What Would A Canadian Debt Crisis Look Like?

What we have to look forward to if public spending is not brought under control

More Than Just A Hypothetical

My inaugural post discussed how to avoid a sovereign debt crisis in Canada; that was perhaps a bit premature without first having explained for those who don’t fully understand just how terrifying that would be to live through.

Debt crises are generally seen as either something that happens to Global South countries like Lebanon, Sri Lanka, Zambia, etc., or else something that’s solved with a bailout by friendly neighbours, as happened in Greece, Portugal, Cyprus, etc. However, with a global Grey Tsunami that’s projected to turbocharge deficits across more or less every developed and semi-developed country at the same time (including every country currently funding the IMF), Canada doesn’t have the luxury of assuming anyone could or would step in to bail us out. While the Trudeau government is correct that Canada’s indebtedness is not an outlier among G7 countries, that also means no peer countries are in a position to bail anybody else out. This piece lays out the steps for how a developed country like Canada could plausibly go bankrupt given our current trajectory.

The Gradual

“How did you go bankrupt?"
Two ways. Gradually, then suddenly.”

―Ernest Hemingway, The Sun Also Rises

As a point of reference, the EU has mandatory debt reduction rules for any Eurozone country with a debt-to-GDP ratio in excess of 60%. The Greek debt crisis was triggered when Greece hit a 113% debt-to-GDP ratio; Canada is already there in terms of total government debt. Making matters worse, Canadian GDP is being artificially inflated via a housing bubble.

(Data source here, and the more recent data is even worse)

Since debt-to-GDP is so commonly used to assess the creditworthiness of a federal government, the housing bubble’s side effect of inflating GDP has essentially functioned as extra collateral Ottawa can use to borrow more money. That party is now over as the federal government has come under heavy domestic pressure to improve housing affordability, but if the Canadian housing market ever did have a correction towards affordability, the country’s GDP would also experience a ‘correction’ and thus debt-to-GDP would rise even further into the danger zone.

As debt rises, interest costs become a larger and larger share of spending. In the 1990s Canadian debt crisis, 34% of tax revenues went to paying interest on the national debt (we are currently at 10%, but that number is growing as we continue to run deficits). The federal government is currently spending roughly as much on debt interest as on provincial health care transfers.

In addition to growing interest costs, a leading indicator of a brewing debt crisis is when a government starts routinely breaking fiscal promises, leading to erosion of federal credibility on fiscal matters. It has now become routine for prominent Canadian economists (and voters) to openly call bullshit on federal economic pronouncements.

Simply put, a government can either have a highly regulated economy or a highly taxed economy; but trying to have both at the same time drives investors and businesses to abandon the country in search of greener pastures elsewhere. Especially when the government is hiring so many employees into a bloated federal workforce that it creates a labour shortage for private businesses, while also forcing the government to borrow even more money to cover its outsized payroll expenses.

Canada is already at a point where high public sector spending coupled with the hyperfinancialization of real estate has lead to crowding out of private investment and is driving capital flight. Over the long term, those trends will continue to shrink the Canadian tax base, straining federal revenues and forcing further indebtedness. And all of that is before the Grey Tsunami fully runs its course of decimating national finances.

The Acceleration

Governments running high deficits generally have to ‘roll over’ their debt fairly regularly, i.e. issue a bunch of new bonds and use a portion of the proceeds to pay off their previous bonds. As Canada discovered the hard way in 1994, the single biggest bottleneck for a federal government trying to roll over their debt and/or increase their total debt is that someone has to provide the loans (i.e. buy the new bonds). Bond markets also often feature discounted buying, e.g. a borrower deemed risky might try to sell a $1,000,000, 1-year bond paying interest at 5%, but buyers aren’t willing to pay more than $900,000 for what they see as a junk bond. So while officially the bond has a face value of $1,000,000 and a 5% interest rate, really the borrower only receives $900,000 and still has to pay back $1,050,000 in a year, which is an effective interest rate of 16.7%.

Federal governments generally have two advantages when raising debt financing via bonds; they get a presumption of high credit ratings, and they can leverage that presumption plus their regulatory authority over the financial sector to secure a certain level of captive markets for their bonds. For example, pension funds like the CPP are often required for risk management purposes to invest a sizeable portion of their funds in low-risk fixed income securities, such as, well, government bonds. Pension funds are thus a (partially) captive market for federal governments looking to find buyers for their bonds (and now the investment-starved private sector in Canada wants a piece of the action).

The more money governments borrow, the more they inevitably experience diminishing returns on their debt rollovers, as an increasingly skittish/saturated bond market demands either higher nominal interest rates (to make the returns worthwhile), or else the bonds start selling at discounted values, which slowly but surely grinds down the government’s borrowing capacity.

As MMT KoolAid drinkers love to point out, government borrowers also have another trick up their sleeve to repay their debt as the need arises; they can simply print more money. Specifically, the way this works is the federal government issues new bonds, but rather than trying to auction them on any open bond market, simply sells the bonds to the Bank of Canada (who then buys the bonds with Canadian dollars that didn’t exist previously). Then the feds use the newly printed money to pay off the old bond debt.

Unfortunately, as much as MMT tries to theorize its way around the problem, if you introduce more money into an economy without also introducing more things to buy with that money, then more money chasing the same limited pool of goods means the economy becomes a series of micro bidding wars, which at the macro level is known as inflation. So governments that print-and-spend will invariably drive up prices, hence why inflation is referred to as a tax on everything. The past several years in both Canada and around the world have shown how quickly inflation stokes popular discontent, so ‘Money Printer Go BRRRRRR’ is not a trick governments can generally get away with for very long.

Inflation and bond discounts both naturally place upper limits on how much money a national government can get away with borrowing. Governments who don’t respect those limitations end up creating stagflation, as they compensate for diminishing returns in external bond markets by turning inwards and printing money. Printing money doesn’t just devalue the currency in domestic transactions, but also in foreign exchange transactions, which makes imported goods significantly more expensive (if you think avocado toast is expensive now….)

Stagflation, coupled with the aforementioned high taxes/unaffordable housing/shrinking private sector, leads to brain drain as Canadians with strong earning power realize they can have a significantly higher standard of living by fleeing exploring opportunities in other countries.

As the private sector continues to be crowded out by high public spending, high tax rates, and onerous regulatory burdens, and brain drain accelerates, Canada would face a shrinking tax base on both the corporate and personal fronts, which would force the government to run even higher deficits, and thus the downward spiral continues to gain momentum.

The Tipping Point

The ‘90s Canadian debt crisis was brought to a head when credit rating agencies began downgrading the federal government’s creditworthiness. Whether triggered by the rating agencies proactively looking to maintain their credibility, or whether the agencies simply react to the writing on the wall from observing the behaviour of bond markets, eventually a rating agency takes a hard look at what’s going on with the nation’s finances, at which point that credibility erosion mentioned above takes its toll. A government that can’t fulfil any of its fiscal promises, with debt levels north of 100% of GDP, paying increasingly higher interest rates in its constant debt rollovers, eventually will lose its presumption of creditworthiness, which is generally seen as, if not a crisis in itself, at minimum a harbinger of crisis to come.

Captive bond markets such as pension funds are kept on the hook to buy government bonds based on the rationale of those bonds being extremely low-risk, so the rating downgrade gives pension funds an alibi to opt out of investing quite so heavily in Canadian government bonds, in favour of, say, US government bonds offering similar returns but with a higher credit rating.

What’s more, in the era of fiat currencies the value of a Canadian dollar is backed up by the perceived stability of the Canadian economy and government. As soon as government is perceived as unstable or impecunious, nobody wants to get caught holding the bag of a fiat currency that could collapse in value at any time, so the negative perception begets reality as everybody stampedes to sell their holdings of the currency and its exchange value plummets (a process known alternatively as a currency run or a currency selloff). A credit rating downgrade would drive down exchange rates on the Canadian dollar and by corollary drive up prices of imported goods like most fresh produce.

As the Liberal governments of Jean Chretien and Paul Martin were keenly aware, credit rating downgrades are a real moment of truth for any country. Unlike the United States government, the Canadian government does not have the luxury of being the global reserve currency or being the home country of the biggest credit rating agencies, so Ottawa doesn’t have the kind of leverage to prop up its own credit ratings and/or currency value that Washington does.

Downgraded credit ratings on the Canadian government leaves two options:

1. Accept that the spending party is over and deficits must be aggressively reined in

   

2. Dispute the rating downgrades and insist everything is fine

The first option (which Chretien & Martin wisely took in the 90s) would look a lot like what I described in my previous post, except instead of being planned and deliberate the spending cuts are reactive and chaotic. Austerity is never fun, but it beats a sovereign debt crisis.

How to Defuse Canada’s Debt Bomb

The second option of ‘nothing to see here’ is tough to pull off for a government that already has a terrible reputation for bullshit promises among economists (which, as noted above, Trudeau does). To accomplish anything more than bluster, the government would likely have to force pension funds to avoid dumping their Canadian gov’t bonds (e.g. by implementing mandatory ‘invest in Canada’ requirements). Another option is forcing everyday savings accounts into GICs.

Speaking of savings accounts, the wonders of fractional reserve banking means most deposits placed in banks are not actually accessible to savers (at least not if they all wanted to access their money at the same time). Canadian bank regulations only require banks to have enough cash on hand to pay out 3.5% of deposits, so if you have $1,000 in your savings account and you try to withdraw it at the same time as everyone else, the bank can only give you $35.

Similar to fiat currencies, if banks ever reach a point where they’re perceived as at risk of running out of money, everyone stampedes to withdraw their savings, at which point the perception becomes self-fulfilling as the bank really does run out of money trying to pay out everyone’s withdrawals at the same time. This phenomenon is known as a bank run, and if not defused quickly it can become contagious and spread across multiple banks (hence the reason why the US government had to move so quickly to bail out Silicon Valley Bank).

Fractional reserve banking only works if savers have enough confidence in the financial sector that they don’t feel the need to pull all their money out of the bank and stuff it in the nearest mattress. Which is why Canadian banks are backstopped by the Canadian Deposit Insurance Corporation (CDIC); a company fully owned and managed by the federal government. If the federal government is perceived to be running out of money, then by extension the Canadian banking sector will be seen as propped up by an imaginary insurance policy.

Terminal Decline

If the federal government reaches the tipping point of downgraded credit ratings and continues trying to run deficits anyways, it will face inevitable diminishing returns on debt rollovers, with steeper risk-based discounting and higher interest rates. Given the backdrop of the Grey Tsunami driving up costs of health care and retirement benefits, finding money to pay those interest rates (let alone the principal balance) will be an uphill battle. Raising taxes will cease to be a viable option given the fragility of what remains of the private sector economy after years of mass retirement, brain drain, capital flight, and the crowding-out effect of high public spending.

Stagflation will also lead to popular unrest and an uptick of separatist movements in both Quebec and Western provinces, as regions of the country begin contemplating fleeing the sinking ship.

Debt Bomb Go Boom

As the junk-bond rated government struggles to fulfill its litany of fiscal promises, from have-not provinces to ever-increasing numbers of retirees to First Nations reserves, etc., eventually the unthinkable becomes inevitable; the government misses a scheduled debt repayment. Printing more money won’t be tolerated by the stagflation-resenting masses, and after years of capital flight and crowding out of private investment, there isn’t enough of an economy left to tax any more heavily. Most governments, push comes to shove, will miss a payment to lenders before letting public sector paycheques bounce or ghosting their domestic spending commitments.

As we saw in Greece, Sri Lanka, Venezuela, etc. this is how a sovereign debt crisis begins. Government bond markets, fiat currencies, and fractional reserve banking all share the same vulnerability: they rely on market confidence in the solvency of the federal government. One missed debt repayment is all it takes to bring it all crashing down in quick succession:

• CDIC, being a Crown Corporation, would have zero credibility as an insurer when the Crown is in a state of default. The financial sector collapses due to a bank run as everyone tries to pull their money out of banks that are both known to have limited liquidity and also are now seen as effectively uninsured

• The value of the Canadian dollar also collapses in a similar currency run as everyone tries to avoid being the last one to convert to a more trusted currency, leading to a hyperinflationary economic environment

• Imports collapse due to the newfound worthlessness of the Canadian dollar; whether or not food shortages occur comes down to how much food is still grown domestically

• The government collapses as Canadian citizens decide whether to riot in the streets or just hightail it out of the country

• Canada is now effectively a failed state; well done everybody.

If all of this sounds paranoid, keep in mind Canada reached the point of downgraded credit ratings just 30 years ago. At that time, Baby Boomers (the largest demographic group in history) were taxpayers in their late 30s to early 50s, as opposed to retirees in their 60s and 70s. The 1990s was also a simpler time when woke governments weren’t constantly sabotaging their own economies to curry favour with the WEF.

When Hugo Chavez came to power, Venezuela had a healthy, largely oil-based economy. After Chavez and his successor Nicolas Maduro were done tackling inequality and reigning in toxic capitalism, the country had defaulted on its debt and was in a state of famine (in an all-time display of gallows humour, the shortages were referred to as the Maduro Diet).

Sri Lanka decided just a few short years ago they were going to be the first country to transition their agricultural sector over entirely to organic farming methods. Their noble green agenda ended with the country in a state of national default, the usual food and fuel shortages, and Sri Lankan President Gotabaya Rajapaksa fleeing the country.

Greece, of course, had generous social benefits programs and remained steadfastly undeterred by the minor issue that nobody ever paid any taxes.

The Liberal governments of Chretien and Martin successfully dug Canada out of the deep fiscal hole the country faced in the 1990s, but Canada at the time more or less had a Norwegian model of using natural resource revenues to fund social programs. The current Liberal government has decided to both massively expand said social programs while also imposing a heavy regulatory burden on the natural resources sector (and also pretty much every other sector of the economy).

The lessons of the 1990s-era Liberals’ fiscal successes have proven short-lived with their successor Justin Trudeau, a man who infamously doesn’t spend time thinking about monetary policy and believes budgets balance themselves. It is unfortunately plausible that current federal profligacy, compounded by the Grey Tsunami and ongoing private sector shrinkage, will lead Canada to sovereign debt default and all the catastrophe that comes with it within the next coming decades. Unless, of course, deficits get brought under control before it’s too late.