debt), I believe we should focus on the quality of the expenditure rather than the quantity of existing debt. If we can make worthwhile investments (either through increased spending or lower taxes) that address one of what I see as Canada’s five big long-term challenges:

1. Climate change and a decarbonizing global economy.
2. Demographic change and an aging population.
3. Stagnant economic growth and productivity.
4. Persistent structural barriers to full participation in the economy and society.
5. Housing affordability and availability, particularly in our most economically dynamic cities.

We should make that investment. Otherwise we shouldn’t.

“Take on good debt, avoid bad.” I know, not exactly ground-breaking stuff, but some pieces of advice never go out of style.