Beware the Canadian Fiscal Model

(I wrote the following to circulate to some European colleagues.)

Apparently former Canadian Finance Minister and Prime Minister Paul Martin is being tapped by the Europeans for advice on fiscal matters. “Former prime minister Paul Martin, finance minister in the 1990s when Canada’s dangerously high federal deficit was tackled and then eliminated, said Thursday he’s been engaged in “informal” discussions with several European ministers and senior officials seeking advice on how to confront that continent’s debt crisis.  ….”There’s a huge, huge interest,” said Hamish McRae, a prominent columnist with the Independent, who recently advised readers that the route out of Europe’s debt crisis was by following Canada’s example. “Boy oh boy. Canada, along with four or five other countries, is attracting tremendous attention here.”http://www.ottawacitizen.com/business/Europeans+Paul+Martin+advice/2616493/story.html

Martin recently spoke to a Public Services Summit organized by the Guardian newspaper in the UK.  The Guardian reported that he stressed the need to set and meet stringent deficit reduction targets while keeping the public on side.  “For his plans to work it was important to get economic commentators onside, which made the budget credible with the public…Deficit elimination must be seen to be for people’s well being, he said. They will not support arcane economic theory.” http://www.guardianpublic.co.uk/martin-canada-budget-deficit-pss

At one level, Paul Martin’s reputation as a deficit and debt slayer is well-deserved.  As Canada’s Minister of Finance from 1993 to 2003 (followed by a short term of just over two years as Prime Minister) he implemented the most sweeping fiscal consolidation ever under-taken in the OECD  (rivaled only by Finland over the same period.) The total Canadian government fiscal balance (which includes provincial government balances) shifted by a dramatic 12 percentage points of GDP, from a deficit of  9.1% of GDP in 1992 to a surplus of 2.9% of GDP in 2000. Over the same period of economic recovery, the average OECD fiscal balance shifted by less than half as much, by 4.8% of GDP. After 2000, Martin shifted the emphasis to tax cuts, and government spending stabilized at a new, much lower, level of GDP until 2008.

One key aspect of the Canadian experience was exclusive reliance on spending cuts to balance the books. Between 1992 and 2000, general government total outlays fell by a huge 12.2%of GDP (from 53.3% to 41.1%) while total revenues stayed almost unchanged, falling very slightly from 44.2% of GDP to 44.1%. By contrast, the fiscal consolidation under President Clinton in the US saw tax revenues rise from 32.8% to 35.4% of GDP.  Putting the burden on spending rather than on taxation meant that the burden of deficit reduction fell on the lower end of the income distribution, and this was a significant factor behind the pronounced increase in Canadian income inequality over the 1990s. Between 1993 and 2001, the after tax and transfer income share of the bottom 80% of families fell as the share of the top 20% rose from 36.9% to 39.2%.

Part of the decline in total Canadian government spending over the mid to late 1990s was cyclical,  driven by a gradual fall in the national unemployment rate from above 11%. But by far the greater part came from a major retrenchment of the welfare state. Paul Martin cut federal transfers to persons by 1.9 percentage points of GDP. With elderly benefits virtually untouched, most of the burden fell upon federally administered Unemployment Insurance.  Access to benefits was restricted, and the maximum benefit was frozen in nominal terms for a decade. Today, Canada has one of the least generous unemployment schemes in the OECD. During the current downturn, only one half  of unemployed workers have qualified for benefits, and the maximum benefit is just 60% of average earnings. The average unemployed worker qualifies for a maximum benefit period of less than 9 months.

Martin also cut deeply into federal transfers to the provinces, which fell by 1.9 percentage points of GDP, 1992 to 2000.  Most of the burden fell on social programs under provincial jurisdiction, notably public health insurance (which covers physician and hospital care) and welfare or social assistance which provides basic income support ton those out of work who have exhausted unemployment benefits. The old formula under which the federal government paid one half of welfare costs was scrapped, and welfare rates were slashed in real terms in almost every province to near starvation levels. Because of cuts to unemployment insurance and welfare, poverty rates remained at near recession level highs through most of the 1990s and the incomes of the bottom half of households rose very modestly, despite falling unemployment.

Martin’s cuts stopped the Liberal government from implementing their promise to introduce a national child care and early learning program, leaving working families  pretty much on their own in seeking care arrangements. Worse,  his fiscal revolution and abdication of traditional federal leadership in social policy made Canada a much more market-dependent society, moving it much closer to  the US model. Between 1993 and 2002, the difference between the level of non defence program spending in Canada and the US fell from a huge 15.2 percentage points of GDP to just 5.7 percentage points.

A key feature of Canada’s deficit wars was the deliberate cultivation of fear.  True, the net debt of Canadian governments was 59.1% of GDP when the Martin revolution began, significantly above the OECD average of 35.7%.  However, as argued at the time by leading Canadian macro-economists such as Lars Osberg and Pierre Fortin (both past Presidents of the Canadian Economics Association), rising debt was not the result of over-spending but of  the very deep recession, 1989 to 1991, which was exacerbated by exceptionally high real interest rates imposed by Bank of Canada Governor John Crow in search of the holy grail of zero inflation.  Canada could have grown its way out of  the deficit problem and had no real trouble financing government borrowing. But officials and the media cultivated acute deficit phobia. As documented by Canadian journalist Linda McQuaig in her book “Shooting the Hippo”, they even resorted to talking down Canada’s debt standing on Wall Street. The Canadian public were sold on the debt crusade in a highly cynical fashion.

The macro-economic consequences  of Canada’s huge fiscal retrenchment were limited by a shift to easier monetary policy, and by a significant depreciation of the Canadian against the US dollar. Canada grew somewhat faster than the US between 1992 and 2000 despite fiscal restraint. But unemployment was very slow to decline, falling from 11.2% in 1992 to a still very high 8.7% in 2000. Average real hourly and weekly wages stood still over this entire period, under-scoring how far the economy fell short of potential. For most Canadians, the 1990s were experienced as a lost decade. On the business side, profits recovered quite strongly but real investment and productivity growth was sluggish at best.

As Paul Martin argues, Canada’s experience holds lessons for others. The key lessons are that deep fiscal restraint is hugely damaging to the well-being of working families, and that better alternatives exist.

(For more on the Canadian experience in the 1990s, see Todd Scarth (Editor) Hell and High Water: An Assessment of Paul Martin’s Record and Implications for the Future. Canadian Centre for Policy Alternatives.  2004.)