David Cameron thinks that Canada can show us how to slash public debt. Is he right?

Author: By Stephen Foley

So it is that the Tories are obsessing about another North American political success story, that of the Canadian Liberal Party, which swept to power in 1993 and proceeded to implement the biggest reduction in government spending in the country’s history, eliminating a crippling C$42bn (£22bn) budget deficit in just four years. The international acclaim was raucous: The Wall Street Journal had proclaimed Canada “an honorary member of the Third World” in 1993, when its national debt was heading towards a peak of 72 per cent of the size of the economy; in 1998, Paul Martin, the finance minister, was heralded by Business Week magazine for having produced “a maple leaf miracle”. The centrist Liberal Party went on to further electoral success ? and Mr Martin inherited the prime minister’s office. No wonder the Conservatives are salivating.

The British Government’s financial position now is far worse than Canada in the Nineties. The national debt will exceed 100 per cent of GDP, as the country works through the legacy of bank bailouts and economic stimulus spending, and the collapse in tax revenues. The deficit ? that is, revenues minus spending ? will get well into double figures as a percentage of the economy, compared to Canada’s 5.8 per cent at its worst.

But, obviously, the reasons that we are in this position are also significantly different, which is why some experts are cautioning against making too much of the comparisons.

“Canada in the Nineties was in a very different situation to the US or the UK today, and its experience is not a black-and-white case that proves some ideological point, says Joydeep Mukherji, credit analyst at Standard & Poor’s. Canada had not balanced its budget since 1970 and it was demonstrably falling behind its giant neighbour to the south in terms of economic growth.

“There was no trigger, no great bankruptcy – the country did not fall apart. It did not happen overnight. There was a feeling across the board that the public had had enough of deficits and the government had to get its books in order,” Mr Mukherji says.

Most of the major parties, in fact, argued that Mr Martin was not going far enough. That despite his handing out 45,000 pink slips to civil servants, instigating cuts of 40-60 per cent in business and agricultural subsidies, and slashing the money federal government hands out to the provinces.

That last one is important. The Canadian system devolves responsibility for healthcare, education and most welfare spending to provincial governments. Mr Martin’s 1994 budget was the result of what he called a “fundamental review” of what government does, but in reality he was able to wash his hands of the difficult decisions on hospital closures and rising waiting times, for which local politicians were often punished.

Shadow Cabinet members have met ministers from that Canadian government in recent weeks, and heard how it was a fear of the financial markets that sped them into action. A financial crisis in Mexico had scared them into thinking that Canada might be next to be punished by the international investors who bought its debt. It risked being locked into a downward spiral, where investors demanded ever higher interest rates on the national debt, payments which only added to the budget deficit.

The same risks apply today. Even economists optimistic about the UK economy fear a mis-step that could cause the financial markets to turn against it. A Canadian-style review of government spending could be just the thing needed to generate an alternative, upward spiral.

Mr Mukherji says: “An attempt to tighten the belt, a few reforms to convince markets that you are serious, can lead the markets to respond by charging lower interest rates, and that gives a central bank more credibility to lower its own interest rates and stimulate the economy.”

The debate, then, is likely to settle into “short, sharp shock” versus “prudence and patience”. While Labour appears to have conceded that cuts to spending will be needed, no matter who is in power, it is possible to argue that major surgery would be unwise and unnecessary. Government austerity can come too early, pulling spending out of the economy just when it is needed to nurture the green shoots of recovery and keep people in jobs. That, after all, is why economists urged the UK ? and the US ? to take on these big budget deficits in the first place.

And the reduction of Canada’s deficit to zero by 1998 was not totally ? perhaps not even mainly ? due to the slashes made in spending. Between 1994 and 1998, expenditure was down C$14bn, but tax revenues were up C$32bn. The return to health of the economy was what put Mr Martin on course to balance his budget. There is plenty of room for believing that he would still have met his deadline without the short, sharp shock of his spending review.

Kevin Logan, senior economist at Dresdner Kleinwort, explains that there were several other positive winds at Canada’s back. First, the US, its largest trading partner, was growing very strongly, sucking in Canadian exports. Best of all, the Canadian dollar had depreciated very sharply. “The welfare of the average Canadian family went down a lot, but that devaluation caused strong growth in the export sector.”

The Tories say they have learnt much from the way the Canadian Liberals conducted their “root and branch” review of government, and the approach they took to hem in spending departments. What they cannot learn for sure is whether it was necessary.

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