The United Kingdom Draws the Wrong Lessons from Canada

by Roosevelt Institute Senior Fellow and Braintruster Marshall Auerback at the New Deal 2.0

For once, Canada is making the news for the wrong reasons. The United Kingdom has braced the country for cuts in government spending up to 20 percent as the new Conservative-Liberal Democrat coalition lays the groundwork for an austerity program to last the whole parliament. Their inspiration? According to The Telegraph, Prime Minister David Cameron’s administration hopes to draw lessons from the experiences of the Canadian Government of the 1990s. Before too much damage is done, we suggest they’d better re-read the history books a bit more closely.

The standard narrative of the Canadian experience in the 1990s is this: in 1993, Canada’s budget deficit and debt-to-GDP ratios were the second highest amongst the G7 countries, after Italy’s, and the US financial press was unfavorably comparing Canada to Mexico. That year, with the IMF supposedly lurking at the door, the Liberal Government of Prime Minister Jean Chretien, and his Finance Minister, Paul Martin, laid out a goal to halve the budget deficit to three percent by 1998, with an unannounced goal of a zero deficit by 2000. Martin began cutting costs significantly in 1994, chopping 10 percent from department budgets and converting a deficit equal to nearly 7 percent of gross domestic product into a surplus by 1997. By 1998, the deficit was eliminated and overall debt was dropping quickly, amidst a rapidly growing economy.

Success, correct? Certainly, this narrative has largely gone unchallenged (even in Canada). It has metamorphosed into received wisdom and has been used by many to justify a renewed assault on the welfare state. It is argued that the impact of Chretien government’s cuts in public spending allowed Canada to get through the Asian crisis with little damage and to go on to become one of the strongest Western economies.

And this is the lesson drawn by the British government. Hence, the remarks of the Chancellor of the Exchequer, George Osborne, who yesterday announced an unprecedented four-year spending review. According to Osborne, every Cabinet minister will have to justify, in front of a panel of colleagues, every pound they spend. He said the task ahead represented “the great national challenge of our generation” and that after years of waste, debt and irresponsibility it was time to bring public spending under control, guided by the principle that people should ask “what needs to be done by government and what we can afford to do”.

The Canadian experience certainly makes for an interesting story, although we suspect that the IMF threat was significantly overstated. In 1995, Canada had a debt to GDP ratio that was around half of that of Italy and Belgium. Yet curiously, those countries were never deemed to be ready-made victims for the Fund’s Little Shop of Horrors, even as Canada was supposedly threatened with the prospect of becoming a ward of the IMF a la the United Kingdom in 1976. In truth, the IMF threat represented yet another in a series of manufactured crises that enabled longstanding opponents of government spending to muscle through budget cuts in vital and politically popular social programs.

The reality is somewhat more complex, as Professor Mario Seccareccia of the University of Ottawa has noted in a paper entitled, Whose Canada? Continental Integration, Fortress North America, and the Corporate Agenda (pp. 234-58). In the paper, Seccareccia noted the real reasons for the “success” of the Chretien/Martin austerity programs:

1. High growth in the US, Canada’s largest trading partner, a sharply declining Canadian dollar (which fell as low as .62 cents against the greenback), and the implementation of the North American Free Trade Agreement (NAFTA), all of which combined to push the export sector’s share of Canadian GDP to 45% by 2000 (now about 33%), and
2. An expansionary monetary policy which did significantly stimulate consumer spending, and which was sustained until the financial crisis.

The turnaround emerged despite the fact that investment remained weak relative to historic economic recoveries. But the massive turn in the country’s external sector was largely made possible through a revival of growth in the US (Canada’s largest trading partner). The stock market boom in the US, the high tech bubble, and the beginnings of the American real estate boom created huge demand for Canadian exports, which largely drove Canada’s recovery. (All of which were fueled by huge increases in US private debt growth, another malign effect of the Clinton budget surpluses.) If anything, this vast improvement in Canada’s external account largely offset the deflationary impact of the fiscal austerity which, in any case, likely impeded, rather than facilitated, economic recovery, given the slashing of employment insurance and social welfare benefits.

The other byproduct of this Canadian “budget miracle” was the increasing indebtedness of the Canadian private sector, a phenomenon mirrored in the US by the Clinton Administration, which repeatedly recorded budget surpluses in the late 1990s. Again, this is no surprise to those of us who adopt the financial balances approach, but it does give a fuller (and less flattering) picture of the ultimate impacts of eliminating Canadian “fiscal profligacy”.

The chart above highlights the importance of Canada’s restrictive fiscal policy in pushing the household sector balances increasingly into the red until the financial crisis of 2008 (also accompanied by a massive increase in the Canadian budget deficit, which almost certainly cushioned the impact of the crisis in Canada).

In any event, Canada’s export boom of the 1990s is a miracle that could certainly not be repeated today, given the decline in global economic growth, and the extent to which the ailing manufacturing exports sector is now being hammered by the so-called “Dutch disease” as a consequence of the Canadian dollar’s relative strength.

By the same token, the United Kingdom would hardly do any better today, given global recessionary pressures and the corresponding implosion of its largest export markets in Europe and the US. If Prime Minister David Cameron is indeed preparing Britons for a Canadian-style attack on the deficit, he is acting on the basis of profoundly misguided historical information. Canada’s growth was largely stock market bubble-driven, so both the US budget surpluses and the Canadian miracle were based on a one-off fluke. From the sector balances approach, we know that unless you get something like one of the biggest bubbles of all time in your own economy or in a major trading partner’s, don’t count on recovery in the face of fiscal retrenchment. The UK government’s current monomaniacal fixation on deficits and its simplistic reading of Canadian history will do nothing more than cut back on vital stimulus that has cushioned the UK from a far greater disaster, all to satisfy the loons in the conservative press and some threatening types in ratings agencies . Not only would a Canadian-style fiscal assault be a nonsensical short-run strategy, given the debt levels the UK private sector is carrying at present, it would not be a sustainable growth policy in the medium-term. Eventually, the private balance sheets would become too fragile and households would attempt to increase saving even further. This would reduce aggregate demand further and income adjustments would force the public balance into an even larger deficit and set the deficit hawks toward cutting government spending with an even greater sense of urgency. The Canadian experience teaches us very little. There is never a case for fiscal austerity in periods of cyclical weakness unless you can recreate the conditions of a financial bubble. But aren’t we paying the price for that today?

Posted with author’s permission from the New Deal 2.0.