From the Archives: Not What, When - Misunderestimating the Debt

Note: I'm going through and adding labels and fixing grammatical errors in my old posts (until I get bored and move on to another project). I figure while I'm at it, I should do some spring cleaning (ok, I'm a little behind schedule) on some of my draft posts that I never finished - what follows is the oldest draft post that remains in the draft folder, it was originally drafted on November 17, 2004 (any comments that I add today as I post will be marked with (ed: ...).
----


Lots of comments these days about what should be done with the Federal Government's surplus. Now, there are a number of arguments that can be made about whether the money should go to debt reduction or not. Arguments about intergenerational fairness, preparing for future economic shocks/rate changes, the impact of the debt on the economy/interest rates and a whole bunch more.

But for this post I'm going to ignore all that and just focus on one question: Which route will allow us to spend more money (be it on health care, tax cuts, child care, the military or whatever):

Option 1) Spending the surplus this year, and every year that follows or
Option 2) Applying the surplus to the debt this year and then spending it next year and every year that follows

To keep things simple, I'm going to assume that every year will be like this one: a $9 billion dollar surplus and an effective interest rate on federal debt of (roughly) 5%.

Under option 1, the amount we have to spend will be $9 billion this year, $9 billion next year, $9 billion the year after that and so on. Simple.

Under option 2, we spend $0 this year, $9.45 billion next year (because we are no longer paying 5% interest on $9 billion we payed off in year 1: $9 billion x 5% = $450 million), and then $9.45 billion the next year and so on.

Clearly, over time we will end up spending more money under option 2 (after 20 years) but to make a proper comparison, we need to consider the time value of money -i.e. that money spent now is worth more than money spent in the future.

If $1.00 spent this year is worth more to us than $1.05 spent next year, than we can get more value by spending the surplus now. So the government should only spend on those items which will gain a greater than 5% return (in revenue to the government)**.

My own opinion is that few options for government spending or tax cuts will yield the same return as paying down debt, a return which has the benefit of being nearly guaranteed.

But that's a minority opinion. Here's an article in the Toronto Star:
http://tinyurl.com/5mp4e (registration required)

If you don't feel like reading it, I'll save you the trouble (ed: especially since that page is long gone, and you don't need to register to look at the Star's website anymore!). Basically, anyone you can think of with any involvement in politics in Canada thinks that the money should go their cause/constituency/whatever and nobody thinks the full amount should go to debt reduction. Quelle surprise.



Why does this happen?

I can think of three reasons:

1) People don't really understand debt or interest
2) People are impatient - i.e. they'd rather have a $10 bill today then a $20 tomorrow (this just means they apply a high discount rate to their consumption).
3) Collective action problems - the various groups figure that if they don't make their case heard the government will give the money to the other side. They could get around this by framing their comments as 'The government should use this money for debt reduction but if it doesn't then it should go to our cause' but maybe that is too long/complicated a message for the sound-bite media.

Solutions:

(ed: this is as far as I got before I left off, back in 2004. As it turns out, maybe there was no foolproof solution...in retrospect the best solution might have been 'don't elect a conservative government', but then that's sort of a default solution to a lot of political problems, isn't it?)

---
** Technically, the required rate of return on any debt financed government spending should really be high enough to cover the cost of borrowing for that specific purpose (almost certainly higher than 5%). i.e. if the government is borrowing
to start (or finance) an experimental high tech firm, we would want a better than 5% rate of return to justify the investment because of the increased risk.

Good Times?

The Globe and Mail was positively filled with good news today. Well, none of it was really news, but it was all good.

First off, Ottawa Flush With Surplus Cash. On current trends it looks like Ottawa will take in $5 billion more than forecast in the budget. People can criticize, but when the government is managing it's books exactly the same way I manage my own - conservatively - I'm not going to. I find it funny that, on the one hand, people bemoan how predictable this turn of events was. And on the other hand, people complain how it's impossible for people to rely on these budget estimates when they're always wrong. Either you can figure out an estimate of our fiscal situation based on the budget forecast or you can't - you can't have it both ways.

Anyway, for the last few years employment growth has been strong, commodity prices have been high and corporate profits have been at record levels. Under the circumstances you would almost expect the results to come in ahead of a forecast which has to allow for the possibility of an economic slowdown. So people can complain away but if Ottawa keeps piling up surpluses and putting them against the debt, we're all getting wealthier and that's fine by me.

Unsurprisingly, Andrew disagrees, but that's OK since we've pretty much agreed to disagree on this topic.

-----

Second, some encouraging results from an industry sponsored propaganda poll looking to drum up support for tougher measures against copying.

"the survey asked students about their attitudes toward theft and found that most did not put illegal software downloading in the same category as offences such as shoplifting.

About 96 per cent agreed that stealing software from a store would be considered a serious offence. By comparison, 40 per cent felt the same way about illegal downloading, file swapping or making copies of commercial software."

It's good to see that, despite industry funded advertising to the contrary, people were able to see the ethical difference between depriving the store of an item they were planning to sell (and causing them a loss nearly equal to the students gain) and making a copy of software (not causing any loss to the company).

The students also seemed to be able (unlike the study authors) to distinguish between plagiarizing (taking credit for someone else's work) and simple copying (making a copy of someone else's work but taking no credit for its creation),

"On the issue of intellectual property rights, about 87 per cent said they would have a problem with someone plagiarizing their own work. When it comes to downloading commercial software, however, just 40 per cent showed similar concerns.

The disconnect, the report said, was particularly strong among computer-science students."

Maybe the media literacy courses they teach these days are actually paying off! For a more useful bit of discussion on intellectual property than the industry poll, see this excellent column by Michael Geist in the Star on why the blank media copyright levy has outlived its usefulness.

-----

Finally, it seems like Newfoundland & Labrador is moving forward with plans for the Lower Churchill project, a massive hydroelectric plant in Labrador. Personally, I am indifferent to whether it is done with or without help from Hydro Québec, but, what I do think is that, when we look back in 50 years, the people who started work on big hydroelectric projects now will be seen as having made smart decisions.

Already, Canadian provinces with well developed hydro resources have a competitive advantage over those that don't and this is only going to grow as a combination of dwindling supplies and increased environmental concerns drives the price (and volatility of the price) of fossil fuels higher.

I believe that if Ontario had taken the billions it has invested in the Nuclear sector and devoted it instead to developing a robust grid linking and developing the hydro capacity of Manitoba, Northern Ontario and Québec, the energy picture would be a lot brighter there. There are issues with hydro of course, such as the flooding of land and Native land claims, but my feeling is that these issues are the lesser of the evils you have to deal with to generate power and that, if dealt with properly, they don't really have to be evils at all.