Canada’s Own Financial Bubbles: Have-Not Provinces

Commentary, Equalization, David MacKinnon

Canadians have taken some justifiable pride that our banking system has performed better than most in the current crisis and that, as the Economist recently reported, we don’t have a housing bubble that is remotely as serious as in Europe or in the United States.

However we do have our own bubbles but we haven’t yet recognized them. They are called Manitoba, New Brunswick, Nova Scotia, Prince Edward Island, Newfoundland, and to a lesser extent, Quebec—the traditional have-not provinces.

The Atlantic provinces and Manitoba are dependent on federal subsidies to support themselves at anything like their present population and scale. Quebec is less dependent but would still be a very different place without the subsidies coming from other Canadians. Overall, the subsidies are as vital for stability in the short term as they are destructive of growth in the medium and long term.

In nautical terms, all the traditional recipients have public sector “ocean liners” pulled by the fiscal equivalent of tugboats.

That is certainly true of in Prince Edward Island (the home province of one of these authors) which, without massive flows of funds from other regions, could only support about 25,000 to 30,000 people rather than the 140,000 who live there.

For example, in 2008-09, PEI will receive $517 million in federal transfers (including cash and tax points), or about $3,711 per person. Dependency in the other three Atlantic provinces and Manitoba is nearly as bad with per person transfers ranging from $3,544 for New Brunswick to $2,759 in the case of Manitoba (and compared to a still significant $2,065 for each Quebecois).

In contrast, Ontario receives $981 per person. But Ontario is (as with BC and Alberta) a net contributor to confederation through federal transfer system, even as federal Finance Minister Jim Flaherty announced on Monday, Ontario itself will begin to receive equalization payments next year. That’s because equalization is only one part of the federal transfer system.

Expressed another way, without a federal equalization and transfer payment program, Ontario “keeps” its $981 per person and much more, while the traditional have-not provinces would suffer revenue hits akin to recently plunging equity values.

This is high risk stuff for all. We have entire populations that see their economies in very unrealistic ways, have a complete sense of entitlement to the subsidies and have little real understanding of the full extent of their dependence on B.C., Alberta, Ontario taxpayers. (Saskatchewan is more complicated. It is a “have” province for the purposes of equalization; it is a “have-not” when all federal transfers are calculated.)

To the extent that the current crisis weakens the capacity of the principal contributing jurisdictions to pay for all this, populations in the recipient jurisdictions are open to all the risks associated with a sudden disruption.

Some may argue our reference to provincial bubbles overdone. It is not.

Bubbles normally have at least four distinct characteristics.

First, the arrangements which lead to bubbles are not transparent and are complex to the point that they are incomprehensible to most people. Observers have agreed for decades that our system of regional subsidies qualifies on this score. So also does the sub-prime mess.

Second, bubbles are driven by expectations and entitlements that have no realistic basis in history or actual need. Again, there is little doubt that the recipient jurisdictions qualify on that score, to judge by their public sectors and expectations for generous government programming which greatly exceed general standards elsewhere in North America. The similarity to American and European housing expectations – the root cause of so much of the current financial turmoil – is remarkable.

Third, bubbles are unsustainable. Equalization payments to other regions in the past four years, largely from Ontario and Alberta taxpayers, have grown four times faster than Ontario’s growth. And equalization payments to Quebec have grown over that period by ten times the rate at which Ontario grows. Now, with Ontario joining the equalization recipients, such growth in payments will fall hard on BC and Alberta.

While Flaherty’s decision, also announced Monday, to limit growth in equalization payments to the growth in the economy helps in the short-term, it does nothing to address ridiculous imbalances of the sort where Ontario (to say nothing of Alberta or other provinces which are net payers) loses massive amounts of money through overall federal redistribution even though and at the very time Ontario’s economy takes a hit.

Fourth, the bursting of bubbles is not controlled by anyone and its actual timing is unpredictable. If we’ve learned nothing else in the past two months, we’ve learned that.

The federal role in all this is analogous to the role Wall Street bankers played in the current financial crisis. Ottawa has put in place a wide variety of subsidies for regions without ever examining, in a public way, the aggregate impact of them. It also took no steps to measure the largest of these – equalization – against its intended impact because it didn’t even bother to measure program comparability, the avowed goal. Finally, Ontario’s federal legislators took no serious steps to understand the problem, a governance failure that ranks with the failure of boards of directors and regulators in the United States to understand the full impact of securitization and the packaging of sub-prime loans.

Our regional subsidy system is not transparent, it is not sustainable and it is driven by excess. It is almost by any definition a bubble. The only real question is when and how the chickens come home to roost.