"Canada's Budget Triumph" - some additional context for the US

David Henderson* of GMU has a working paper (h/t Tyler Cowen) on the story of how Canada's federal government solved its budget balance woes during the latter half of the 1990's, with almost no apparent ill effects. Much of the paper sets out the political context that made this possible, and is very useful in that respect.

Less convincing is the suggestion that Canada's experience can be used as a template for a US austerity program in the short term. The paper misses two important points, both crucial to Canada's success, and neither currently applicable to the US.

1) Austerity wasn't implemented during the recession.

Henderson suggests that "the Canadian experience does not support the Keynesian view that policymakers should not cut government spending during an economic slowdown." In point of fact - and it remains an open question in my mind whether this was by luck or by design - Paul Martin's famous austerity budget of 1995 was brought down at a point when private-sector employment had reached its pre-recession levels:

 

If we're going to apply our model to our cousins to the south, then we're going to have to wait a couple of years before US employment comes back.

 

2) Monetary policy could and did offset the fiscal contraction.

Henderson hardly mentions monetary policy, except to note that inflation was low and stable, and that by February 1995, the CAD had depreciated to USD 0.71. But there's much more to the story than that:

In the two years following the 1995 budget, the Bank of Canada reduced interest rates by more than 500 basis points. And by 1999, the Canadian dollar had depreciated by 10% in USD terms, fueling the export-led expansion.

Of course, we all know that the Fed doesn't have 500 basis points to give away, and engineering a depreciation of the US dollar is proving to be no small task.

Given these two very important differences, I don't see how Canada's experience of the 1990's can be used as a reliable guide for the current-day US economy.

Update: I got the affiliation wrong. It's a GMU working paper, but he doesn't teach at GMU

Comments

[Mike Moffatt]

Another point: Henderson mentions in the paper that the Feds reduced transfers to the provinces. However, I would wager a guess that the budget situation of U.S. states is a little more dire than the situation was for Canadian provinces in 1995-1997, making this type of downloading more difficult. I don't see that mentioned in the Henderson paper anywhere, but I may have overlooked it.

[Jim Rootham]

"with almost no apparent ill effects"

Ye gods and little fishes. How can you say that with a straight face?

You may not have seen the ill effects, but the people at the bottom of the heap sure did.
EI cutbacks, housing cutbacks, welfare cutbacks.

And the the deficit was almost entirely caused by high interest rates in the first place (cf Ivan Fellegi).

[Just visiting from Macleans]

Funny what you can demonstrate through your choice of scaling, normalization etc in graphs to support your arguments. Most mathematically illiterate won't notice, however.

[Stephen Gordon]

I'm really not in the mood to put up with this sort of passive-aggressive innuendo. Make your point.

[Patrick]

JVFM: Henderson or Stephen?

And as Jim points out: sure getting the deficit under control didn't crater the economy (and ultimately served us well, IMO), but to say it didn't hurt is simply not true.

[Stephen Gordon]

Good thing I didn't say it, then. Indeed, I made the opposite point last time I discussed the point.

This was about why the Canadian experience can't be used for the US.

[Just visiting from Macleans]

A more meaningful first graph would be public sector employment, private sector employment, total employment, and unemployment. In pct or actual numbers.

Normalizing numbers (especially public employment) can provide a distortion as to their relative size. Maybe not important to economists who are familiar with these types of graphs - but to the general public, can be misleading.

If I was to look at that graph, at first glance - I'd think - well, the gov'ts austerity efforts led to a direct transfer/ more employment in the private sector. And a welcome conclusion if one advocated smaller gov't.

OTH I'd personally be more interested in knowing how commodity prices fitted into the equation, knowing how Ralph Klein's austerity efforts in Alberta during the same period fitted into the equation.

[hosertohoosier]

The assessment that the political cost of budget cuts was low misses the boat. The problem is that it compares the 1997 election results with the 1993 results. A far better basis of comparison would be to look at where the Liberals were before the 1995 budget.

In Q1 1995 54.1 % of Canadians were satisfied with the government, 64% expressed satisfaction with Chretien, while 48% indicated that they would vote Liberal according to an Environics poll. Of decided voters, Liberal support stood at an astounding 55%. This was a phenomenally popular government by Canadian standards.

In the 1997 election the Liberals only won 38.5% of the vote, barely clinging to a majority. I would say that a loss of about 16% is pretty darn significant.

Moreover, a key feature of the Canadian system helped diffuse anger towards the federal government. A lot of the deficit reduction mileage came out of cuts to provincial transfers. Since the delivery of education and healthcare are provincial responsibilities, however, it was the Premiers that faced the ire of those opposed to cuts, not the federal government. To this day many of the same people that tout Chretien as a great Prime Minister or Paul Martin as a great finance minister seethe at the mention of say, Mike Harris.

My broad point is that the Liberal austerity program did have serious political costs. Only a deeply divided opposition, Canadian federalism, and unique international circumstances (eg. the fact that nobody else was cutting their interest rates like we were, enabling devaluation) made budget cuts politically feasible.

[Stephen Gordon]

Meaningful how? The point was about the timing of the budget at the point where employment - and in particular, private-sector employment - had reached its pre-recession peak. I wanted a graph to demonstrate the point. That's what I made.

If I wanted to make another point, I'd draw another graph.

[Patrick]

Stephen - FWIW, I was agreeing with you. I took Jim's comment as being directed at Henderson, though on second reading it's not clear.

[Just visiting from Macleans]

Meaningful how? The point was about the timing of the budget at the point where employment - and in particular, private-sector employment - had reached its pre-recession peak. I wanted a graph to demonstrate the point. That's what I made.

The graph I suggested could also be used to demonstrate your point, as well as providing better context, without risking misinterpretation. You have the data. Try plotting as I suggest and then overlay commodity prices/index. It may further support your argument that Canada's experience cannot be exported to the US.

[Qc]

What happens to private debt during the surplus years in Canada? It skyroketed.

Remember the national saving identity:
Current Account ≡ (T-G) + (S-I)
If the US Government becomes a net saver, and maintains its current account deficit, it necessarily means that the private economy (households, businesses) will have to dive deeper into debt. The same result holds true right now for Canada since Canada is currently in a current account deficit.

Any analysis of the fiscal situation in the US or Canada that fails to look at the national saving identity is a total farce. Perhaps we should send Mr Henderson the above equation as a friendly reminder.

[Jim Rootham]

@Patrick

Sorry for being unclear. I was referring to the original post. Stephen and I have a long running disagreement on the nature of the world.

[Jon]

I'm not sure I get this. Short-term austerity is easy to reach in the US. In 2007 the Fed Govt was looking at a deficit of around 1% of GDP.

What's blowing a hole in the Federal budget these days is the continued injection of funds into the GSEs and temporary measures such as the extension of UI benefits.

[Kosta]

Interesting article by Henderson, and as you point Stephen, it would seem that a major lessons from the Canadian austerity experience is that timing is everything.

While Henderson claims that Canada managed its austerity with no ill effects, he does mention that the unemployment rate was 9.7% right the before the 1997 election -- that is two years into the austerity budget with the deficit shrunk to 1% of GDP. To me, that seems to be quite a high cost to pay for austerity; if the opposition wasn't so fragmented could Chretien and Martin have pulled it off? The other major lesson from Canada is that is helps to have absolute control of both the executive and legislative branches against a divided opposition.

Of course Henderson after mentioning the 9.7% unemployment rate ignores it as he writes that "[t]The second big lesson is that the Keynesian argument that big cuts in government spending will slow an economy receives no support from Canada’s experience." I believe Henderson is wrong here as it seems that the unemployment situation in Canada suffered after the austerity budget -- this is somewhat apparent in Stephens employment chart with the growth rate in private employment slowing from 1995-1997 while public employment dropped.

[Charles Campbell]

You would think there would be more interest in the contemporaneous U.S experience, where a deficit of 4.6% of GDP in 1992 swung to a 2.4% surplus in 2000, but of course that involved the Bush I and Clinton-era tax increases, thus anathema in some circles.

[Jim Rootham]

The paper is from George Mason University. That's a credibility red flag right there. It is a libertarian hotbed.

[finance]

Sorry Stephen but this is a terrible terrible White Paper. It looks at a very narrow aspect of the problem, nowhere does it mention how the Federal government simply cut its participation in joint Federal/provincial programs -- in effect telling the province that the real cut in services was their problem.

Moreover, the Canadian economy is much more open than the US, especially in the mid 90s, so that Canada was able to export itself out of the problem (Beggar thy neighbor policy). I don't want to denigrate the work that Mulroney/Martin did, there is no doubt that their action were necessary.

I suggest that Mr. Henderson have a pre-determined objective and used the necessary facts to prove his point, on the very edge of intellectual dishonesty, but then again GMU is a strange place (he seemed to think that health care was a "pan-Canadian" service, when in reality it is a provincial matter).

In fact, the Americans have little choices in what they will eventually be forced to do: Reduce entitlements, defense expensitures and raise taxes. Because, unlike Canada, America is not only heading towards a bankrupt federal system, its states and cities already are bankrupt, and interest rate are already at the zero boundary level.

You have to be honest that had you received this paper (I hope from an undergrad) you would have indicated that a little context would have helped the "honesty" of the argument.

Moreover, the BoC was able (as you mentioned) to lower interest rate by 500 bps.

[tomslee]

The "do like Canada in the '90s" line is also receiving a lot of play in the UK right now, as the government there prepares to introduce large spending cuts.

[Appalled but not confused]

re: that big dip in public sector employment: did the authors look at / take into account the govt's total HR spending, or just its actual FT employees? Because a big shell game started then, with people being 'retired' from the civil service and then hired back under a different budget line on a contract basis. And just the other day, there was news of the continued use of an awful lot of actual Temp employees from outside agencies. Is all that reflected here -- did the gov't actually shrink?

http://ottawa.ctv.ca/servlet/an/local/CTVNews/20101005/OTT_Temp_workers_101005/20101005/?hub=OttawaHome

[Stephen Gordon]

Those are LFS employment numbers, and I suppose it's possible that some of this is simply workers being reclassified from the public to the private sector.

But the decline in the size of the government as a share of GDP did happen.

[Barry]

"Moreover, the Canadian economy is much more open than the US, especially in the mid 90s, so that Canada was able to export itself out of the problem (Beggar thy neighbor policy). I don't want to denigrate the work that Mulroney/Martin did, there is no doubt that their action were necessary. "

Yes - Canada was dealing with the US, which itself was coming out of a prolonged slump. When your major (and much larger) trading partner takes off, coat-tailing is easy.

[Kosta]

Stephen,

Paul Krugman just cross-posted your second figure on his blog. I guess you've gone global ;)

[Peter Principle]

I guess the fact that Canada devalued by 10% and slashed interest rates at exactly the same time that its largest trading partner (by a long, long shot) embarked on the biggest consumption boom in history doesn't count for much in Henderson's universe.

I mean, why let the facts get in a way of a good ideology?

[JW Laliberté]

We might also argue that the austerity measures of the federal government were short-run solutions that gave birth to long term problems. For instance, by cutting in transfers to provinces, some provinces (I'll take Quebec as an example since that's the case I know better) inherited budget problems. In Quebec, those difficulties were "solved" by cutting in essential services (early retirement of nurses for instance) which in turn fueled the actual health care system crisis.

Those who take "Canada in the 90's" as a model scenario generally fail to look at the other side of the story : the consequences on the provincial government (Of course, in addition to all the elements brought up by M. Gordon).

[Alex Plante]

I remember the mid-90s very well - at the time I was young civil engineer just out of school. In 1994 the economy finally seemed to climb out of the long 1990-93 recession, then in 95 the Liberals cut spending and the bank of Canada raised interest rates and by 1995-96 we were back in recession. The only thing that finally pulled us out was the cheap dollar and the export boom to the US.

I especially remember how angry and frustrated people were. there were 2 major riots in Montreal and 1 in Quebec City.

If the US follows the same pattern of destroying people's hope for a recovery after a long and grinding recession, then you should expect riots in Major US cities by about 2013.