“From Canada with Love”

This piece from the WSJ reports on Canada´s fiscal adjustment in the 1990s:

Former Canadian Prime Minister Paul Martin has a stern warning for the U.S. political class: Get real about the gap between federal revenues and spending, or get ready for disaster.

Mr. Martin knows of what he speaks. In 1993, when he was Canada’s finance minister, his country faced a daunting fiscal crisis. It wasn’t Greece, but by 1994 Canada’s federal debt-to-GDP ratio was getting close to 80%, and the cost of servicing the debt had begun to eat up an incredible one-third of government revenue.

The central lesson from that crisis, Mr. Martin told an American Enterprise Institute audience in Washington last week, is that delay only ensures that the inevitable adjustment will be more painful.

When the Liberal Party government of Prime Minister Jean Chrétien took power in October 1993, Mr. Martin was charged with pulling his nation out of the fiscal death spiral. He did it with deep cuts in federal spending over two years that amounted to 10% of the budget, excluding interest costs.

Nothing was spared. Even federal transfers to the provinces to fund Canada’s sacred national health-care system got hit. The federal government also cut and block-granted money for welfare programs to the provinces, giving them almost full control over how the money would be spent.

In the 1997 election, the Liberals increased their majority in parliament. The Chrétien government followed with tax cuts starting in 1998 and one of the largest tax cuts—both corporate and personal—in the history of the country in 2000. The Liberals won again in 2000.

That certainly qualifies as a “fiscal cliff”. What happened to the economy? The charts illustrate.

Nominal GDP (and Real GDP) faltered in late 1995 and early 1996, impacted by the draconian fiscal measures, but quickly roared back.

Inflation (GDP deflator) was well behaved, tumbling in the wake of the Asia crisis which impacted oil (and commodity) prices. When oil prices picked up again inflation accelerated. But that was a reflection of a relative price change, which should not concern monetary policy.

The main lesson from Canada´s successful fiscal adjustment is given in the next chart which shows that nominal spending (NGDP) was kept close to trend at all times. Like in almost every country, in the wake of the 2008-09 crisis Canada´s nominal spending faltered, but the resulting gap is much smaller than that observed in the US and most certainly much smaller than the one that afflicts the Eurozone countries.

Unemployment fell throughout, going up at the start of the 2008-09 crisis, but falling back to levels experienced in 2004.

Overall, either during the fiscal adjustment of the 90s, or following the 2008-09 crisis, not a bad comparative performance.

HT: Catherine Johnson

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