What belongs to everyone actually belongs to no one.

This timeless piece of wisdom, a common saying in many South Asian languages, helps us understand why government finances are so often mismanaged. Within the geographical limits of a political unit, government finances represent the maximum extent to which financial resources can ‘belong to everyone’.

As long as previously built up capital can sustain the waste, everything looks hunky-dory. At some point, the capital starts running out. To maintain appearance of prosperity which everyone has become used to, the government starts borrowing money. But financial discipline is still lacking, and at some point, the government reaches a precarious condition known as:

The Debt Trap

Without meaning to offend the well-informed readers, let me furnish the definition of a ‘debt-trap’:

‘A person or entity is said to be in a debt-trap when he / she / it has to resort to borrowing in order to service existing debt obligations.’

‘Debt servicing’ is defined as the total of the payment of interest on, and repayment of the principal amount of, the amount borrowed.

In the past one year or so, Ontario’s indebtedness as a province has been a frequent topic of discussion. With its total debt now exceeding $ 308 billion (See Chart 1), Ontario has the dubious distinction of being the highest sub-sovereign debtor in the whole world. The interest payment on this debt amounts to around $ 12 billion annually, or some $ 1 billion a month (See Chart 1). This represents 8% of the government’s overall revenues (See Chart 2), and is among the top five expense heads in the books of the Ontario government.

As the opposition parties began ramping up for the 2018 election, this naturally became a contentious issue. In response to their continual criticism, the government, either directly or through its sympathizers, sought to offer counter-arguments to the points raised by the opposition. Let us briefly examine some of these counter-arguments, and see if they hold up to scrutiny.

Debt-to-GDP Ratio

Those criticizing Ontario’s debt-level, perhaps in a fit of overzealousness, often compared the province to Greece and other European jurisdictions facing economic difficulties on account of having excessive debt. This was, of course, a stretch, and so it was naturally pointed out from the government’s side that Ontario’s debt-to-GDP ratio stood at a bit over 37% (See Chart 3). Compared to the same ratio of the aforesaid problematic jurisdictions, which typically exceeded 100%, Ontario’s finances didn’t appear as troublesome, prima facie. The government’s defenders made this point strenuously.

The problem with this argument is that the debt-to-GDP ratio, while useful to some degree, has its limitations. The first problem with this measure is that there are two distinct entities involved; while the debt is that of the government, ‘GDP’ is an aggregate of the income of all the constituents (i.e. citizens and other entities paying tax) situated within its jurisdiction. So the ratio compares the debt owed by one entity to the collective income of another entity. The reason why this distinction is significant is that the servicing of the government’s debt has to be done through its own revenues, and not out of the income of its constituents. As government revenue is collected from the said constituents, who contribute to that revenue out of their own incomes, the relationship between government debt on one hand, and the constituents’ aggregate income on the other, is an indirect one. It therefore follows that the GDP is relevant to the servicing of government debt only to the extent that the government can extract a portion of it from its constituents. It would not be unfair to say that there are limits to the government’s ability in this regard.

A more meaningful measure would be to compare the government’s debt with its own revenues, from out of which that debt would be serviced. This figure currently stands at around $ 150 billion per year (See Chart 4). So the ratio of government debt to government revenue is well over 200%. This is a very high level of financial gearing, and is more typical of capital-intensive businesses or operations. Providing ‘social goods’, which is what a government does, does not fall in the category of ‘capital intensive’ operations – or at least, it shouldn’t. Of course, there are areas of government operations that require a high level of investment, e.g. roads and other civil structures, but there are other areas as well where the amount of capital required is relatively low. On average, therefore, running a government is not so much a capital-intensive endeavor as it is a labor-intensive one. That is one reason why salaries / remuneration to workers constitute such a large portion of a government’s expenses.

The New Debt Is For Investment in Assets

It is often argued that the new debt that has been incurred in recent years is not on account of annual deficits (i.e. the government spending more than it gets in revenue) but rather on account of investing in assets, including productive capacity such as electricity etc. This is problematic on two counts.

Firstly, while between the years 2009-10 and 2017-18, accumulated government debt went up by $ 114.6 billion (See Chart 1), the accumulated deficit went up by almost $ 61.5 billion (Chart 1). Obviously, this deficit was financed by borrowing. It therefore follows that some 53.7% of the additional debt incurred was intended to pay the expenditures of the government, and was not deployed in assets. In other words, the province is borrowing more to run the show that it does to increase capacity.

There is some discrepancy between the accumulated deficit in Chart 1 and the individual yearly deficit reported by the government. According the latest budget, the total of the yearly deficits between 2009-10 and 2017-18 is $ 80.2 billion (See Chart 5). If this figure is the correct one (and assuming the accumulated debt figure remains unchanged), then the ratio of borrowing spent on paying recurring expenses – as opposed to investing in assets – increases to nearly 70% (to be precise, 69.98%).

When, out of every $ 100 borrowed, only $ 30 is being deployed in creation of assets, it is not a tenable position to say, in a blanket manner, that the additional borrowing is on account of investments made.

Secondly, there is the issue of consistency in accounting treatment. When the government realized some $ 9 billion from the sale of shares in Hydro One, the proceeds were treated as revenue. However, the sale of these shares was a one-time event; by the principles of accounting, it cannot be treated the same as the revenue that the government (or any entity for that matter) receives on a regular basis.

Beyond that, however, if proceeds from the sale of capital assets are to be treated as revenue, then the money spent to acquire capital assets must be treated as expenditure as well. It is patently dishonest to treat outlays of capital as separate from regular expenditure, and then to treat the proceeds from liquidation of assets as regular revenue.

Unfortunately, there is precedent for this financial skullduggery. A previous government did the same thing many years ago, when it sold Highway 407 for $ 3 billion to ‘balance its books’, i.e. treat proceeds from the sale of an asset as regular revenue. The Highway had cost $ 104 billion to build and improve. So in a strict accounting sense, the province incurred a loss of some $ 100 billion on the transaction. However, this loss is unlikely to have shown up in the government’s accounts.

Interest Rates Are Historically Low, So It Makes Sense to Borrow

The first thing that can be said against this contention is, whether it makes sense to borrow in order to pay regular expenses. As we have seen above, regular spending accounts for anything between 53% to 70% of the amount borrowed. This part of the borrowing only serves to increase the regular spending in the future, by way of increased burden of interest, without any benefits flowing in (as they do with investing in assets).

Beyond that, a look at Chart 1 shows us that in the year 2009-10, the average rate of interest on all accumulated debt of Ontario government was 4.71%. This average would have included some amount of debt that was contracted before the interest rates were lowered to ‘historically low’ levels following the dot-com crash of the year 2000, and the 9/11 attacks in 2001. Generally speaking, interest rates have remained at more or less the same level till now. In other words, the past seventeen years have been an era of what is called a ‘secular low-interest rate environment’.

But from the same Chart 1, we see that the average rate of interest on the accumulated debt of Ontario in 2017-18 is 3.88%. The reduction in the average rate of interest is less than one percentage point. Given that in this duration, a good deal of the legacy debt (i.e. dating back before the year 2000, carrying a higher rate of interest) would have been retired, and any new debt incurred at ‘historically low’ rates, the reduction in the average effective rate of borrowing seems paltry.

Given that for the last decade or so, even individual borrowers have been able to avail mortgage debt at rates between 2% to 3%, provided they have good credit, the rate paid by an entity like the government of Ontario – which we expect to enjoy better creditworthiness – seems to be rather high.

So the question is: in the current borrowing climate, does it make sense to incur debt at almost 4%? And that too, incur debt largely for paying regular expenses?

Is Ontario In a Debt Trap?

Returning to Chart 1, we find that the total amount of interest paid on government debt between the years 2009-10 and 2017-18 amounted to $ 98.23 billion. From Chart 5, we know that the total deficit during these years was $ 80.2 billion.

It therefore follows that had it not been for interest cost, the province would have accumulated a SURPLUS of just over $ 18 billion over this period. It also follows that 70% of the borrowing was necessitated by the said interest.

If Ontario is not yet in a debt-trap, it is almost there.

There is another aspect to this:

Between 2009-10 and 2017-18, the total additional borrowing was $ 114.6 billion. Out of this amount, $ 80.2 billion was spent on funding the deficit. This yields the amount that was invested in assets as $ 34.40 billion.

As we have noted above, minus the interest cost, the province would have had a surplus of over $ 18 billion.

This leads us to the disturbing conclusion that, but for interest cost, the province would have generated well over half of the amount required to invest in assets, from the regular revenues. We would have needed to borrow only $ 16.40 billion. But because we were (and are) paying interest, we were forced to borrow the full $ 34.40 billion, in order to meet our requirement to invest in assets.

This can be restated thus:

We are borrowing money because we are paying interest on borrowed money.

The requirement to pay interest forces us to borrow even more money, even if doing that will increase the amount of interest that we have to pay in the future. This would undoubtedly further increase the amount that we will need to borrow in the future. At that point, it will have become a vicious cycle.



Charts 1, 2 and 3 from Ontario Financing Authority https://www.ofina.on.ca/borrowing_debt/debt.htm
Charts 4 & 5 from the Ontario Budget for 2018, http://budget.ontario.ca/2018/chapter-3a.html