Policy Lessons from Canada’s Deficit Slashing Days Are Limited

Country’s Experience Shows Austerity Measures Didn’t Generate Growth

SOURCE: AP/J.Scott Applewhite

Under Finance Minister Paul Martin, above, Canada's Liberal Party made large spending cuts in the 1990s in an effort to reduce Canada's deficit and bring down the debt.

By Jordan Eizenga | September 14, 2010

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Recent claims that 1990s Canadian fiscal policy should serve as a model for other countries trying to achieve stronger economic growth show a misunderstanding of what actually happened in Canada’s economy during that decade. The bottom line is that Canada’s budget cutting was appropriate under a unique set of circumstances, and in fact had little to do with the growth that ensued.

In 1993, following a prolonged economic recession, Canada’s Liberal Party took over a federal government that had incurred historically high debt and deficit levels. Government debt was over 60 percent of gross domestic product, and deficits were running at 8 percent of GDP, more than twice the OECD average. Under Finance Minister Paul Martin’s helm the Liberal Party made large spending cuts in an effort to reduce the deficit and bring down the debt. Martin’s 1995 budget slashed departmental spending by 20 percent to cut the deficit to 3 percent of GDP by 1998. By 2000, government debt levels had dropped, the deficit was eliminated, and economic growth had increased.

George Osborne, British chancellor of the exchequer, calls 1990s Canada a “striking example” of cuts leading back to prosperity and recently sought the advice of Mr. Martin. The British Government has even gone so far as to establish a Canadian-style “cuts committee” in which cabinet ministers must justify every dollar of expenditure to a panel of their colleagues.

One should be careful, however, not to straightforwardly apply Canada’s experiences in the 1990s to the current economic situation of other developed nations. The Canadian experience of the 1990s is very different from the present environment of other advanced economies.

Even after Canada cut spending, for example, its government still spent more as a share of GDP than the United States and the United Kingdom [1]. Further, closer examination shows that Canada’s economic growth was not actually due to spending cuts. Growth was instead bolstered by the bustling business activity of Canadian exporters, which occurred for several reasons.

First, from 1992 to 2000 the Canadian loonie depreciated by over 20 percent against the U.S. dollar from $0.87 (USD/CAD) at the beginning of 1992 to $0.68 (USD/CAD) [2]. This allowed for the spending cuts’ contractionary effects to be offset by export-led growth driven by a cheaper loonie. Second, the Liberal government’s spending cuts coincided with the creation of the North American Free Trade Agreement, which eliminated import tariffs on most goods traded between Canada, the United States, and Mexico.

This meant that deficit slashing coincided with the implementation of practically tariff-less trade between Canada and its largest trading partner (and the world’s largest economy). Exports during this time grew to account for 45 percent of Canada’s GDP, and between 1994 and 2001 exports to its NAFTA partners increased by 80 percent. Canadian exports to the rest of the world, by contrast, grew by only 12 percent over the same time period [3].

This is not to suggest that the Liberals do not deserve credit for their handling of the economy. It is simply to say that spending cuts were not the prime mover of Canada’s success and that countries looking for the keys to turning their economies around should not misinterpret Canada’s experience. In the 1990s many countries employed a broad range of fiscal policies and experienced economic growth as much of the global economy—driven by many factors—prospered. It’s mistaken to single out one country with one fiscal policy as the model for the current situation.

The larger point is that austerity measures during economically unstable periods do not produce economic growth. This point is important because developed countries such as the United States are currently plagued by large gaps in aggregate demand and are looking for ways to rejuvenate their economies. Private firms are unwilling to hire and invest the surpluses of cash they have on their balance sheets. Households are reluctant to consume and unemployment remains at historically high levels. During such times, public spending that temporarily compensates for the reduction in private spending is good policy that helps stabilize the economy.

Jordan Eizenga is a Policy Analyst with the Economic Policy team at American Progress.

Endnotes

[1]. Statistics from OECD Stats Extracts.

[2]. Ibid.

[3]. Ibid.