Serious Budget, Debt Ceiling and Fiscal Reform?... It Takes A Crisis

As the federal budget and debt ceiling Kabuki dance continues in Washington, the headlines on the negotiation this morning were ominous:

  • “Moody’s Puts US On Review For Downgrade”
  •  “S&P Warns Lawmakers on Debt Limit Downgrade”.
  • Harry Reid..”Kick Cantor Out”
  • POTUS…”Enough is enough” and “walks out of White House meeting”
  • Ron Paul…”America’s AAA Rating Not Worth Saving” Because? “We Are Insolvent”

And the news on the economy in the past week wasn’t much better:

  • Initial claims remain weak at 405k
  • Tops 400k for 14th straight week
  • Retail sales fall for first time in a year
  • Bernankspeak…QE3?..yesterday..”Maybe”…today…”Maybe Not”
  • Unemployment rate ticks up to 9.2%…only 18,000 NFP jobs in June

Where and how does this deficit ceiling debate and budget game of chicken end and what’s it going to take to get the economy back on the rails? Increasingly it seems only with a crisis of confidence on the part of US Treasury investors both domestic and foreign….and, in the short haul, that may not be such a bad thing if that’s what it finally takes to get the attention of legislators and the White House to do the right thing.

And the right thing is? Well that’s easy to answer…follow Canada’s fiscally responsible policy lead where they dug themselves out of their mid 1990’s debt crisis via serious spending cuts and take the advice I laid out for US policy makers in an article I posted on BI back in February to follow their example. Canada, facing debt downgrades, a currency crisis and possible IMF intervention threats took the bitter spending cut medicine and survived the crisis. Can we? Yes. But, like them, it may take a crisis level catalyst to get there.

To recap Canada’s early 90’s critical fiscal situation and proactive policy response briefly:

  • In 1994 gross government debt hit 101% of GDP
  • The government’s budget deficit hit 9% of GDP
  • Net debt was over 70% of GDP
  • There were concerns about failures of Provincial debt auctions
  • In 1994 Moody’s downgraded Canada’s Aaa foreign debt rating
  • The Canadian Dollar was renamed the Canadian Peso
  • Government spending as % of GDP had expanded from 15 to 23%
  • Unemployment was rising
  • The public sector workforce was bloated
  • Entitlement/non discretionary spending was eating up an increased amount of declining tax revenues

The policy response was swift and decisive. When the fiscal tsunami finally hit in 1995 the policy makers were forced into action. Ironically the Liberal led government whose tax and spend policies had helped contribute to the crisis, passed an historic austerity budget. (They don’t deserve all of the blame for causing the crisis…their Conservative predecessors were just as culpable)  In it Federal spending was cut by almost 10% over the next two years and federal employment roles were slashed by 14%. The government also committed to reform two formerly untouchable entitlement programs…welfare and the Canada Pension Plan (CPP). Over the next three years, working with the provincial governments, the CPP was reformed to include the investment of surplus contributions into equities and bonds, cut overly generous benefits and increased the contribution rate….all of the moves contributing to the future solvency of the fund.

In relative terms, the economic results were just as swift…and beneficial. By 1998 the federal government was in surplus and had reduced nearly $650bil of debt. The provincial governments had similar positive debt reduction experiences. Despite the naysayers suggesting that austerity budgets would lead to slower growth and lower employment… the exact opposite happened as the Canadian economy has thrived….which has helped to grease the skids toward meaningful tax reform. In 2001 the federal corporate income tax rate was cut and is now 18%, down from 28%….and the plan is to cut it more. From a competitive standpoint compare this to the US federal rate of 35%. Capital gains taxes have also been reduced twice to 14.5% and the national sales tax was also cut from 7 to 5%.

Much of the Canadian fiscal crisis experience described above is similar to what the US is experiencing now. Some will argue that Canada had some external/global positive economic factors working in their favour that helped to expedite their quick recovery. For example:

  • The global economy was in better shape than today, aiding Canada’s commodity based economy
  • The weaker Canadian “peso” helped them export competitively
  • The US economy…Their largest trading partner…via NAFTA…was booming

The key point for the reader to remember here is that Canadian policy makers were only forced into action after the crisis took hold…and when it hit…disregarding their myopic political ideologies…they did the right thing…their austerity led spending cut budget strategy was swift and decisive…and the positive economic performance since tells the rest of the story.

At this point… the US is about to hit the fiscal crisis wall I am reminded of the phrase “It Takes a Village”. Historically…Canada takes its name from the Iroquois word “Kanata” which translated means “village”…and so…from a US fiscal crisis response point of view and to paraphrase… in this crisis, it does “Take a (Canadian) Village” and I recommend (again) that US policy makers, in their efforts to get meaningful and lasting fiscal and budget reform, do indeed follow the Canadian example and “Take it”…to the limit!

Business Insider Emails & Alerts

Site highlights each day to your inbox.

Follow Business Insider Australia on Facebook, Twitter, LinkedIn, and Instagram.