Understanding trends in government spending can be like navigating a maze without a map. However, one key factor can guide us through this complex landscape: interest rates.

Yes, those seemingly innocuous numbers can profoundly impact how governments allocate funds, prioritize projects, and manage their finances.

Interest Rates

Interest Rates are essentially the cost of borrowing money or the return on investment for lending money, often expressed as a percentage over a specific period of time. Various factors, including the supply and demand of money, inflation expectations, central bank policies and overall economic conditions, determine them.

They vary depending on the lender – typically banks or government institutions – and are influenced by the loan's type, reliability, and size. 

For borrowers, interest rates directly impact the cost of financing

Higher interest rates mean borrowing is more expensive, whereas lower rates can make loans more accessible and affordable. Lenders often assess the risk associated with each borrower; those deemed ‘more reliable’ are often offered lower interest rates as an incentive to borrow.

For governments and banks, interest rates are a powerful economic lever

By setting benchmarks, such as floors for the lowest rates among financial institutions, they can influence the amount of borrowing and spending in the economy. Lowering interest rates can stimulate economic activity by encouraging businesses to invest and consumers to spend. Conversely, raising rates can cool down an overheated economy or curb inflation by increasing the cost of borrowing.

Government Borrowing Explained

While government borrowing is similar to how the average person borrows from a bank, there are some key differences to be aware of.

More money, more problems

For obvious reasons, government borrowing typically involves much larger sums of money over longer periods than individual or corporate borrowing. It turns out that it costs a lot of money to finance large-scale infrastructure projects, social programs, and to manage budget deficits. Who knew?

Credit score through the roof

Governments have higher ‘creditworthiness’ than regular people due to their ability to raise revenue through taxes and other means. This also allows governments to borrow at lower rates.

Government borrowing impacts the economy

Government borrowing isn’t just a drop in the economic bucket; it can send ripples across the board, affecting interest rates, inflation, and overall economic stability. In contrast, regular borrowing tends to have a localized impact, influencing smaller-scale economic factors.

More red tape

Government borrowing is tightly regulated and overseen to ensure fiscal responsibility and transparency. This typically involves rigorous budget approvals, debt ceilings, and reporting requirements that do not apply to regular borrowing practices.

Nuances

Interest rates are among governments' most immediate and impactful tools to shape economic conditions. They can significantly impact government funding in several ways.

Interest rates impact the cost of borrowing

Governments often borrow money by issuing bonds to finance infrastructure projects, social programs, or to cover budget deficits. The interest rate they have to pay on these bonds is crucial. If interest rates are low, borrowing costs decrease, making it cheaper for the government to increase funds through debt issuance. This could lead to lower debt servicing costs and more affordable financing of public projects.

Interest rates impact debt sustainability

Generally speaking, more spending on debt means less investment in people. Interest payments are a major consequence of debt accumulation. Similar to households that must pay interest on borrowing related to mortgages, vehicles, or credit cards, governments must make interest payments on their debt. The revenues directed towards interest payments ultimately mean less money will be available for tax cuts and investing in public services and programs. 

However, there have been cases in Canada whereby the government temporarily halted debt payments. During the Covid-19 pandemic, the federal government paid considerably more debt than its provincial counterparts. The federal portion of total government debt grew about 8 per cent from 2019 to 2021. Government debt in Canada, both federally and provincially, is projected to reach $2.18 trillion by the end of 2024. 

Interest rates are influenced by fiscal flexibility

Since lower interest rates provide more fiscal policy flexibility for governments, they can easily pursue expansionary fiscal policies to get the economy up and running during economic downturns. On the other hand, higher interest rates can limit the government's ability to use fiscal policy as a tool for economic stabilization.