As the market focus has shifted from the daily COVID-19 data towards the gradual reopening of the economy, a question that is coming up more frequently in conversations is, “who is going to pay for all of this stimulus?” The real question is, “how are we going to get out from underneath all of this debt?”

The Canadian federal government is currently tracking towards a budget deficit of $200B this year. And that figure could grow to $300B when all is said and done. The situation would leave our country with a debt equal to 11-14% of GDP, the most extensive level since WWII. In the United States, the numbers are even more massive, with a projected $3.8 trillion deficit.

 

Why do interest rates matter more than debt levels?

When considering the government’s ability to manage debt, the current interest rates matter more than the absolute debt levels. In Canada, the prevailing interest rate environment is extremely low. Back in the late ’80s/early ’90s, the government was issuing 10-year bonds at 10%. At those rates, debt was compounding at 10% annually, and the debt burden was growing much faster than the economy. That combination leads to a ballooning of debt-to-GDP. Fortunately, today is a different story. The Federal government can fund crisis response efforts by borrowing at a rate of 0.6% per year over the next 10 years. It is highly possible that the government’s total interest rate burden may not change at all despite the $200B+ of new debt. The lower rate environment allows us to refinance higher-cost debt at rock bottom rates, a dynamic that happened after the 2008/09 financial crisis.

 

So how does all of this the debt get “paid off?”

As long as the economy is growing faster than new debt is accumulating, the country will grow its way out of the debt. For anyone skeptical of that assertion - this is how Canada and the United States handled the considerable debt burden post-WWII.

 

The concept isn’t intuitive to us because this approach does not apply to individuals. When we take on debt through a home mortgage, auto loan, or other, there is a repayment date. That is because we have a finite career and lifespan, so there is an end date when all debts are repaid. Countries are different. They have indefinite lives so they can remain indebted indefinitely.

 

The ongoing burden of our national debt is simply the interest payments. Economists usually measure this as a percentage of GDP. When we look at the United States and take the 10 year U.S. Treasury yield of roughly 0.67%, we can calculate that the annual added interest cost of the $3.6 trillion COVID spending initiative equates to approximately $24 billion per year. Yes, that is a significant absolute number, but in the context of a $20 trillion + annual economy, it amounts to less than 0.1% of GDP. This amount would be analogous to an Engineer who earns $100,000 year receiving a $100 speeding ticket.

 

One time event

Another critical point to consider is that the majority of the current deficit spending is related to actions needed to keep households and businesses afloat until the economy can reopen. As a result, many of these spending initiatives will come to an end. As such, it is unlikely that there will be a need to cut program spending or raise taxes to rein it in. Conversely, the swollen deficits of the late 1980s were a function of persistent government overspending.

 

Finally, consider that Canada came into this crisis with a strong fiscal position, having the lowest debt-to-GDP ratio of the G7. Accounting for the $200B this year, our debt-to-GDP will undoubtedly rise, but we would sit at levels still well below where our counterparts stood before the crisis (see chart below).

 

Source: IMF, CIBC

 

Parting thoughts

Talking about national debt has always been a touchy subject. In my entire career speaking with investors, it is a topic that frequently comes, and yet it is an issue that markets mostly shrug off.

We are not attempting to make a case for governments irresponsibly running high deficits permanently. Instead, we are trying to answer the question of how governments can afford to fund these crisis relief packages, and why we believe these debts won’t unhinge the economy. At some point, the federal government may raise taxes or make cuts to program spending, but it is not an initiative that requires attention in the near-term. Many questions remain – will interest rates stay forever low? Will we avoid another catastrophe that requires billions/trillions of new debt? How much growth will be real growth vs. inflation? No one has the right answer to those questions.

 

Just remember this isn’t like a mortgage that has to be paid in full by a specific time. Without paying a single dollar of this new debt down, the burden could easily be less in another generation than it is today.