On the mysteries of debt reduction

One of the mysterious aspects of public sector debt is what happens to the bondholders when debt is retired. Take the Canadian government`s debt repayment plan as a case in point. The Government intends to pay down as much as 31.5 billion dollars according to its economic plan over the next 6 years.

First of all the bulk of Canadian federal government debt holders (about 80 %)are Canadian residents and taxpayers. So paying off these debt holders will return money in the form of interest and principal payments within the domestic economy. Previously invested savings will now have to seek new outlets for investment.

As less and less new government debt is issued because governments are with the exception of Ontario running surpluses where will these savers turn ? Alberta alone has an 11 billion dollar plus surplus.


In addition the interest payments unless they are sheltered within RRSPs will be subject to taxation thereby returning a portion of the income flow back into the Government`s revenues. This has been true even before the debt was retired as regular interest paid on the debt went in large measure to Canadian taxpayers. But the absence of new issues will likely lead to an increase in the supply of savings seeking investment outlets. Where will the money go ? The stock market ? The corporate bond market ? The foreign bond and stock markets ? These are interesting questions that have implications for the future value of stocks, the behaviour of medium and long term interest rates and the exchange value of the Canadian dollar.
Beyond this paying down the debt will not be stimulative, although reducing the Government`s surplus through tax reductions and new program spending is. Unless you believe that paying down the debt significantly reduces interest rates through increasing the supply of loanable funds there is nothing stimulative about increasing the supply of liquid savings.So long as the overall economy is growing there is no problem. But should it slow down the increase in liquid savings will complicate matters.Of course, if these former bond holders become consumers with their savings thats a different story. But not a likely one.


More about this later.