How Canada Saved Its Bacon: Deep cuts in government spending pulled Canada back from an epic fiscal crisis 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.
September 27, 2012

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.

Truer words were never spoken. Nor has it ever been more likely that they will fall on deaf ears, at least as long as Federal Reserve Chairman Ben Bernanke keeps financing the partying in our nation's capital.

As Canada's finance minister in the mid-1990s, Paul Martin (pictured in 2011) won budget reductions that pulled the country back from fiscal crisis.

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.

What drove the left-of-center Liberals to shoulder the burden of downsizing government in the 1994 and 1995 budgets—Mr. Martin takes great pains to point out—was not ideology but "arithmetic." That is to say that everyone recognized that the magnitude of the debt, and the cost of servicing it, was unsustainable.

The problem had been building over many years. In 1965, federal spending had been 15% of GDP. By 1993 it was 23%. Markets didn't like it. Between February and March of 1994, the three-month Canadian Treasury bill rate went to 5.82% from 3.85%. The Mexican peso crisis in December of that year didn't help. By February 1995 the interest rate on the Canadian Treasury bill reached 7.8%. In a world of increasing uncertainty and a flight to quality, Canada was paying dearly for its deteriorating risk profile. As the exchange rate sank, Canadians were getting poorer and the government was speeding toward a wall.

Another speaker at the American Enterprise Institute conference (which was co-sponsored by the Ottawa-based MacDonald-Laurier Institute) was Janice McKinnon, the finance minister for the center-left New Democratic Party government of the province of Saskatchewan in 1993. Ms. McKinnon told her own war stories.

In 1991, when her government took over, the "province was on its knees." In 1992, according to Ms. McKinnon, Standard & Poor's reported that Saskatchewan's "tax-supported debt was 180% of its annual revenue." "When our credit rating dropped to triple B rating, we had trouble borrowing money."

Ms. McKinnon described some of what followed: "In one budget we closed 52 hospitals, many schools and thousands of people lost their jobs. But we knew we had no choice, and we couldn't look back."

Ms. McKinnon likened the U.S. today to Saskatchewan in the 1980s. You are "not to the point where you are in a crisis, people aren't saying 'maybe we won't lend you money.' " And that means that the politicians can still put things off. "Before you actually realize 'we've got to do this because there is no choice,' there is a lot of denial," Ms. McKinnon explained. "I think you're at that stage."

She's right. Market discipline doesn't exist in Washington, which has the "privilege" of an accommodating central bank issuing the world's reserve currency. The big spenders don't need to pay attention to pesky numbers. As Stanford University economist John Taylor has noted, the Fed bought 77% of all new federal debt last year. It is doing so at rock-bottom interest rates. By holding the short-term fed-funds rate low while it buys up long-term securities, Mr. Bernanke is helping our political class ignore the real cost of rising federal indebtedness.

Of course these battle-scarred Canadians fully understand that the U.S. will reach a day of reckoning when the Fed has to constrain the money supply and interest rates start going up. "Our only plea," Ms. McKinnon said, "is that if you start tackling it before you hit the crisis stage, it's going to be a heck of lot easier. The longer you wait, the worse it gets."

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