Veterans of the “northern peso” fight appear to be worried their efforts have been forgotten.
The Great Recession and now the COVID-19 pandemic consume the headspace of the current generation of policy-makers. But before those life-altering events, Canada suffered the costly humiliation of falling out of favour with international investors in the 1990s. Back then, currency traders referred to the Canadian dollar as the northern peso, an uncharitable comparison to Mexico, and the Wall Street Journal in an editorial sarcastically called Canada an honorary member of the Third World.
In early 1995, creditors demanded yields of around nine per cent to lend the federal government money for 10 years, pushing interest payments to more than 30 per cent of revenue. With a debt approaching 70 per cent of gross domestic product, Canada looked like a risky bet and investors demanded extra compensation for the possibility that the federal government would default.
Most of us still remember what it took to get the situation under control. “Great sacrifice was required to make the fiscal situation sustainable,” Don Drummond, an associate deputy minister at Finance when Jean Chrétien’s government finally reversed a couple of decades of overspending, said in a commentary published by the C.D. Howe Institute last month.
Drummond, who is now an adjunct professor at Queen’s University in Kingston, Ont., expressed concern that the federal government is once again drifting towards a similar fate. He called on Prime Minister Justin Trudeau to re-establish a “fiscal anchor” to keep debt from returning to levels that would test the confidence of international investors.
He’s not the only one.
Scott Clark and Peter DeVries, two former senior Finance officials, warned in an article published by Air Quotes Media on Aug. 28 that Finance Minister Chrystia Freeland’s credibility will be “completely undercut” without a “credible and publicly accepted fiscal anchor.” A committee of policy experts assembled by C.D. Howe and co-chaired by John Manley, who served as Chrétien’s industry minister when they erased the deficit, also pushed for a “clear fiscal anchor” this week.
But maybe the hardest to ignore is David Dodge, who led Drummond, Clark and DeVries as deputy minister and was later rewarded for his efforts during the budget fight with an appointment as governor of the Bank of Canada. Dodge, now a senior adviser at law firm Bennett Jones LLP, has come off the sidelines to urge Trudeau and Freeland to set a cap on spending.
“It cannot be overstated that control of debt service costs is essential to maintaining social and economic programs and keeping the tax burden on the middle class at reasonable levels,” Dodge said in a 30-page research paper released this week by the Ottawa-based Public Policy Forum.
Trudeau’s fiscal credibility was tied to memories of what his party did when it was last in power. In 2015, he said his plan to run deficits would end before the next election. Once in government, his spending commitment evolved into a promise to keep the debt-to-GDP ratio on a downward track, a wobbly anchor since governments have little influence over the denominator in that equation.
The Liberals added a fiscal commitment in the 2019 campaign, saying they would ensure that Canada retained a top rating from all the main bond rating agencies. But they didn’t talk about that pledge much after election day, and they surely would like to forget about it now that Fitch Ratings has downgraded Canada’s status to AA+ from AAA.
The message for Trudeau from the Fitch downgrade and the universal anxiety of Finance veterans is clear: his credibility as a fiscal manager is shot. If he wants to restore it, he’ll have to start over with a spending restraint that is easy for people to understand.
New Opposition leader Erin O’Toole senses an opportunity. He said earlier this month that he would balance the budget in a decade, restoring the anchor from the Chrétien-Paul Martin years that O’Toole’s former boss, Stephen Harper, was happy to deploy when he led the Conservatives to power in 2006.
Central bankers for now appear to have run the bond vigilantes that Dodge and others worried about in the 1980s and 1990s out of town.
A balanced budget would restore fiscal credibility in Ottawa, but it might be unnecessarily rigid as a target. The rules of finance have changed since the 1990s. Central banks didn’t know then that they could create hundreds of billions of dollars to buy bonds without stoking runaway inflation. There are probably limits, but central bankers for now appear to have run the bond vigilantes that Dodge and others worried about in the 1980s and 1990s out of town.
That means Trudeau and Freeland have some flexibility. Debt can be gradually eroded by economic growth as long as output increases faster than the government’s borrowing costs. That’s why Trudeau isn’t necessarily lying when he claims he won’t need to raise taxes to get rid of the deficit.
But the new rules of public finance aren’t so established that a government should assume it can borrow cheaply forever. The world is awash in debt, which could re-empower the bond vigilantes. The central banks are trying to stoke inflation; interest rates will rise if they are ever successful. A prudent government would hedge by making it harder for itself to take on more and more debt.
Clark and DeVries suggested keeping the deficit around two or three per cent of GDP, while the C.D. Howe committee leaned towards a spending ceiling. Dodge proposed tapering deficits to one per cent of GDP over the next few years and then lash fiscal policy to a “rock” that would keep debt-service costs below 10 per cent of GDP.
Experts will debate which of those would work best. Any of them would be an improvement.
Copyright Postmedia Network Inc., 2020