September 2012 Truth in Labeling Why the Critics are Wrong and Canada’s Fiscal Turnaround is Relevant to America Today Brian Lee Crowley and Robert P. Murphy Introduction Amidst the mounting fiscal crises plaguing major governments around the world, many point to Canada’s successful turnaround. In the mid-1990s America’s northern neighbor was caught in a full-scale fiscal crisis that had been decades in the making. As we argue in a newly released MLI book (Northern Light: Lessons for America from Canada’s Fiscal Fix), compared to some of the proposals for the United States today, the Canadian response of the mid-1990s was very muscular. Program spending, which excludes interest payments, fell by $12 billion from the 1994/95 budget to the 1996/97 budget, a drop of 9.7 percent. Total federal spending, including interest, fell by more than 7 percent over two years. From January 1995 through January 1998, federal employment dropped by 51,000 – a fall of 14 percent.1 The Canadian government then ran 11 consecutive budget surpluses beginning in 1997/98, causing the total public debt to plummet from 80.5 percent of GDP in 1997/98 to 45 percent a decade later.2 Perhaps most surprising of all, the Canadians achieved this immediate and serious fiscal turnaround without plunging themselves into economic recession. In this context, the Canadian lessons for America seem clear. Yet some American critics consistently object that the Canadian austerity episode is irrelevant for their situation today. They explain away the Canadian success story as occurring in spite of that country’s vigorous reining in of spending, not because of it. These “alternative explanations” include falling interest rates, a depreciating Canadian dollar, rising oil prices, and Canada’s parliamentary form of government. The authors of this document have worked independently and are solely responsible for the views presented here. The opinions are not necessarily those of the Macdonald-Laurier Institute, its Directors or Supporters. 1 COMMENTARY – Truth in Labeling: Why the Critics are Wrong and Canada’s Fiscal Turnaround is Relevant to America Today This commentary is a supplement to Northern Light, taking up each of these alternative explanations in turn. As will be seen, none of them succeeds in refuting the relevance of Canada’s example in America’s time of trouble. Although one of these alternative factors (falling interest rates) explains a little of the Canadian success story, one unalterable truth remains: The Canadian government emerged from its rapidly deteriorating debt quagmire chiefly by getting its spending under control, although it modestly increased taxes too; the ratio was roughly five dollars in spending cuts for every dollar in tax rises. This fiscal discipline in turn started a virtuous circle of greater private investment, future tax reductions, rising employment, and strong economic growth. If US policymakers want to do the same, they need only copy the Canadian example. The Canadian Debt Crisis In the mid-1990s the Canadian federal government had run substantial budget deficits consistently for over 20 years. Ottawa’s indebtedness was reaching crisis levels, and a third of all federal government revenue was being frittered away on interest on the debt. The status quo had become unsustainable. Without significant fiscal reform, Canada was at risk of hitting the “debt wall” – when investors stop financing government debt. The federal government was caught in an unsustainable cycle of higher interest costs leading to higher deficits, which required more borrowing, which further increased interest costs as investors demanded higher returns to compensate them for the increased riskiness of lending to the Canadian government. Deliverance from this untenable position came when the ruling Liberals tabled their historic budget on February 27, 1995. This document set in motion a fundamental change from the status quo and ultimately became a defining moment in Canada’s fiscal history. The 1995 federal budget proposed cutting billions in spending, with a cumulative reduction approaching a tenth of all program spending over the first two years. In addition, the budget proposed reducing federal government employment by almost a sixth once fully implemented. More astonishing than the bold plans for a massive rollback was the fact that the Canadians actually did it. The absolute dollar amount of total Canadian federal government spending fell by more than 7 percent from 1995 to 1997, while program spending (excluding interest) fell by almost 10 percent. As a share of the economy, federal spending fell from almost 22 percent to 19 percent during the same two-year period. From January 1995 through January 1998, federal employment plunged by 51,000 – a drop of 14 percent.3 The federal government ran 11 consecutive budget surpluses beginning in 1997/98. Consistent surpluses meant a reduction in the dollar value of federal debt. With the federal government paying down debt and the economy expanding, the total public debt plummeted from 80.5 percent of GDP in 1997/98 to 45 percent a decade later. The Canadian experience shows that with courageous leadership and sound policy, even a serious fiscal crisis can be reversed in just a few short years. US and European policymakers should pay close attention to the lessons from Canada. Americans probably think that their “socialist neighbor to the north” has a much bigger federal government than they do, but figure 1 shows that this is simply not true: 2 COMMENTARY – Truth in Labeling: Why the Critics are Wrong and Canada’s Fiscal Turnaround is Relevant to America Today FIGURE 1 Total federal spending as a percentage of GDP in Canada and the United States, FY 1972-2011 30% 25% 20% 15% 10% 5% 0% 1972 1976 1978 1980 1982 1986 1988 1990 1992 1996 1998 2000 2002 2006 2008 2010 1974 1984 1994 2004 Canada United States SOURCES: Canadian Fiscal Reference Tables; Congressional Budget Office (CBO). Figure 1 makes clear that when their debt situation demanded it, the Canadians found the political will to cut federal spending well below the levels of the United States. US policymakers cannot protest that austerity programs would be too painful or politically impossible; the Canadians show that it can be done. Critics Reject Modern-Day Relevance of Austerity Growth Episodes Canada is not the only success story in this arena. Back in June 2010, the Monthly Bulletin from the European Central Bank (ECB) made the case for what could be called “expansionary fiscal consolidation” that was based on spending cuts rather than tax rate increases. In the words of the ECB report: Past experience suggests that creating significant primary surpluses through fiscal consolidation will be pivotal to reducing the very high debt ratios for many euro area countries and thereby limiting their dampening impact on output growth. Moreover, case studies conducted for Belgium, Ireland, Spain, the Netherlands and Finland found that fiscal consolidations based on expenditure reforms were the most likely to promote output growth, especially when combined with structural reforms. Overall, it appears that expenditure-based fiscal consolidations are more 3 COMMENTARY – Truth in Labeling: Why the Critics are Wrong and Canada’s Fiscal Turnaround is Relevant to America Today successful and have more beneficial effects on long-run economic growth than revenue-based ones.4 [Footnotes removed.] When the ECB’s Bulletin came out, several of the world’s leading economists criticized its analysis as being completely irrelevant to the current global crisis. To take but one example, here is Paul Krugman’s reaction in a NYT blog post: It’s really amazing to see how quickly the notion that contractionary fiscal policy is actually expansionary is spreading. As I noted yesterday, the Panglossian view has now become official doctrine at the ECB. So what does this view rest on? Partly on vague ideas about credibility and confidence; but largely on the supposed lessons of experience, of countries that saw economic expansion after major austerity programs. Yet if you look at these cases, every one turns out to involve key elements that make it useless as a precedent for our current situation.5 In the same post, Krugman linked to another list of apparent austerity success stories, including Canada. Here was Krugman’s reaction: Canada 1994–1998: Fiscal contraction took place as a strong recovery was already underway, as exports were booming, and as the Bank of Canada was cutting interest rates. As Stephen Gordon explains, all of this means that the experience offers few lessons for policy when the whole world is depressed and interest rates are already as low as they can go…. So every one of these stories [i.e., Canada, Denmark, Finland, Ireland, and Sweden] says that you can have fiscal contraction without depressing the economy IF the depressing effects are offset by huge moves into trade surplus and/or sharp declines in interest rates. Since the world as a whole can’t move into surplus, and since major economies already have very low interest rates, none of this is relevant to our current situation. In response to such claims by Krugman and other critics, we will argue that the Canadian success story with fiscal consolidation cannot be explained away simply by falling interest rates or other alternative factors. An examination of the relevant charts shows that such dismissals are not up to the task. We are left with the unavoidable conclusion that cutting government spending is the most effective way to emerge from a fiscal crisis, without plunging the economy into a painful recession. Currency Depreciation One common objection is that the Canadian success story only occurred because the government engineered a weakening of the Canadian dollar. This “stealth devaluation” allegedly triggered an export boom that counteracted the drag on output from government spending cuts.