The lesson from Canada on cutting deficits

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I Can't Hear Poors
The lesson from Canada on cutting deficits

The Globe and Mail

Louise Egan and Randall Palmer

November 21, 2011

Finance officials bit their nails and nervously watched the clock. There were 30 minutes left in a bond auction aimed at funding the deficit and there was not a single bid.

Sounds like today’s Italy or Greece?

No, this was Canada in 1994.

Bids eventually came in, but that close call, along with downgrades and The Wall Street Journal calling Canada “an honorary member of the Third World,” helped the nation’s people and politicians understand how scary its budget problem was.

“There would have been a day when we would have been the Greece of today,” recalled then prime minister Jean Chrétien, a Liberal who ended up chopping cherished social programs in one of the most dramatic fiscal turnarounds ever.

“I knew we were in a bind and we had to do something,” Mr. Chrétien, 77, told Reuters in a rare interview.

Canada’s shift from pariah to fiscal darling provides lessons for Washington as lawmakers find few easy answers to the huge U.S. deficit and debt burden, and for European countries staggering under their own massive budget problems.

“Everyone wants to know how we did it,” said political economist Brian Lee Crowley, head of the Ottawa-based think tank, Macdonald-Laurier Institute, who has examined the lessons of the 1990s.

But to win its budget wars, Canada first had to realize how dire its situation was and then dramatically shrink the size of government rather than just limit the pace of spending growth.

It would eventually oversee the biggest reduction in Canadian government spending since demobilization after the Second World War. The big cuts, and relatively small tax increases, brought a budget surplus within four years.

Canadian debt shrank to 29 per cent of gross domestic product in 2008-09 from a peak of 68 per cent in 1995-96, and the budget was in the black for 11 consecutive years until the 2008-09 recession.

For Canada, the vicious debt circle turned into a virtuous cycle that rescued a currency that had been dubbed the “northern peso.” Canada went from having the second worst fiscal position in the Group of Seven industrialized countries, behind only Italy, to easily the best.

It is far from a coincidence that the recent recession was shorter and shallower in Canada than in the United States. Indeed, by January, Canada had recovered all the jobs lost in the downturn, while the U.S. has hardly been able to dent its high unemployment.

“We used to thank God that Italy was there because we were the second worst in the G7,” said Scott Clark, associate deputy finance minister in the 1990s.

Canada’s experience turned on its head the prevailing wisdom that spending promises were the easiest way to win elections. Politicians of all kinds and at all levels of government learned that austerity could win.

The turnaround began with Mr. Chrétien’s arrival as prime minister in November, 1993, when his Liberal Party – in some ways Canada’s equivalent of the Democrats in the U.S. – swept to victory with a strong majority. The new government took one look at the dreadful state of the books and decided to act.

“I said to myself, I will do it. I might be prime minister for only one term, but I will do it,” Mr. Chrétien said..

A shrewd political strategist, he believed Canadians were on board, after they were shocked and embarrassed a year earlier when Standard & Poor’s downgraded Canadian foreign currency debt to double-A plus from triple-A.

He wanted history to remember him as the man who rescued Canada from financial ruin and humiliation.

Mr. Chrétien sat his skeptical cabinet down and laid down the hard truth. He would get rid of the deficit, it would be painful and unpopular and nobody would be spared. There was no choice, no room for negotiation. It had to be done.

The chill in the room was such that newly appointed junior minister for veterans affairs, Lawrence MacAulay, called his wife afterward to say he would soon be out of a job.

“He said, ‘Darling, I will be back home in the next election. I will be defeated, because the prime minister explained to us this morning what he intended to do,’” according to Mr. Chrétien’s recollection.

MacAulay, who represents the Prince Edward Island fishing community of Cardigan, has been re-elected six times and sits in the House of Commons today. He couldn’t be immediately reached for comment to recall the conversation.

Canada’s scrape with disaster had been building for a long time.

Over a decade earlier, top Finance Department bureaucrats had begun raising the alarm about the problem of rising debt, a hangover from the big government era of the 1970s.

The period before Mr. Chrétien came to power in Canada is often likened to the situation in the U.S. today. The country was not yet peering over a precipice, but was fast approaching it.

Mr. Clark said he and his colleagues sent memos to their bosses in the 1980s explaining “the arithmetic”: growth was low, interest rates were high and it was only a matter of time before Ottawa would not be able to pay interest on its debt.

But successive governments ignored the warnings and wrote budgets that allowed spending to continue to grow.

“It was hugely frustrating,” Mr. Clark said. “Every year we put out forecasts showing the deficit going away. We just based every budget on ridiculous assumptions.”

The budget deficit more than doubled between 1980 and 1990, rising to 8 per cent of GDP in 1983 and 1984, before shrinking to a still unsustainable 5.6 per cent just before Mr. Chrétien took over, and all the time debt was soaring. The debt-to-GDP ratio shot up to 67 per cent in 1993-94 from 29 per cent in 1980.

The numbers aren’t that different to the U.S. today with its deficit of around 9 per cent for 2011, and debt-to-GDP ratio at 74 per cent, up from 40 per cent at the end of 2008.

Drawing a parallel to Washington, Mr. Clark said Canadian leaders before Mr. Chrétien paid lip service to the debt problem but did nothing.

“There are no lights blinking saying you’re at the edge of the cliff,” he said. “The one lesson others can give the U.S. is that the higher that debt-to-GDP ratio goes, the more difficult it’s going to be.”

Canada already faced a gaping current account deficit, a weakening currency and high interest rates, and more misery was inevitable if the debt crisis wasn’t addressed.

The first kick in the teeth from abroad came from the October, 1992, S&P downgrade.

Even two decades later, Don Drummond, in charge of the budget at the finance ministry at the time, bristles at the memory, saying that the downgrade should have been “completely irrelevant” because so little of Canada’s debt was in foreign currency. But the damage to public opinion was done.

“We were just mobbed by the media. Here’s some foreign institution that says Canada is a basket case. If we had had a Canadian agency downgrade us, probably nobody would have shown up,” Mr. Drummond said.

The politicians had ignored the bureaucrats, but there was no way to sweep international criticism under the rug.

“Fear drives people. It drove us,” Mr. Clark said.

The Liberals thought their first, rushed budget – delivered in February, 1994, three months after taking office, was tough.

It reformed unemployment insurance entitlements, and cut defence and foreign aid, as well as closing some business tax loopholes and ending a $100,000 lifetime capital gains exemption. The savings totalled $10-billion over two years.

The government said it would review all programs and predicted a deficit of 3 per cent of GDP in 1996. But program spending was still budgeted to rise slightly, and the budget was widely seen as a failure.

Pete DeVries, who headed the fiscal policy division, remembers overhearing chatter from economists’ and others as he waited for a flight to Toronto just after the budget.

“The mood was so depressed on that plane that I thought we’re never going to get off the ground and if we did get off the ground we’d crash, because it was just doom and gloom,” he said. “Everywhere you heard the words, ‘They don’t get it. They just don’t get it.’ ”

Voters certainly didn’t get it. People who had cancelled vacations or taken a second job to make ends meet in the recession couldn’t understand why Ottawa thought it could live beyond its means.

The upstart Reform Party, then the main national opposition party, had campaigned on “zero-in-three” – balance the budget in three years. “We were always trying to go faster,” said Reform’s leader at the time, Preston Manning.

Three months later, Moody’s Investors Service lowered its rating on Canada’s foreign currency debt, citing the government’s large and growing debt.

In December, 1994, Mexico suffered a run on its currency and the following month The Wall Street Journal stung with its “Bankrupt Canada” editorial, lumping Canada with Mexico as a country that might need an International Monetary Fund bailout.

The Liberals were stung by the criticism and, at first reluctantly, but then with gusto, they got out the chain saws.

“I think the Moody’s and Wall Street Journal stuff reflected what we knew inside,” said then industry minister John Manley.

Cutting government spending programs went against the Liberal grain. Contrary to the Reform Party, the Liberals saw a more important role for government.

Paul Martin now has a lasting reputation as the finance minister who slayed Canada’s deficit, but the conversion from spender to cutter was painful. His father, also called Paul, had helped create Medicare, Canada’s publicly funded health care system, and suddenly here was Paul Junior contemplating massive cuts.

Mr. Clark remembers riding in a taxi with Mr. Martin after meetings in New York.

“He said, ‘I don’t want to do this. I don’t want to do this.’ And I said to him, ‘You don’t have any choice because if we don’t do it that means you won’t be able to keep the programs you’ve already got. We’re going to go over the cliff and we’ll be cutting like you won’t even believe,’ ” Mr. Clark said.

“We told him you are still a Liberal but you have to be a small ‘c’ fiscal conservative to be a nice good Liberal.”

In the end, Mr. Martin famously vowed to tackle the deficit “come hell or high water.”
Mr. Chrétien and Mr. Martin later parted ways bitterly, but they formed a formidable duo during the budget cutting.

At one 1994 cabinet meeting, Mr. Martin announced a spending freeze. A minister put forward a project that needed funding but Mr. Chrétien cut him off, reminding him of Mr. Martin’s freeze.

A second minister raised his hand to ask for funding, and a testy Mr. Chrétien told the cabinet that the next minister to ask for new money would see his whole budget cut by 20 per cent.

Mr. Chretien’s scrappiness, which was one result of his upbringing in a working-class family in rural Quebec, had already earned him the nickname of “Dr. No” when he was finance minister in the 1970s.

“The prime minister was the man with the steel rod up his spine. He was inflexible,” Mr. Manley said.

For ministers it was brutal. Mr. Manley lost half his budget as industry minister in the 1994 budget and went from 54 programs down to 11.

“Everyone knew they had to face the music, and they did it,” Mr. Chrétien said in the interview in his law offices. “They had no choice. There was no great debate. I had made my view very clear.”

The ratio of spending cuts to tax hikes was seven-to-one. Asked why, Mr. Chrétien said simply: “There was more need on one side than the other.”

That contrasts with proposals this year by President Barack Obama and the Democrats to have a much higher proportion of revenue increases in the deficit-tackling mix.

Canadian ministers were told how much they had to cut and then told to come back with a plan on how to do it. Cuts ranged from 5 to 65 per cent of departmental budgets and included controversial cuts in transfers that help provinces pay for health and education, decisions that lengthened medical waiting lists for years to come.

Mr. Chrétien exempted just a few areas from the cuts, including the Department of Indian and Northern Affairs. He also blocked big changes to benefits for the elderly and made sure tax collectors had enough resources.

In the end, program spending (everything except interest payments on the debt) fell by about 12 per cent, or $14 billion, between 1994-95 and 1998-99. The percentage fall was substantially more after adjusting for inflation.

The gloomy Canadian reaction to the 1994 budget changed to applause in 1995. “People came up to me to say, ‘You guys got it,’ ” Mr. DeVries said.

The deficit disappeared by 1997 and the debt-to-GDP ratio began a rapid decline – it is now at about 34 per cent.

“The entire political class decided to stop treating this as a matter of political contention and started treating it as a matter of national interest,” said Mr. Crowley, the political economist.

After wrestling the deficit to the ground, Canada enjoyed what Mr. Crowley calls the payoff decade, outperforming the rest of the G7 on growth, job creation and inward investment. From 1997 to 2007, it averaged 3.3 per cent economic growth. while U.S. growth averaged 2.9 per cent.

Canadians are the first to admit that a lot of their success was the result of good timing that cannot be replicated today. The rosy global economy then contrasts with today’s turmoil. There was no euro zone crisis to worry about. The United States and China were growing fast, demanding Canadian exports. Nobody else was reining in spending.

Mr. Clark says the U.S. dollar’s role as the world’s reserve currency may be disguising Washington’s problems and means the critical period could be a ways away.

“There’s no market discipline,” Mr. Clark said. “People want to buy U.S. Treasuries and they always know they will get paid.”

The parliamentary political system also helped Mr. Chrétien, since there is no effective division of powers between the executive and legislative branches as in the United States. A prime minister with a majority in the House of Commons can push through whatever he wants.

And politicians were almost all on board. The opposition Reform Party was screaming for even deeper cuts and public opinion was ahead of the politicians in calling for austerity.

Some of Canada’s lessons are applicable elsewhere and Britain’s Liberal Democrats and the Conservatives both cited the Canadian model when peddling their austerity plans to voters in their successful 2010 election campaigns.

Mr. Chrétien said he had had no qualms in telling Britain’s coalition government that it was wrong to exempt areas such as the National Health Service, regarded as sacred by many in Britain, from the drastic spending cuts.

“I told them they made a mistake,” Mr. Chrétien said. “I remember talking with a very senior person in health who said to me privately, ‘I’m not very happy that I’m exempt’ ... He needed the same pressure as the others.”

The Canadian mantra was to go big, spreading the pain and sparing no one, to prevent rivalries and resentment.

“You have to take immediate action and it’s got to be primarily on the spending side ... but at the same time everybody has got to come to the market and that really means tax increases as well,” Mr. Martin told Reuters in August.

Members of the deficit-slaying team have since advised countries as far ranging as Bahrain and Bangladesh. Canada has touted its fiscal record to push for co-ordinated deficit reduction in the Group of 20 most powerful economies.

Some veterans of Canada’s successful rebound believe the United States needs a value-added tax similar to the goods and services tax (GST), which Canada’s Conservatives introduced in 1991.

The Liberals say they were pragmatic, not ideological, on taxes. But they could not boost tax revenues much because Canadians’ top marginal income tax rate was already uncompetitive at around 55 per cent and the unpopular GST was already on the books.

Reform Party’s Mr. Manning said the U.S. spending-versus-tax debate does not have to be a question of either/or, but he saw a lesson from the way Ottawa cut its own fat before holding out its hand to taxpayers.

“So you don’t completely rule out tax changes or tax increases in the future, but you make them conditional on achieving a certain degree of financial order now,” he said.

Former bureaucrats also say flat, across-the-board spending cuts are a bad idea, even though it’s more palatable to staff to shave 5 per cent off the top of each program.

Unless whole programs are killed, departments might simply postpone vitally needed capital spending, including such things as maintenance and repair, and have to boost it back to former levels within a few years.

The final lesson is that you can impose painful spending cuts and still win elections. Mr. Chrétien went on to win two more back-to-back to form majority governments, a rare feat. He argued that a responsible Liberal who believes the state has a role in reducing poverty can only do so by ensuring a financially healthy government.

Mr. Drummond, who later moved to the private sector and is now an adviser helping the Ontario provincial government slash its deficit, noted that governments on the right and left in Saskatchewan, Alberta and Ontario won more voter support after their own budget cuts in the 1990s.

“Brutal, brutal fiscal restraint, and all won majority governments right afterward,” he said.
I Can't Hear Poors
Beefy Rep

A quick look on Wikipedia reveals that Canada's debt as a ratio of GDP is currently not at 69%--but rather 84%. Some solution!--and some crisis for that matter.

The only thing that's helped Canada is the fact that its--Canada. A huge, resource rich nation with a sparse population located right next door to the United States.

Team Zissou

The 'successful' social democracies are all remarkably alike: low population density; abundant natural resources, a white super-majority, and an ethic that discourages net tax consumption.

Canada is becoming more crowded and less white, and, to my admittedly anecdotal observation, populated increasingly by people who devote considerable efforts to figuring out how to avoid paying taxes. The thrifty whites whose productivity enabled the welfare state in the first place join very quickly in the race to get while the gettin's good. Who's going to make the books balance for Canada? Africans, with their poor impulse control and IQ problems and working lifespans limited by the northern latitude? The market-dominant Anglos and Scots-Irish, marching in slutwalks?

Here's another neat fact:

The CMHC (which is a government entity) insures over $1,000,000,000,000 (one trillion) worth of mortgages. They have $0.009 trillion (that's 9 billion) in assets. When the housing bubble pops up here, they'll go bankrupt, and the government will have to continuously bail them out, or just take on the liabilities themselves. This stuff isn't on the books, either.
I'm bearish on the Canadian and Australian RE markets. So is Garth Turner:

Indeed. Conrad Black is a leading example of this class of parasite you mention. The swarm of bullshit US Chicago school style economic ultraism is, like in Canada, also polluting the Australian body politic, however lucky our population is sensible enough to see through it.

Hence the passing of the mining tax last month. Sadly the original version didn't get through but the population was so annoyed by the lying ad campaign run by the miners they actually eased off on the second version.

Now there's something in place, the level can be relatively easily jacked up in future.

While I share IT Wizards view of Australian real estate dropping significantly, I don't think it will be at the levels of the cataclysmic drops seen in the US and UK (for various reasons I CBF going into here)

What kills me about these kinds of articles is flailing around right wingers engage in when confronted by them. SST is reduced to crying we'll all be rooned by the nigras like a drunk at a tramstop.

The historical reality is that Canada and Australia are doing well and survived the North Atlantic meltdown relatively unscathed for two reasons.

One is both are resource rich countries with an extensive Pacific and Asian outlook and focus, geographically, historically and demographically.

Far more importnat is the fact, as alluded to in the article but not fully explained, that when the structures that would govern how the country operates in the new economic era, they were put in place by social democratic parties not in thrall to the Great Lie of market infallibility.

Unfortunately for the US and the UK, free market ultras in Thatcher and Reagan and their associated appratchiks set the running. Hence the decline and recession/depression in those countries.

This is not to say that the Canadian Liberals or the Australian Labor operators like Bob Hawke or Paul Keating are or were commos or even socialists. Both, especially in Australia, introduced major reforms aimed at freeing up trade and all believed that the market is the most efficient means of distributing resources and increasing prosperity.

But they also realised, much like a certain Adam Smith chap, that the market has to be regulated in order for it to operate properly on a macroeconomic scale. They recognised that the market might be infallible in theory and on screens in a trading room, but not in a modern country with a representative democratic system of government.

Hence the Australian banks were de-regulated and but still required to maintain levels of liquidity etc beyond what was the "norm" elsewhere. Hence Australians continual rejection at the ballot box of US style "labour market reforms" - we know that collective bargaining is a key function of a fair IR system.

Had John Howard - who lead Australia into a savage recession in the early 80s as Treasurer - in the 80s and 90s no doubt we'd be in the shit like the US and UK now.

Instead we had one of the greatest Western politicians of the post war era in Keating as Treasurer then PM. And he laid in place the conditions that have led to Australia enjoying 25 years of growth, saw us avoid even a technical recession in the 2008 economic crisis and jnow has us well placed to again avoid the worst of the European debt crisis.

I have said many times that ultra free marketism is exactly the same as communism. It works in theory but never in practice. And when it is tried and failed, its adherents, who have a religious belief in the myth, claim it "wasn't done right" there and continue with their delusions.


SLF, I think you're just connecting coincidental variables and considering it to be causation. I know for a fact that Canada undertook the same policies as the US has regarding housing and real estate, except that during the 2008 crisis, the US backed off and realized there was error. The Canadians took the broken programs and amplified them to kick the can down the road. We had the same bank bailouts here that the US had, except the media failed to report it.

In the US, there was plenty of regulation:

The SEC - failed to catch bernie madoff after being tipped off many times. We're only left wondering what else they missed.
The CRA - community reinvestment act. It forced banks to give loans to poors who otherwise wouldn't qualify for a mortgage.
The fed - this government backed monopoly which was suggested by the communist manifesto, set interest rates far below market value.
Fannie and Freddie - government insurance for banks, so that banks wouldn't have to bear any risk from home loan default.

Seriously, does this sound like sane policy? This is a clear-cut case of unintended consequences. It's plain economic ignorance. The purpose of low interest rates, the CRA and Fannie and Freddie was to help everyone in America own a home.

How about the inclusion of 0% down 40 year mortgages in Canada when the 2008 collapse hit? The Harper government's orders to bankers to give out more loans? It's really not a huge leap of logic to say the following policy is not free market and is borderline criminal/insane: Let's create government programs that entice people to invest everything into housing, force banks to give home loans, and shift the risk from the banks to the public.
Team Zissou
LOL. I bet your Middle Eastern and SE Asian immigrants line up ten deep at the tax office to make sure they declare their income.