April 2010

Welcome to the age of debt

In response to the recent economic and financial crisis, governments around the world injected massive amounts of cash in their economies. Those billions are now on their balance sheets. Welcome to the new age of debt.

You know the story about the four little pigs? That’s right. Four. Portugal, Italy, Greece and Spain. Economists are using the acronym PIGS for this group of countries because of their serious debt problems. Here’s how the tale goes: first the four little pigs, and then the rest of Europe, Japan, the United States… all on the verge of crumbling under the weight of their debt.

Are things really that bad?

The truth behind the tale

Fortunately, Canada is not included in this group. It is actually in a strong position compared to the other developed nations, thanks to its exemplary public finances. But the numbers can be perplexing. Take a look at the following chart:

Gross debt of the G-20 countries
As a percentage of GDP
Great Britain44.168.781.7
Saudi Arabia18.514.512.5
South Africa28.530.833.5
South Korea29.634.939.4
United States61.984.893.6

Source: International Monetary Fund

As you can see, although Canada is doing relatively well, it is still among the eight developed countries whose debt will be around 80% or more of GDP in 2010. The rate itself should not be cause for undue concern. After all, if you owe $100,000 and you earn $100,000 a year (your “personal GDP”), then your rate of indebtedness is 100%, which would not necessarily set off any alarms, particularly if that debt was linked to an asset, such as your house, for example.

The problem is when your debt starts to climb out of control, particularly if it’s growing more quickly than your income can handle. And that’s exactly what will happen soon to many countries – possibly including Canada, if Finance Minister Flaherty’s growth forecasts turn out to be incorrect.

Out of control?

The situation already appears to be out of control in some countries, such as Japan, which has increased its deficit by 320% to counter the recession. Japan’s debt will be 245% of GDP within five years. Even the United States may be caught in a debt spiral. According to the Congressional Budget Office, Americans born this year could see the country’s debt hit 800% of GDP during their lifetime. The combined debt ratio of the G-20 countries could rise to 118.4% in 2014, up 50% from 2007.

We are left with the impression that, by bailing out a private sector in deep trouble over the last two years, governments have actually nationalized losses and debts that had become unmanageable. Suddenly, debt has become everyone’s problem.

What happens next?

When a private borrower becomes insolvent, arrangements are made with creditors or bankruptcy is declared. Governments are rarely backed into the bankruptcy corner. What they usually do instead to preserve their liquidity is use the fiscal and budgetary tools at their disposal: they increase taxes and tariffs, and cut costs.

Ireland is a chilling example of this. A report published in July by the Special Group on Public Service Numbers says that, to deal with its debt, Ireland will have to cut 17,000 public service jobs and cut spending by 8% in education, 5% in social welfare, 20% in children’s aid and 7% in public safety.

Such measures generally tend to slow economic growth, which consequently reduces tax revenues. For a country like Canada, which is betting on growth, this could be an issue. Add to the equation a decline in the working population and an aging population that is costing the state more and more, and the situation starts to looks tricky down the road. It wouldn’t be the apocalypse that some doom-and-gloomers predict, but it would certainly pose a challenge to our governments.

Are your finances in order?

As a taxpayer, you would be wise to make plans based on the likelihood that governments are going to soon be asking us to contribute more heavily to help them reduce their debts and deficits. That makes this a particularly good time to reassess your own debt and your ability to repay it, no matter what happens. It might also be a good time to speak to your financial services professional and see if the current situation affects your financial strategy.

For whether we like it or not, we have all just entered the new age of debt, and it is likely to last quite a while!