Government is not a Business - Part 2

Last week, Ellen Russell from The Canadian Centre for Policy Alternatives (sort of a well organized, high profile, left leaning group blog which specializes in really long posts¹) came out with a report with the reassuringly straightforward title of, "What Should We Do With the Federal Budget Surplus".

Carol Goar had an approving take on the report in the Star, and Andrew, at Bound by Gravity, [partly] agreed [Update: Just to clarify, while Andrew agreed with not making debt repayment our top prioirty he preferred to get rid of the surplus via tax cuts not via new spending] (warning: I wrote a long comment on this topic at Andrew's site so if you've already read that discussion, this will be a little redundant).

Now if you know anything about the Centre for Policy Alternatives you don't need to read the report to guess what they think we should do with the surplus (increase spending to fight poverty, build infrastructure and so on). But what I found interesting was three of the arguments put forth to justify spending vs. paying down the debt: The demographic argument, the intergenerational fairness argument and the return on investment argument.

The demographic argument Russell makes is that,

"The budgetary implications of our aging population are not necessarily as ominous as Canadians have been led to believe. ... There is considerable evidence to suggest that deferred tax payments on the more that $1 trillion held in registered pension plans and RRSPs can nicely offset the health care costs,as well as the Old Age Security,Guaranteed Income Supplement,and Spousal Allowance costs associated with an aging population."

Furthermore, she also suggests that if we want to prepare for an aging population we should be spending money on expanding nursing care and so on now, so as to be ready when the boomers retire. (although at the end of the survey when the time comes to say what the government should spend it's surplus on, these expenditures are not mentioned, at least not that I can see).

What Russell fails to address is the real demographic problem which is not that we're going to need more hospitals for all the old people, it's that once those boomers all start trying to withdraw their trillion dollars at the same time, there's a really good chance it will drive up interest rates (note: interest rates are largely a measure of the demand for money. Once boomers retire they will no longer be supplying money to the financial markets, they'll be demanding it back - thus leading to a likely increase in interest rates.)

Holding ~$500 billion in debt as we do currently, every 1% rise in interest rates puts a $5 billion hole in our budget. i.e. we are very vulnerable to a large interest rate shift. If we were to get hit with an economic mess like we got hit with in the 70's, but starting from this debt position, well, it doesn't bear thinking about.

Given that rates are near all time lows and demographics are pointing to an increase, the time to lower our debt (and pay down your mortgage) is now.

The second argument is the inter-generational fairness issue. Russell says,

"Using budget surpluses to repay debt is a highly dubious gesture of inter-generational fairness if today's children are neglected in order to lighten the load of future taxpayers."

But today's children and future taxpayers are the same people - the fairness issue has nothing to do with them. The fairness issue is about all the people who benefited from piling up the debt who will soon be leaving the workforce and will no longer be in a position to repay their debt before it passes on to their children. And the fact that controlling spending to pay down the debt affects all members of society, including children, doesn't mean that the children of future generations should have to pay interest on $500 billion of debt that we piled up and never paid down.

The final, most important and most dangerous argument is the 'return on investment' argument. Here is what Russell argues,

"When budget surpluses are used to pay down debt,it means that this money is not available to fund other priorities. Arguably, the benefits of the alternative uses of budget surplus dollars outweigh the savings in debt service charges produced by debt repayment. For example,government spending that enhances labour force skills contributes to economic growth,which has a host of benefits (including improving the debt/GDP ratio).

The possible benefits of funding other priorities in lieu of debt repayment can be illustrated by a number of studies. A 2003 paper prepared for the Panel on the Role of Government in Ontario concluded that the social benefits of higher education provide a real rate of return to society in the range of 7% to 10%.

The Association of Colleges of Applied Arts and Technology of Ontario released a study in January 2004 finding that public investments in Ontario colleges repay the taxpayer at an annual rate of 12.7%,counting the additional earnings of college graduates as well as improved health,reduced welfare, unemployment and crime. The provision of high-quality child care provides a high social rate of return: using relatively cautious assumptions, a recent study found that every dollar spent on comprehensive public child care programs produces about $2 worth of benefits for children and their parents."

To be fair, she does note that these rates of return are not strictly comparable with the 5.5% interest rate on the debt but it still seems like making that comparison is exactly what she is doing and that it is the basis for her conclusion that,

"It may well be that the savings produced by debt repayment are inferior to the benefits generated from spending budget surpluses in other ways."

The thing is, if we are going to justify borrowing at 5.5% in order to spend the money because that spending earns a return which is greater than 5.5%, that return has to be a return in increased tax revenue - not a 'benefit to society'.

Now when a business takes on an investment, it often borrows money to do so, so you may wonder why it doesn't make sense for a government to do the same thing. But think about all the other things that a (well run) business does. First of all, it only invests in projects which have a clear business case to show how that specific investment will generate a specific return which covers the cost of the money used to make that investment. Furthermore, the business will track the success of this investment, making adjustments as necessary to ensure that that return is met. Finally, if the return being generated is inadequate, the business will terminate the investment and use the freed up resources on some other project.

Now, consider one of the primary spending objectives that Russell suggests: "rebuilding the wide range of social programs that play a role in combating poverty and promoting social equity". Now, does anyone think it is really possible to do a study which will accurately estimate what the impact of doing this on total tax revenue collected by the federal government would be? And if this policy is implemented can we track whether we are getting the return we expected? And if we aren't, will these programs be shut down? We have to remember that government is not a business. That's why, if government takes on some activity which is like a business, that activity is isolated into a crown corporation which follows different financial rules from the rest of government.

Another point to consider - when a business is thinking about investing in a project, the required rate of return in order for that project to be considered worthwhile is not the cost of borrowing the money (or using equity) to invest in that project. The required rate of return depends on how risky the project itself is.

Now you may ask yourself, if a large corporation (say General Electric) can borrow at 7% in the market and has a risky project with a projected return of 10%, isn't that a good investment? The problem is that the reason GE can borrow at 7% is because it is such a large organization that, even if this particular project fails, GE can make up the difference from other areas and still pay back the people it borrowed from. So the risk to the people putting up the money for the project is less than the risk of the project itself (and the risk to GE) because the other parts of GE are effectively providing a loan guarantee.

So in the context of the federal government, the reason the government can borrow at a low rate (5.5%) is because the people lending to the government know that, if push comes to shove, few people win a shoving match with the federal government - since they can increase revenue or decrease spending by legislative fiat (in effect, at the barrel of a gun). What it means is that while the cost of funds for a spending project which the federal government borrows to pay for is only 5.5%, the true cost (depending on how risky the project is), may be much higher. The reason the rate is only 5.5% is because it is guaranteed by you, me and all the other taxpayers who are on the hook if the spending doesn't generate a return (in tax dollars) adequate to cover the interest.

Now this all sounds pretty abstract but it's not. Consider what happened in the 1970's and 1980's when the government effectively took the advice of the Centre for Policy Alternatives and borrowed money to invest in social programs (i.e. ran deficits).

Did this spending create growth in tax revenue which more than covered the borrowing costs? No, and we could see this by how the % of our taxes which went to interest payments kept increasing - hitting a high of near 40% in 1995. At some point, the government's lenders started to get nervous because the government was looking less and less able to make it's interest payments. Given the increased risk, they lowered our credit rating and raised our borrowing costs.

And what happened? All of a sudden taxes went up and spending went down: The government said, 'not to worry, we can force the taxpayers to get us out of this mess' and that's exactly what they did. The borrowing which was done in order to spend in the 70's and 80's failed to generate an adequate return, and we all ended up on the hook for what were essentially bad debts.

What we have to remember is that government generally spends money on things the market won't. And if the market won't spend on them, it's probably because the return is too uncertain or too low. Who really knows what the return on running a passport office is, or of operating a military. We shouldn't determine what our government spends it's money on based on the rate of return it generates in terms of tax dollars, we should determine it based on what's in our best interests as a society - the two are not the same.

In a nutshell, what I'm saying is that government should be funded by taxpayers, not lenders, because its culture, nature and spending priorities are such that it shouldn't, won't and can't make productive investments in the same way that a business does - and when the 'investments' inevitably fail to generate an adequate return in the form of tax dollars, it is the taxpayers who are left to pick up the tab - with interest.


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¹ Credit to Dalton, in the comments at Bound by Gravity, for helping me realize that think tanks/centres/institutions are not so different from group blogs - possibly a topic to explore further in a separate post.