As we have seen time and again, every country pursuing profligate debt-financed fiscal policies ultimately hits some sort of wall - as was the case in Iceland recently, not to mention the Club Med countries in the euro zone. The United States may, too, if it doesn’t get its fiscal act together, as the recent Standard & Poor’s credit outlook warning attests.
Canada did hit that debt wall nearly two decades ago as its deficits and debts became increasingly difficult to reverse. The federal government, both Liberals and Conservatives, borrowed and spent like drunken sailors for a long time. Similar actions unfolding in the U.S. today may well create the illusion of prosperity, but as any Canadian will tell you (or perhaps anyone from New Zealand a decade earlier), there is no such thing as a free lunch.
Canada endured not just the ignominy of credit downgrades but also recurring financial market gyrations that frequently disrupted business activity. The Liberal government that found its way to power in 1993 spent most of the next five years enacting tough deficit-reducing policies that it never campaigned on.
Former finance minister Paul Martin was so successful at turning the bloated deficit around and helping reverse Canada’s long-standing reliance on big government that he has since been hired as a consultant to the David Cameron-led coalition in the U.K. Note that Henry Paulson and Lawrence Summers weren’t offered any postings.
Indeed, at a time when the world is looking for leadership, especially when it comes to fiscal rectitude, Canada has evolved as the poster child for how to do things right. After years of massive deficit financing from the late 1960s to the early 1980s, Canada headed into the 1990s in very rough shape from a national balance-sheet perspective.
In Our Image
In fact, it would not be a stretch to say that Canada looked a lot like the U.S. does today - years of budgetary recklessness followed by political wrangling over what to do. Of course, it took a few credit downgrades and heightened financial and currency volatility to push the politicians into action, but Canada serves as a reminder to all countries feeling the fiscal stress that moving back to a balanced budget and arresting structural increases in debt-to-GDP ratios can be done.
In 1993, Canada had a 5.6-per-cent deficit-to-GDP ratio. By 1998, that deficit had swung to a 0.3-per-cent surplus, and by 2008 it was in the black to the tune of 0.6 per cent.
Canada’s federal debt-to-GDP ratio, which was stable at around 30 per cent to start off the 1980s, was 50 per cent at the end of the decade and then approached 70 per cent (where the U.S. is today) by the mid-1990s, which was the threshold for action. At one point in the 1990s, almost 40 per cent of Canada’s revenue base was being absorbed by interest costs on the mounting level of public debt.
It took years of painful retrenchment and tax increases, and it took public acquiescence to make Canada’s fiscal progress stick. For the U.S., it will end up playing out much the same way. The process will be contractionary, deflationary, and very bullish for the bond market, and it will ultimately pave the way for more sustainable economic growth.
Worse Pain Ahead
Considering that the deficit ratios in the U.S. are much worse, the retrenchment may be a lot tougher – but even a Canadian-style $1-trillion restraint over a similar five-year period would clip real GDP growth by roughly 1.5 percentage points annually. That is a lot of pain, to be sure, but not insurmountable, considering the rewards down the road of reclaiming one’s fiscal flexibility.
The problem for the U.S. is that the deficit ratio is about twice what it was in Canada, and in Canada we had a government with a majority that could take charge without special-interest groups exerting an influence on the decision-making process. Sacred cows were slaughtered, just as unaffordable U.S. handouts like mortgage-interest deductibility will be, once real tax reform eventually comes their way.
One of the critical reasons why Canadian assets are in such high global demand is the courageous battle over runaway fiscal deficits and debt that was fought and won during the austere 1990s. The tough measures that were needed to raise revenues and cut expenditures eradicated the structural budgetary imbalances and restored Canada’s triple-A credit rating.
The U.S. is facing much the same national balance-sheet predicament today. While seemingly intractable, the Canadian experience shows that fiscal recklessness can indeed morph into fiscal integrity, assuming that the political will exists.
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