The theory of everything debt

Neither a borrower nor a lender be, The Bard said, but how possible is that if credit is a driver of modern economies?

Will there be a repeat of the excess that led to the global financial meltdown in 2008, the downturn of the 1990s and the Great Depression of the 1930s? Thanks to human nature and greed, it’s possible and maybe even probable. Debt remains all too easy to access even after it nearly destroyed world markets. The frightening fact is that debt really does make the world go round.

Witness the release in early 2015 of McKinsey Global Institute’s Debt and (Not Much) Deleveraging, which surveyed 47 countries and revealed that since the most recent financial crisis, no major economies have reduced their ratios of debt to GDP. Advanced nations, those with more sophisticated financial systems, are the worst, with the debt-to-GDP ratio averaging 280% compared to a more modest average of 121% in developing countries. From 2007 to Q2 2014, global debt has grown by $57 trillion. Yikes. Even in countries where household debt is down significantly (definitely not the case in Canada), government debt is up more.

 ratios of debt to GDP in developing economies

In order to get a handle on all that leverage, CPA Magazine presents debt in all its glory and danger and answers a few key questions.

The sky is not falling: a less pessimistic view of government debt

“There’s an old saying, ‘Government debt doesn’t matter until it matters,’” says Douglas Porter, chief economist at BMO Financial Group. “I don’t view it as a negative to build a bit of debt, particularly if you have a growing population and you’re borrowing now to invest in roads, schools and hospitals. But you have to be careful.” Greece, we’re talking to you.

A word on deficits and debt securities

Federal, provincial and municipal governments create budget deficits whenever they spend more money than they bring in through income-generating schemes such as taxes. To make this work, governments can issue debt securities to acquire the cash they need. For example, the federal government can issue short-term paper, treasury bills and longer-term bonds in the form of Canada Savings Bonds purchased by Canadians, and Government of Canada Bonds purchased by foreign investors. These are typically issued in $1 billion to $2 billion increments. Roughly 25% of Ottawa’s debt is owed to foreign investors; the rest is owned by Canadians. Provincial governments and larger cities such as Toronto and Montreal can also issue bonds. Debt securities represent about 70% of the total liabilities for the federal, provincial and territorial governments.

Federal and privincial net debt

What is government debt and why should you care if it’s increasing?

Direct government debt is money owed now, for example to pay for day-to-day expenses such as salaries and supplies and to pay for contracted infrastructure projects. Over the past six or seven years, governments across Canada have been increasing their debt. In fact, net government debt in Canada has ballooned from $823 billion in 2007/08 to more than $1.2 trillion in 2013/14, or $34,905 per capita, according to research from think-tank the Fraser Institute. “This is a worrying trend driven in part by budgetary deficits [governments spending more than the revenues they bring in] and how they are financing capital projects,” says Charles Lammam, director of fiscal studies at the Fraser Institute. For example, the growth in Ontario’s net debt is primarily driven by budget operating deficits or borrowing to fund current-day spending, while recent increases in the government of BC’s net debt are the result of borrowing to pay for capital infrastructure projects that will benefit future generations. It’s the difference between borrowing to pay for the groceries and borrowing to pay the mortgage. “Governments, like families, have to pay interest on the money they borrow. That has consequences. Today 11¢ of every dollar the federal government collects goes to interest payments. If government debt continues to increase, there is the risk of more money going to interest payments and less to programs such as healthcare, education and social services. It could also lead to credit agencies downgrading governments, making investors nervous and thereby increasing the cost of borrowing, which in turn could lead to a hike in taxes during a soft period in the economy and more borrowing — a vicious cycle.” All of this happened in Canada in the 1990s, by the way. We fought that battle and brought down those deficits, giving us a leg up on other countries.

William Shakespeare 

In Hamlet, Shakespeare says, “Neither a borrower nor a lender be.”

Is this a good approach to the modern world for governments, businesses and individuals? Would economies collapse if governments and individuals took Shakespeare’s advice?

Simply put, no, it is not a good approach, and yes, economies would collapse. Derek Holt, vice-president of Scotiabank Economics, explains why. “This describes a state in which you are spending every last dollar that comes in — it’s a subsistence model. Going into the crisis, the world borrowed far too much, but there is a very legitimate role debt can play in a person’s life cycle. One of the great accomplishments of the 20th century was the deepening of capital markets and the greater access to debt that enabled people to smooth their obligations [the cost of consumption] over their lives. Good luck trying to buy a car or a home on a 25-year-old’s paycheque without the ability to borrow.”

Roman Emperor statue

Debt is debt thanks to Rome

At least that’s how Michael Hudson, president of The Institute for the Study of Long-Term Economic Trends and author of The Bubble and Beyond sees it. Here’s what we know: from about 2000 BC to the time of Jesus, it was normal for governments — Sumer, Babylonia, Egypt — to cancel debts when they got too big in order to restore equality. Rome was the first country not to cancel debt. Rather, it went to war in Sparta to overturn governments that wanted to cancel debt.

A little current trivia

While we’re used to seeing bonds ranging anywhere from one year to 30 years, Mexico has issued a bond that doesn’t mature for a full century, making the most of what is perhaps a once-in-a-generation opportunity to lock in cheap funding for a very long period of time.

Lever of opportunity or coping mechanism?

While there’s nothing inherently right or wrong about borrowing, financial experts often distinguish between “good debt” and “bad debt.”

  • Good debt is an investment in something that creates value or produces more wealth in the long run. Examples include a mortgage on a home, a student loan to pursue education for a career, a loan to launch a business or to purchase capital equipment.
  • Bad debt, says Natasha Nystrom of the Financial Consumer Agency of Canada (FCAC), is debt taken on to buy something that immediately goes down in value or to buy something that you can’t repay on time and in full, thus incurring interest charges and more debt. Examples include charges on a store credit card at a high rate of interest, a personal loan to pay monthly expenses or anything you don’t need or that is not useful.

That said, the FCAC urges consumers to keep in mind that a debt may be good or bad depending on the circumstances. For example, a mortgage is usually considered a good debt because it’s an investment in property that is expected to increase in value — but it could be a bad debt if you can’t afford the payments. Hello, subprime mortgage crisis that brought down world financial markets.

Business debt: $1,611,810,000: value of corporate loans Q4 (2014)

There are a variety of ways Canadian businesses can access debt: asset-based loans, lines of credit, mortgages, angel investment, venture capital, corporate bonds, debentures, short-term commercial paper, common shares and preferred shares. However, Canadian businesses are fairly risk averse, which is good from a sustainability standpoint but doesn’t bode well for moving into new markets or developing new products.

Is debt necessary for modern capitalism to work?

“Yes. But that doesn’t mean every business has to use it,” says Ted Mallett, vice-president and chief economist at the Canadian Federation of Independent Business, which represents 109,000 small and medium-sized businesses across the country. “Only two-thirds of our members have a major loan, either from a financial institution or other sources. The rest are self-financing. They’ve developed their reserves so they can operate without the help of revolving lines of credit or loans. These businesses are stable and likely aren’t in high-growth mode; for those that are, debt is important. We need lenders that know how to lend to these businesses — we’ve been critical in the past, pointing out that lending is more tied to the asset as opposed to what the strategic potentials are.”

An explanation of the US subprime mortgage disaster that brought the world to its knees

Government, lenders, Wall Street, and individual borrowers all played a role in bringing down world markets. The root cause may date back to the mid-1990s when the Clinton administration gave government mortgage agencies Fannie Mae and Freddie Mac their affordability mandates in order to maximize home ownership in the US. California banks started outsourcing mortgage lending and the approval process to third-party brokers, which divorced ownership of the risk from the people originating the mortgages. US banks also introduced high-risk products such as teaser mortgages with low to zero interest rates and strategic default mortgages available in the southern US that gave borrowers the opportunity to walk away from the mortgage with impunity. People with modest incomes were assembling portfolios of homes they could not afford. Lawmakers played a role in allowing that kind of lack of accountability. The Federal Reserve, under the control of Alan Greenspan, kept interest rates too low for too long, causing a further lack of discipline on the part of borrowers who thought rates would never go up, according to Derek Holt. Wall Street joined the party and started to take debt and turn it into different kinds of debt, compounding debt upon debt. When one part of that chain started to default, it created a massive domino effect.

Did you know?

According to the Fraser Institute, Canadian governments collectively spent an estimated $61.7 billion on interest payments in 2013/14.

Why are individuals warned to cut back on credit card debt and told that it will ultimately harm the economy?

Should everyone cut up their credit cards, or is there a happy medium?

Credit cards can be useful and convenient, but if you aren’t careful, you can put yourself on a path to serious financial trouble. There is also a broader societal issue in that “while consumer spending can create jobs and economic growth, extreme debt-financed consumer spending can reduce subsequent spending if interest rates go up and consumers find that they cannot service their old debts at the new higher interest rates,” says Amin Mawani, associate professor of accounting at York University’s Schulich School of Business. “When consumers hold back on their spending, businesses experience reduced sales, which makes it harder for them to raise new equity.” And so a downward spiral begins.

You are what you owe chart