How is money creation related to our national debt?

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First, let us establish to whom this debt is owed. Any Canadian individual, corporation, or bank that buys a Canada Savings Bond, a treasury bill, or other type of government bond is lending money to government. The payment of interest and the redemption of the bond is the responsibility of government. In this sense, it can be regarded as a debt that we Canadians owe to ourselves. However, one of the major problems with the debt is that the “we” and “ourselves” in the previous sentence do not refer to the same groups of people. We, the taxpayers, are responsible for paying off the interest and principal to ourselves, the bondholders. But while all bondholders are taxpayers, not all taxpayers are bondholders. And therein lies one of the problems. As the size of the debt increases, and with it the interest payments, increasing amounts must be raised in taxes, and those amounts are then transferred to bondholders. Since it is normally the comparatively wealthy who hold the majority of bonds, while taxes are paid by rich and poor alike, the payment of interest on the national debt could represent a major redistribution of income.

For another angle on this redistributional aspect, let us assume that the debt is entirely internal and that in response to public pressure, it was decided to repay the entire debt of approximately $602 billion (as of 2013). How could this be done? The most straightforward answer is for the government to raise $602 billion additional dollars through increased taxes, of which all Canadians would pay some (relatively) small part. What then would Ottawa do with this incredible rush of additional revenue? Turn around and send it back to those Canadians who hold Canada Savings Bonds and those institutions holding the other bonds. The net effect: all Canadians pay $602 billion in additional taxes, and some Canadians receive $602 billion in bond repayments. As many might argue, why bother? Why not leave it where it was in the first place?

Before considering some of the problems associated with big government deficits and debt, let us look at the facts. It is unfortunate that public discussion of the national debt often runs to hyperbole, and we used to hear mention of a “staggering” debt of “enormous” proportions as a result of “crippling” deficits. Dollar amounts in billions are certainly enormous from an individual's perspective, but one seldom hears the size of Canada's GDP described as staggering. We therefore need to put things in perspective. Just how big is our national debt? It might help if we look at it over a period.  

Source: Principles of Macroeconomics, eighth edition, Sayre/Morris, 7.5 Fiscal Policy and the National Debt page 241

In recent years, the percentage has steadily declined. In fact, since 1995, Canada's debt burden has fallen from being the second highest to the lowest of the G7 countries. (The United States sits at 61 percent, Italy at over 109 percent, Greece at 148 percent, and Japan tops the list at 184 percent.)

These figures show clearly that one of the major causes of the growth of Canada's debt was the financing of World War II. During a major war, few nations are able to finance their military expenditures through taxation alone. They are often left with little choice but to borrow, and the majority of this borrowing is from the nation's own citizens. Most would feel this is a legitimate reason to increase the debt and might also agree that there are other legitimate reasons for the increased debt—for example, deficit financing to prevent or escape from a recession, or the financing of necessary infrastructure such as bridges and airports. The third explanation for the increased Canadian debt, especially since the early 1970s, has been the increase in the size of income-support programs. Here, controversy about whether this is a good reason for the debt to increase heats up; some have suggested that these programs are too generous in comparison with those of some other countries.

Finally, it should be noted that the very high interest rates between the mid-1970s and the 1990s compounded the size of the debt. (As we saw, some economists suggest that the reason that interest rates were so high in the first place was the result of borrowing by governments. Complicated world, isn't it?) Leaving the statistics behind, let us examine some of the problems associated with the debt.

The first perceived problem involves the size of the foreign portion of the debt. Private financial agencies give ratings for government bonds sold around the world, to help their clients who wish to invest. The lower the rating for a particular government's bonds, the higher the perceived risk and therefore the higher the interest payments that must be paid by the borrower. In early 1995, there was a perception that Canada's national debt was too large. The result was a lower bond rating, and the outflow of interest payments on the foreign-held debt increased. (It should be noted, however, that currently in Canada's case 69 percent of the debt is owed to Canadians, with 31 percent owed to foreign individuals, corporations, and financial institutions.)

Second, we noted that payment of interest on the debt represents a redistribution of income from lower-income Canadians to higher-income Canadians. This is because only higher-income Canadians receive interest payments that come out of the taxes of all Canadians, including middle- and low-income Canadians.

As a third point, large interest payments also mean that each year government must earmark 27 to 32 billion dollars in interest payments (the amount depends on the prevailing interest rates) before it can even start to consider other spending claims. This obviously curtails its ability to satisfy the desires by citizens for other items like health, education, or the nation's infrastructure. However, there is some good news on this front. In 2010 total interest payments were about 10 percent of tax revenue, which is down considerably from the peaks of the mid-1990s. This is a reflection of low interest rates of recent years. Nonetheless, there is a conundrum working here. If government did not have to pay these interest charges, then it would be much easier to balance the budget. But because it did not balance the budget in the past, it has to pay these interest charges.

A final criticism comes from the fact that a federal government has almost unlimited power to spend. Theoretically (and legally), there is no upper limit to how big a deficit can be. That does not mean that big deficits are not harmful to an economy; it simply means that a national government has supreme power to tax, to borrow, and to print money. This means that without checks on its spending, a government can become power-hungry and wasteful in its fiscal affairs. And for this we would all suffer.

In summary, these are the problems with high deficits and debt:

· the interest payments that must be paid on foreign-held debt

· the income redistribution effects of large interest payments

· the reduced ability of government to meet the needs of its citizens

· the possible increased power grabbing and wastefulness of government

Let us now take a brief look at what are sometimes seen as problems of the debt, but really are not.

One of the bogus arguments about the national debt seeks to draw an analogy between a household or a business and the operations of the federal government. It suggests that just like an individual or a business, if revenue falls short of expenses for a long enough period, then bankruptcy will follow. This is just not a legitimate concern when applied to a federal government, which, as we just mentioned, has unlimited powers of taxation and borrowing, and has direct control over the nation's supply of money. Therefore, it is highly unlikely that the federal government of a large economy such as Canada will “go broke” as a result of internal borrowing. It is true that the German government went broke following World War I, but this was a result of external debt imposed on it by France and the United Kingdom. If urban decay and high taxes drive many higher-income taxpayers and businesses out of a city, that city might go broke in that it could default on interest payments on the bonds it sold to borrow money. The same might be said, although this would be stretching it, of a particular province or state, but not of a country as large and as desirable to live in as Canada.

Another argument suggests that a big national debt means that we are encumbering future generations, who will eventually have to pay it. It is true that our children and grandchildren will inherit a larger debt and the interest charges associated with it. However, it is also true that future generations will inherit the Canadian-held portion of the assets (bonds) represented by that debt. That is, if our descendants have to pay extra taxes to service a larger debt, they also, as a generation, will get those same taxes back as the interest payments are made to whoever holds those bonds.

While it is true that the federal government is in debt to the tune of hundreds of billions of dollars, it is also true that the government owns assets—airports, military hardware, land, buildings, and so on—that also total a great deal. Is the debt too large relative to the assets owned?

Most observers suggest that a debt/GDP ratio of less than 50 percent is not particularly worrisome. Canada's debt in the early 1990s was cause for some concern, but as we saw in Table 7.6, the national debt in 2013 has been reduced to a manageable 33 percent, which is one of the lowest in the world, as of 2017 the national debt was lowered again to 31%, the lowest of the G7 countries. 

Source: Principles of Macroeconomics, Sayre/Morris, eighth edition, 7.5, pages 241-245, only changes are updated statistics7

When discussing policy, it is important to focus on the economic issues that are important to the well-being of the citizenship of a country as a whole. This means that in a recession unemployment is a serious concern for all of us, not just those without work. In this situation, the appropriate action should be expansionary fiscal policy implying a deficit in the government budget. However, it should also be recognized that government must keep the size of the national debt—as a percentage of GDP—under control. In the long run, these goals can be achieved if government policy is adjusted to fit the inevitable changes in the immediate economic circumstances. This means government budget surpluses in good times as well as budget deficits in times of recession. This long-run approach implies balancing the budget over the life of the business cycle and will serve the economy far better than getting caught up in any kind of single-minded ideology about how to manage fiscal policy in any particular year. By and large, Canadian governments of the past have done rather well in achieving all of this.

 Source: Principles of Macroeconomics, eighth edition, Sayre/Morris, 7.5 Fiscal Policy and the National Debt, page 245