Provinces with lowest debt-to-GDP ratios have the most vulnerable household sector

TD Bank recently released an interesting report identifying British Columbia and Alberta as the regions with the most financially vulnerable household sectors in Canada. The assessment is based on a comparison of the household sector in each province or region using standard financial indicators, including the debt-to-income ratio, share of households with a high debt-service ratio, personal savings rate, debt-to-asset ratio and home price-to-income ratio. Among other things, the report highlights that BC and Alberta have household sectors with the highest average debt-to-income and debt-service ratios.

But does TD's assessment give us the full picture? And is it a coincidence that out of the four regions deemed to be most vulnerable in the report, three of these regions also happen to be the provinces with the lowest government net debt in Canada? Probably not. This is especially apparent when you look at the financial situation in each province using a stock-flow consistent approach to macroeconomics.

The sectoral balance approach is useful in this regard because it takes into account the financial status of the various sectors of the economy at the macro level. Based on the insights of economists John Maynard Keynes, Hyman Minsky and Wynne Godley, this approach provides a useful lense for understanding why households in BC and Alberta are now in a precarious financial state.

The sectoral balance approach is based on a simple premise derived from standard double-entry accounting: the government deficit equals the non-government surplus and vice-versa. This means that, assuming no changes in the trade account, government deficits add funds to the private sector (household and corporate sectors combined) while government surpluses do the opposite by removing funds from the private sector.

In the case of BC and Alberta, years of government surpluses have led these provinces to reduce their net debt down to 14.7 and -9.6 percent of GDP respectively (Alberta has a negative net debt or surplus). Given the average provincial net debt currently is over 25 percent, it is clear that, from a sectoral balance standpoint, BC and Alberta are the provinces where government surpluses have gone the furthest in diverting funds away from the private sector.

Also, given that a large portion of the provincial debt is held by foreign investors, the strict policy of retiring public debt has resulted in a significant outflow of funds away from the government sector and the provincial economy as a whole. This outflow of funds means less investment, less public services and reduced purchasing power for households in the face of rising housing costs and decreased lending activity by banks. Considering also that the corporate sector balance in Canada is currently very high, it is easy to understand why the household sector in these provinces are facing difficult times.

The sectoral balance approach also takes into account financial flows entering or leaving the economy. This means that, assuming no changes in the public sector balance, trade deficits decrease the private sector balance while trade surpluses increase it. In the case of Canada, the recent current account deficit has affected the provincial economies in more or less the same way, and the result has been an overall weakening in the financial position of both households and businesses in each province.

To sum up, although there are many factors that affect households' financial position, it is clear that the weakness currently affecting the household sectors in BC and Alberta is in part a consequence of the debt reduction efforts of the BC and Alberta governments in years past. The financial outflows caused by Canada's recent trade deficits and the huge funneling of funds away from households toward Canada's corporate sector have only worsened the situation.*

In a way, it is ironic that the report points to the two provinces Canadians have always been told are models of "sound" public finance (i.e. low government debt). But then again, we should have known better given that double-entry accounting is several hundred years old...

*For more on the sectoral balance approach in the Canadian context, see this excellent article by Marshall Auerback.