Peak Debt: A World Drowning in Debt

A world awash in debt

Globe and Mail

Kevin Carmichael
Ottawa — Globe and Mail Update
Published on Friday, Nov. 27, 2009 7:29PM EST


The financial crisis provoked a global front to stimulate economies through massive spending. But this was fuelled by a staggering amount of borrowing. Now governments are realizing that a new calamity looms - higher taxes and slashed social programs

or 220 years, through civil upheaval, global conflict and a depression, the United States largely kept its public debt under control.

But the world's largest economy may finally have met its match. In its bid to prevent the Great Recession from spiralling into a global depression, the U.S. government spent tens of billions rescuing financial institutions and automotive companies. In the process, the federal budget deficit swelled 220 per cent from 2008 to a record $1.6-trillion (U.S.).

The world's biggest economy has plenty of company: Seven of the members of the Group of 20 nations are on a trajectory that will leave them with debts bigger than 75 per cent of their economies by 2014, according to the International Monetary Fund.

It's hard to understate the fiscal cost of the financial crisis, which continues to send shock waves around the world. This week's move by Dubai World, a state-owned conglomerate that fuelled the United Arab Emirates' rapid growth, to withhold debt payments shows the financial crisis continues to put government finances at risk.

Even in Canada, a relative paragon of fiscal prudence, the combined gross debt of the federal and provincial governments is on pace to reach 79 per cent of gross domestic product next year, compared with 64 per cent in 2007.

The numbers are staggering. But as the dust settles from the financial meltdown, policy makers are slowly coming to grips with the fact that a long battle with deficits and debt is only beginning.

The immediate threat posed by economic calamity allowed them to forget about a reality that's been staring them in the face for years: The baby boomers are about to blow the budget.

U.S. President Barack Obama is feeling the most pressure these days.

One of the reasons the U.S. dollar has slumped this year is that investors lack confidence that the President and Congress are up to the challenge of restraining a long-term fiscal crunch that makes reducing the current deficit look routine.

Consider this: If the U.S. government was to slip into neutral today, allowing Bush-era tax cuts to expire and inflation to push many of the middle class into higher tax brackets, the country's debt would climb to about 300 per cent of gross domestic product over the next seven decades, according to the Congressional Budget Office.

Tweak that forecast for the political and demographic reality – the extensions of many of those tax cuts and higher payments to doctors as the population ages – and the CBO's model predicts the debt-to-GDP ratio would approach an astonishing 800 per cent over the lifetime of an American born this year.

“Relative to the future, the debt runups associated with the Civil War, World War I, World War II, the Regan deficits, and the current fiscal stimulus are mere hiccups,” Troy Davig, an economist at the Federal Reserve Bank of Kansas City, and two co-authors from Indiana University write in a recent paper on the looming U.S. fiscal crunch.

It's a demographic challenge that gets tougher every year in most advanced economies, where costly welfare states have grown alongside all the wealth produced in the decades that followed the Great Depression.

In Japan, where the aging population has long crimped economic growth, the budget deficit has increased by more than 300 per cent from 2007, putting its gross debt on track to reach 227 per cent of gross domestic product in 2010 from an already scary 188 per cent in 2007.

In Canada, seniors aged 65 and over accounted for a record 13.9 per cent of the country's population as of July 1, 2009, according to the latest count released yesterday by Statistics Canada. In two decades, that percentage is projected to rise to 25 per cent, Statscan said.

The deficits accumulated over the past two years, while almost certainly necessary to avoid a global depression, have also robbed governments of some of the precious breathing room they had before facing some of the most difficult choices of their careers.

The CBO forecast is an accountant's version of shock and awe; an effort to focus the public's mind on the unavoidable choices awaiting a country that promised adequate medical insurance and a decent retirement to about 79 million people who came to live in the U.S. between 1946 and the early 1960s by either birth or immigration.

Medicare and Medicaid, the U.S. federal programs that provide health care for the elderly and the poor respectively, are on pace to account for nearly 90 per cent of all growth in non-interest spending between now and 2080, according to the CBO.

While the U.S.'s fiscal woes are getting most of the attention because of the turmoil the weaker dollar is causing in financial markets, the threat of perpetual structural deficits in order to meet their obligations to the baby boom is one facing most every major developed country.

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The populations of Japan, Australia and many European nations are aging faster than that of the U.S., which benefits from a faster birth rate.

Even in Canada, which confronted the financial crisis with by far the lowest debt level among the big industrialized countries in the Group of Seven, the federal and provincial governments have less than a decade before health care costs begin rising faster than the revenue that can be reasonably expected from economic growth, according to Christopher Ragan, an economist at McGill University in Montreal.

Canada's labour participation rate has peaked at about 65 per cent, and is now projected to decline to below 60 per cent by 2040 as boomers retire faster than they are replaced by new workers and immigrants. Fewer workers mean less economic growth and less revenue.

The combined financial obligations of the federal government and the provinces – currently at about 78 per cent of GDP in terms of gross debt, according to the IMF – would increase 35 percentage points between 2020 and 2040 if revenue and non-age-related spending remained constant, Prof. Ragan wrote.

Governments have been long aware that trouble is looming, but have struggled to muster the political will to do little more than postpone the threat.

In the U.S., former treasury secretaries John Snow and Henry Paulson both made ill-fated attempts at overhauling the pension system to make it more affordable. In Canada, the baby boom's march into old age explains much of the commitment of successive Liberal and Conservative governments to paying off debt, yet the allure of spending increases and tax cuts has undermined some of those gains.

“There's an inconsistency between a high-spending and low-tax country,” said Charles Freedman, a scholar in residence at Carleton University in Ottawa and a former deputy governor at the Bank of Canada. “It just doesn't work.”

Neither U.S. Treasury Secretary Timothy Geithner, Finance Minister Jim Flaherty nor their counterparts in the G20 are under pressure to reconcile that inconsistency until there's more certainty the financial crisis has passed.

Echoing the other finance ministers of the G20, Mr. Flaherty last week told an audience in Toronto that he had no intention of reversing his stimulus program, saying there remains no evidence of firm growth.

Mr. Geithner has made similar comments, and the Obama administration hasn't ruled out spending more to reduce an unemployment rate that is above 10 per cent.

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“The U.S. economy is not going to collapse because of the U.S. debt burden,” said Phillip Swagel, a visiting professor at Washington-based Georgetown University's business school and a former chief economist at the Treasury Department. “It's a problem. It's just not an imminent problem.”

It's unlikely the U.S.'s finances will spiral as wildly out of control as the CBO's accounting exercise suggests. The country's creditors would demand change by forcing interest rates so high that even the most intransigent politicians would be forced to act.

But it's difficult to understate the rickety foundation on which the world's developed countries will attempt to support the aging of the baby boom generation.

Japan expanded its deficit by 320 per cent fighting is recession, setting the gross debt of the world's second-largest economy on track to reach 245.6 per cent of GDP by 2014.

On average, the debt of the developed nations in the Group of 20 will rise to 118.4 per cent of GDP in 2014, compared with 78.2 per cent in 2007, according to the IMF.

Debt that high will impede the recovery, eating up time and money to prepare for the retirement of the baby boom.

The bonds governments issue to pay the bills from their economic stimulus programs will absorb money that otherwise would have been invested in the economy. Interest payments will rise, leaving less money in treasuries for education, infrastructure or tax cuts.

For now, governments are focused on the short term, but “they know there is a day of reckoning,” said Paul Vaillancourt of Franklin Templeton Managed Investment Solutions in Calgary. “Developed nations will have to cut back on spending. This comes at a tough time demographically. There will be pain and investors need to prepare.”

But governments are under pressure to prove to people like Mr. Vaillancourt that they are serious about dealing with their debts as soon as the recovery allows.

This is easier for some than others.

Mr. Flaherty is simply making a pledge to balance the budget as quickly as possible, stressing that there will be no new spending measures in his next budget.

Britain's government plans to legislate a commitment to halve its budget deficit, and Mr. Obama this week indicated support for a bi-partisan commission that would recommend policies to deal with the U.S. longer-term debt issues.

The ultimate success of their efforts to trigger an economic recovery rests on their keeping those debt promises.

A recent study for the IMF by Mr. Freedman, the former Bank of Canada deputy governor, shows that higher debt for the U.S. over the long term would have a trickle-down effect that would reduce the growth of the global economy.

While the stimulus measures were successful, governments now need a “conservative medium-term fiscal framework which ensures that deficits and debt do not drift upwards permanently as the economy recovers,” Mr. Freedman concluded. “In the absence of such a framework, the long-run costs would far exceed the short-run benefits.”

Source: Globe and Mail