 | | Glen Hodgson
Senior Vice-President and Chief Economist
Forecasting and Analysis |
The critical financial problems in Europe are forcing all governments to re-examine how their fiscal deficits and public debt are managed, even if they are not in a state of turmoil. The richer euro-zone members, led by Germany and France, are being forced by circumstances to bail out a growing list of heavily indebted euro-zone countries led by Greece. In Canada, Ottawa and the provinces have worked hard to convince financial markets and the public that they have credible plans to re-balance their budgets and manage public debt effectively.
However, there has been near-silence on a related issue that would impact Canada as a federation: is there any debt management responsibility between different levels of government? Specifically, is the federal government responsible for back-stopping the debt payments of the provinces? Our view is, certainly not—and if the feds were ever forced to intervene, there should be a huge financial and political price to pay.
The federal government has no legal obligation to make payments on provincial debt. While the feds transfer considerable sums to the provinces each year through various programs—about $58.4 billion in 2011–12—there is no systematic federal oversight or approval of provincial fiscal plans or budgets. The provinces borrow in their own name, based on their fiscal track record and reputation, and make their own payments to bondholders.
Moreover, any hint of a federal guarantee to the provinces without comprehensive federal oversight could create what economists call “moral hazard.” Moral hazard occurs when an institution inadvertently creates the conditions it is trying to avoid. A federal guarantee on provincial debt would provide false comfort; it might encourage provinces to run larger fiscal deficits and borrow more than they can sustain, and encourage lenders to extend additional credit. This combined effect would increase the risk of over-borrowing and could leave provinces unable to service their debt on their own.
In contrast, the federal government does have a legal obligation to backstop federal institutions and agencies; indeed, it provides a “full faith and credit” financial guarantee to many federal crown corporations and agencies, which reduces their borrowing costs. However, this federal guarantee comes with significant oversight and approval of the agencies’ business plans, borrowing plans and financial management capacity—to minimize the risk of the guarantee ever being required.
Developments elsewhere are instructive. In the euro-zone, the failure to build a strong common fiscal foundation for the euro when it was launched helped to create the on-going financial crisis today. The euro-zone is not a federation; it is a collection of still-sovereign governments that decided to adopt a common currency, partly to reduce transactions costs for trade, but largely to create a common political interest in sticking together. Euro-zone members are now frantically trying to solve a problem that could and should have been avoided through better design of the single currency system. The stronger euro-zone members, along with the European Central Bank and the International Monetary Fund, have become the de facto re-financing window for fiscally irresponsible countries like Greece, Italy and Portugal. The recalcitrant countries are being forced to adopt severe fiscal retrenchment in order to access re-financing. But despite the efforts so far, the euro-zone public debt crisis has yet to hit bottom and future of the euro itself is in doubt.
In the U.S., the federal government has been transferring huge sums to individual states to help them meet their existing financial obligations. In some states, like California, there is now a statutory limitation on new borrowing, which constrains the fiscal risk of the federal government. But many U.S. states (and cities) still have significant amounts of debt and are straining to meet their debt service obligations on time. The U.S. federal government has not yet had to intervene directly to make state and city debt service payments—but those conditions could arise, as they have before.
The U.S. has also been forced to bail out the mortgage-refinancing agencies Fannie Mae and Freddie Mac, which over many years had developed an implicit debt guarantee from the U.S. federal government. Due to this implicit guarantee, these agencies did not show sufficient discipline in their financial management practices. When the U.S. housing bubble ruptured in 2008, Fannie Mae and Freddie Mac were forced to seek a massive bailout from the U.S. federal government—thereby confirming that an implicit guarantee had indeed been in place all along.
Are there lessons for Canada from the public debt problems in Europe and the U.S.? Most assuredly, the federal government should not take ownership of provincial debt, nor be seen as taking any responsibility for it. But what if a province did get into trouble in servicing its debt? In our view, the federal government might choose to intervene only if there is a serious risk of financial contagion—that is, others provinces and Ottawa would face much higher interest rates, or even lose access to credit, if one province failed to meet its debt payment obligations on time.
That kind of event is highly unlikely, but not impossible. Remember that two Canadian provinces actually experienced debt defaults during the 1930s; Alberta (a surprise to many today) and Newfoundland (as a separate British territory at the time).
And if federal intervention were ever required to support a province’s debt service payments, there should be a heavy political price to pay, including deep cuts to provincial programs to restore fiscal balance quickly and federal approval of future provincial budgets, just as there will be a steep price to pay for the bailouts in the euro-zone. So in Canada, there should be no doubt—provincial debt is not a federal responsibility!