Biting the bullet

EU and U.S. have it easy compared with Canada in 1995

The Quebec referendum was the culmination of years of political acrimony particularly accentuated by the Meech Lake
 constitutional discord—all set against the back drop of rating downgrades and an enormous debt burden.

By Derek Holt and Karen Cordes Woods

The night of the Quebec referendum on Oct. 30, 1995 portrayed Canada at its worst. The palpable fear in the markets was keyed off deep intertwined concerns about the country’s fiscal, economic and political circumstances. A respected U.S. financial daily slammed Canada as a “banana republic” and the nation’s political leaders dismissed capital markets critics as “armchair observers who wouldn’t know how to run a country.” Such a market-unfriendly backdrop understandably drew the ire of rating agencies and bond markets as the country faced the threat of breakup and dissolution of monetary union. Simply put, Canada then was Europe today.

The U.S. and core eurozone economies face arguably easier conditions within which to pursue necessary fiscal and political reforms today. Those who say Canada faced an easier time at restructuring its finances than either the U.S. or Europe would today are guilty of historical revisionism at best, and shameful affirmation of today’s global fiscal malfeasance at worst.

Canada’s past experience lends support to Germany’s current opposition to non-sterilized bond buying by the European Central Bank and other short-term solutions in favour of accelerated fiscal austerity and reforms. The only long-run viable policy solution for the ultimate survival of the eurozone is through reining in the purse strings.

Unstable politics With the U.S., France and Germany facing elections over 2012-13, many argue that this makes it harder for them to pursue fiscal austerity today. Political instability in Canada during the 1990s, however, occurred as a backdrop to aggressively pursuing fiscal austerity. The Quebec referendum was the culmination of years of political acrimony particularly accentuated by the Meech Lake constitutional discord. Canada also faced tumultuous federal election campaigns throughout its efforts toward fiscal repair, including 1993 and 1997. The Liberals who led the effort toward fiscal repair were rewarded with a third consecutive majority government in 2000.

Great fear existed in Canada in 1995 over how the debts would be split if Quebec pulled out of Confederation, and whether Quebec would abandon Canadian monetary union. The mountain of debt and the controversial push by the federal government toward solving it in part on the backs of the provinces almost broke up Canada. Eventually, federalism won in Canada simultaneous to achieving fiscal repair and it is this twin battle that Europe must fight now, with the same stakes in play.

World growth It’s a fallacy that it was easier for Canada to right its fiscal ship because the world economy was growing much faster during the period in which it brought its debt-to-GDP ratio from the 102% peak in 1996 through to the 80% range by the early 2000s and the 66.5% trough in 2007. For a commodity producer and trading nation like Canada, it is world GDP that matters, and the country’s fiscal progress was achieved despite the Asian financial crisis, Russia’s technical default and eurozone debt-market turmoil. World GDP growth was only in the 2%-3% range from 1990 through 1995, only accelerated to about 4% growth in 1996-97, and then abruptly slowed again to the 2½% to 3½% mark over 1998-99, when the Asian financial crisis hit. The dot-com bubble period lifted world growth to 4.8% in 2000 and then it crashed again in 2001-02 at about the same time that 9/11 hit, yet it was just after this point that much of Canada’s fiscal repair had been achieved.

After collapsing in 2009, world GDP growth was 5.1% in 2010 and we are projecting it to slow to 3.8% this year, 3.7% in 2012 and 4.0% in 2012. That is still not outside of the bounds of world growth experienced by Canada in the 1990s.

U.S. growth A further fallacy is that Canada could achieve fiscal repair only thanks to the backdrop of decent U.S. economic growth. This argument is heard more from foreign sources than from those who recall that most of Canada’s fiscal improvement in the 1990s was achieved through domestic program-expenditure reduction — not through revenue gains. Federal government program spending as a share of GDP dropped from 17.4% in 1992-93 to about 12% by 2000-01. This five full percentage-point reduction in program spending swamped any changes in revenues, which were largely flat at about 18% as a share of GDP.

Any advantage stemming from decent U.S. growth was more than negated by other severe disadvantages facing the country, versus Europe and the U.S. today.

Interest expense Canada achieved virtuous fiscal rectitude within the context of a crushing interest-expense burden that neither the U.S. nor most of Europe presently face. In the 1990s, total federal public debt charges as a share of GDP soared to about 6.6% by 1990-91 and remained over 5% until the 1997-98 fiscal year, in stark contrast to how low interest rates are keeping the U.S. interest-expense burden at rock-bottom levels today. In order to achieve fiscal balance, Canada had to pursue the draconian cuts to program spending noted above, as a high interest burden made achieving fiscal balance vastly more difficult.

Monetary policy U.S. monetary policy is exceptionally easy right now, in stark contrast to Canada in the 1990s. Canada’s floating currency was pummelled in the 1990s and went from $1.12 against the U.S. dollar early in the decade to about the $1.40 range by 1995, before cruising around such depths until a renewed round of depreciation took it to the $1.50 mark by decade’s end. This is too simplistically offered as an explanation of how Canada must have been able to achieve fiscal balance by relying upon currency depreciation through a floating exchange rate. What’s missing here is what monetary policy was doing, partly in response to such currency weakness, which occurred despite the fact that the Bank of Canada pushed rates skyward, with the overnight rate rising by about four full percentage points to about 8% by 1995. This failed attempt at defending the currency — including through outright intervention — is one of the reasons why the BoC has not attempted intervention since. Thus, Canada achieved fiscal repair against the backdrop of tighter monetary policy that didn’t allow the mixed benefits of currency depreciation to flow through, whereas the U.S. and more of the eurozone should be pursuing fiscal austerity against the backdrop of exceptionally easy monetary policy and forgiving bond markets, which makes the task far easier.

Housing bubble Like the house-price collapse in the U.S. today — and its sharply differing regional magnitudes — Canada and specifically its biggest province of Ontario was going through the popping of a housing bubble in the early 1990s. Toronto house prices had peaked by 1989 and didn’t hit a trough until 1995, when they had fallen by almost 30% in value. Toronto house prices on average did not regain their 1989 peaks until 2002. The depressed state of the country’s housing market was also reflected in housing-start volumes that collapsed from the 200,000-280,000 range of the latter half of the 1980s down to the 100,000-160,000 range from the mid-1990s throughout the rest of the decade.

Labour markets In the 1990s, Canada’s unemployment rate was in double digits. Canada’s truer measure of unemployment stood at about one in five after including discouraged workers who simply dropped out of the labour force. U.S. pressures are comparable today, but the European experience is mixed, from peripheral pressures all the way down to Germany’s 7% unemployment rate.

Corporate balance sheets Europe and the U.S. have the enormous advantage of having excellent corporate balance sheets. That wasn’t at all the case for Canada back in the early 1990s, when the country’s corporate debt-to-equity, interest-coverage and profit-margin ratios were severely strained. The fact that Canada achieved fiscal deleveraging simultaneous to both household and corporate deleveraging made its achievements far more impressive.

Negative feedback effects A Keynesian might argue that now is not the time to pursue fiscal austerity because the global economy is weak. Had that been the prevailing wisdom for Canada in the 1990s, and had Canada not taken a big bath against a weak domestic growth backdrop, it would have never been in a position to reap the benefits of the fiscal dividend that emerged in the past decade. Instead, Canada leveraged its general government debt-to-GDP ratio down from a peak of 102% in 1996 steadily lower throughout the rest of the decade and to 66.5% by 2007, before accelerated pre-crisis spending and the crisis response pushed this ratio back upward to about 84% now. While this ratio has trended higher of late, it remains superior to the 100%-plus U.S. ratio today and Canada’s financial asset position results in a net government debt-to-GDP ratio of just under one-third.

Printing presses Before priming the printing presses to fund governments became the convention across Western economies, Canada achieved fiscal progress the old-fashioned way: through austerity that followed an over two-decade-long debt binge and by paying its bills. The country took its very hard knocks to growth and financial markets versus the unwillingness to do so across much of today’s Western world, and the path toward enhanced federalism and fiscal repair was littered with doubters and critics.

It’s important to rectify a false impression that quantitative easing amounts to cheap insurance in a low-inflation world against global sovereign-debt shocks. Contrary to this view, the full consequences to Germany and the ECB to caving in to pressures to monetize debt are that fiscal profligacy never gets cured and long-run inflation results. For one thing, the moral hazard associated with a central bank bailing out politicians could well amplify future fiscal pressures. For another, it is wistful thinking to hope that central banks will know when to turn off the taps at the right time, given their historical track record, particularly the Fed’s over the decades.

It is in this respect that the eurozone must pick its poison: Risk a greater crisis now toward the possibility of expedited fiscal austerity and effective oversight, or cement the long-run failure of the eurozone project at a later date. The ECB should be much firmer in clearly stating it has no policy desire to rescue politicians in the short term.

As a consequence of its earlier sacrifices, Canada is today part of a dying breed of AAA-rated markets. Its status as the eight-largest global bond market at face value somewhat hides the additional fact that fewer yet are AAA rated among the world’s deepest bond markets. Canada offers an important lesson to nations like the United States and large parts of Europe that are delaying fiscal repair and punting the problem down the road toward a more ruinous crisis later.