January 1, 2012

Sleeping with the Elephant

Canada worries about the United States and offers a lesson in how to cut deficits and restore an economy.

Bordering on the world's economic colossus, the people who run Canada's modest-sized and moderately paced economy must always worry about every fluctuation in the U.S. economy, even when Canada's home-grown fortunes are faring relatively well.

“Living next to you is in some ways like sleeping with an elephant,” quipped Canadian Prime Minister Pierre Elliott Trudeau in a 1969 speech to the National Press Club in Washington. “No matter how friendly and even-tempered the beast, one is affected by every twitch and grunt.”

Canada's economy, with its population of about 34.5 million, remains primarily dependent on the U.S. market, with its 300 million residents. Almost three-quarters of 2010 Canadian exports went to the United States, and roughly one-third of the Canadian economy now consists of bilateral trade with the United States. The integration of the continent's market has intensified since the U.S.-Canada Free Trade Agreement in 1988—and then the North American Free Trade Agreement, which added Mexico to the free-trade zone in 1994.

Canada thus must fret over every potential skip of the U.S. economy's heartbeat. With the U.S. economy's vital signs still worrisomely weak, Canadians are understandably concerned about the possible spillover effect of reduced U.S. purchases of Canadian exports.

“Every single day, $1.6 billion crosses the [Canadian-American] border, and we're not immune from the problems around us,” says Satinder Chera, Ontario vice president of the Canadian Federation of Independent Business.

An International Monetary Fund (IMF) report released Oct. 31 found that Canada's GDP seems likely to grow, albeit slowly, in 2012—although it noted that Canada could be vulnerable to “a very unsettled external environment that tends to weigh on demand for Canadian products.” The IMF noted that Canada's economy suffered far less than other G-7 countries during the 2008-2009 downturn, a remarkably strong performance, given Canada's reliance on exports to the slumping United States.

Canadians in fact are doing the only logical thing in the face of its dependency. It continues to work on breaking its addiction. In 2000, 87% of Canadian exports went to the United States, but that figure fell to 73% in 2010.




The downward trend suggests that Canada's effort to diversify its international trade relations, seeking additional overseas markets, is gradually succeeding. That diversification has been a priority in Ottawa for almost half a century, since a series of Canadian governments in the 1960s grew wary of Canada's degree of strategic overdependence on the U.S. market.

“It's no different than if you're a business. You don't want to be reliant on any one customer,” Chera says, noting that customers' needs can change unpredictably. Canada and the United States “are the best of friends, but we want to open up new markets for our businesses.”

One result: The country's exports to emerging markets have grown in the last decade from 4% to 11% of its total export volume. Canada's current prime minister, Stephen Harper, has made continued trade diversification a high priority, sometimes taking planeloads of Canadian CEOs and policymakers with him on overseas trade missions.

Harper's high-visibility trade efforts included a week-long odyssey last August to four Latin American nations: Costa Rica and Colombia (which already have free-trade agreements with Canada), Honduras (where free-trade negotiations are underway) and Brazil. Those are increasingly lucrative markets for Canadian goods: Exports of Canadian merchandise to Brazil—a fast-growing nation of 230 million people—totaled CAD$2.6 billion (roughly $2.5 billion) in 2010, a 60% increase over 2009.

Since 2006, Canada has signed free-trade agreements with eight nations, and the Harper government will soon enter a crucial phase of negotiations for a trade deal with the European Union. Free-trade talks are underway with 50 additional countries. “Canada should build up trade links with nations with relatively young populations to take advantage of demographically driven improvements . . . as well as strong economic growth in those nations,” said the Institute for Research on Public Policy (IRPP) in its December 2010 report titled “Canada's Strategic Trade Policy Options.” Expanding Canadian trade with fast-growing nations that have young populations, like India, would add much more to Canadian economic growth than would continued reliance on the aging populations of the United States and the European Union, according to the IRPP analysis.

“[Canada is] extremely well-positioned for the long run,” former U.S. Treasury Secretary Robert Rubin said at a conference last November. “For a long time one of Canada's great strengths was it shared a border with the United States. Given the problems we're having and the effects it has on our demand for your exports, . what had been a great advantage for Canada arguably is now one of the issues.” He was speaking at the Washington, D.C., conference “The Finance Crisis: Lessons Learned from Canada and the Way Forward” co-sponsored by the Embassy of Canada, the Atlantic Council, Thomson Reuters and the Rotman School of Management at the University of Toronto.

Another significant issue for both countries: Canada and the United States are now bracing for more volatility due to the continuing aftershocks of the global financial crisis. The world's wealthy nations seem likely to absorb a severe blow in 2012 from the prolonged European sovereign-debt debacle: The World Bank and the IMF in November forecast a potential contraction in the world's developed economies in 2012—with IMF leader Christine Lagarde ominously warning on Nov. 9 of “the risk of a downward spiral of uncertainty, financial instability and the potential collapse of global demand.”

And Europe may not be the only problem. “I don't think we fully realize what happened [with globalization],” Canada's former Finance Minister Paul Martin said at the same conference where Rubin spoke. “We're in a globally integrated economy. The biggest threat to the Canadian auto industry was the tsunami in Japan earlier this year [which hurt Japanese automakers]. The biggest threat to the Canadian technology industries was this year's floods in Thailand. . What's going on in Asia will determine what will happen in our economy 20 years from now.”




Shrinking demand would surely reduce Canadian exports of manufactured goods, to some degree, to developed and developing markets alike. Yet Canada has not just been increasing the number of its export markets in recent years. The country has also been diversifying the range of its exports.

Manufacturing has long been the centerpiece of Canadian exports to the United States. But the contraction of the automobile industry and other heavy manufacturers—most of whom are based in Canada's central regions of Ontario and southern Quebec—means that the manufacturing sector's relative importance has declined. “It's similar to the situation in the Rust Belt of the U.S.—places like Ohio, Pennsylvania and Michigan,” Chera says.

An increasing proportion of Canada's exports now involve an even more lucrative, and more strategically important, part of its export base: oil and natural gas. “The Oil Patch is certainly having an impact” in broadening Canada's export mix, Chera says. The flow of oil from the tar-sands region of the Alberta Province now makes Canada the leading source of energy imports to the United States. Indeed, Canada now has the world's second-largest proven oil reserves—boasting a stockpile of more than 175 billion barrels, behind only Saudi Arabia.

More than 90% of Canada's oil and natural gas production now flow to the United States, which surely sees oil imports from its stable Canadian ally as more strategically secure than imports from the volatile Middle East. Having pumped 2.8 million barrels of oil per day in 2010, Canada's oil production is projected to rise to 4.7 million barrels per day by 2025.

The recent controversy over the expansion of an existing pipeline, aiming to ship more Canadian oil to the United States, has been a concern in U.S.-Canadian relations in the short term, Chera says. Yet long-term U.S. reliance on Canadian oil and natural gas exports seems destined to increase: “The reality is that the U.S. obviously needs oil, and we're a pretty secure channel for that oil.” But that also means that despite its diversification drive, the strength of the Canadian economy will continue to rely heavily on the vibrancy of the U.S. economy.




Canada may succeed with its global trade-diversification efforts, but the fragility of U.S. finances remains an understandably worrisome issue to many Canadians.

Among the policy twitches that Canadian observers fear most is the continuing U.S. failure to reduce its federal budget deficits and its overall public-sector debt. There is significant impatience and frustration with the American gridlock on this issue in large part because Canada not too long ago dramatically cut its own similarly vast federal budget deficits. Their deficit-reduction success, Canadian officials say, offers an example of the range of choices that American policymakers can make in trying to bring U.S. public finances under control.

“The vast majority of all Canadians wish America well—and we need you to be strong and vibrant again,” professor Thomas J. Courchene, a professor of economics and financial policy at Queen's University in Kingston, Ontario, told a Washington, D.C., think-tank audience on Oct. 27. A high-profile Canadian public-policy analyst, Courchene was the keynote speaker at a symposium—organized by the Tax Policy Center (a joint Brookings Institution-Urban Institute research organization) and the Montreal-based IRPP—on “Fixing U.S. Budget Policy: What Can The United States Learn From Canada?”

Panelists across the ideological spectrum—including the libertarian Cato Institute and the Urban Institute—agreed that Washington has a great deal to learn from Canada's budget-balancing example. “The United States today doesn't have the luxury of doing nothing, just as Canada didn't in the 1990s,” Chera asserts. “You folks [in the United States] are in a bigger pickle than we were in the 1990s. The United States would be wise to take the Canadian example to heart.”

Canada in the mid-1990s was enduring a budget situation that was arguably more chronically chaotic than that of the United States today. After 27 consecutive years of worsening deficits, Canada's federal debt-to-GDP ratio had climbed from about 20% in the 1970s to almost 70% in 1995—a ratio then surpassed, among the wealthy Western G-7 nations, only by Italy.

Confronting a federal budget deficit of more than CAD$40 billion (considered an enormous sum in that era), then-Finance Minister Paul Martin—despite the misgivings of then-Prime Minister Jean Chretien—resolved to set Canada's finances right with his 1995 budget. “If we hadn't done that, we would be Greece today,” Martin said, using Greece as a metaphor for bankruptcy.

Remarkably, it was Chretien and Martin's Liberal Party—Canada's left-of-center party—that set rigid deficit-reduction targets and made them stick.

Balancing the budget required a combination of painful spending cuts to virtually every Canadian public function—along with significant tax increases that hit every Canadian, rich or poor. It included a 10% across-the-board cut in federal program spending; a 25% shrinkage of the federal work force; an almost one-third reduction of federal payments to the provincial governments (which trickled down to become severe local cuts in human services); and the privatization of once-public functions like the air-traffic control system.

Spending cuts were only one side of the ledger, however. The federal government also raised revenue by imposing a federal goods and services tax on top of existing provincial taxes. The federal levy taxed consumption, but did not tax savings.

In a significant trade-off, the higher tax on consumption was accompanied by the removal of a counterproductive tax on industry: a now-vanished, and unlamented, 13.5% manufacturers sales tax, which had been a drag on industry and investment, and thus a drag on employment.

The austerity measures were far-reaching—and, perhaps, in hindsight, overreaching in some cases. The drastic measures included a federal raid on the surplus in Canada's unemployment-insurance fund—with Courchene bluntly asserting that the finance ministry “stole, or illegally used” about CAD$6 billion in excess unemployment insurance premiums over about six years. In effect, he said, the federal government in Ottawa “got rid of the deficit on the back of the provinces and the UI fund.” Panelist Paul Posner, a professor of public administration at George Mason University, regretted that Canada had been driven to use “stealth” and “non-transparent behavior,” but noted that “our Congress would never permit” such budgetary sleight of hand.

Canada's economic shock therapy was traumatic. The result was stunning: Martin's austerity agenda quickly jolted the economy out of its doldrums.

Within nine years, Canada's debt-to-GDP ratio had fallen from nearly 70% to less than 40%, and the federal budget was running a surplus—with annual surpluses destined to continue for a decade, until the global financial crisis and recession struck in 2008. Those federal surpluses were largely used for further deficit reduction (although some new programs, like a generous child tax benefit, were created). The virtuous cycle of using new revenue to pay down debt cut the cost of servicing the public debt in half, from 6.1% of GDP to only 2.9%.

Thanks to the Martin spending-cuts-plus-revenue-increases package of 1995, Canada's economic turnaround was so dramatic that BusinessWeek dubbed it “The Maple Leaf Miracle,” and The Economist called Canada “the fiscal virtuoso of the G-7.”

Remarkably, the economic rescue agenda, tough as it was, proved politically popular. The Liberal Party went on to win the next two national elections. Martin himself went on to become, if only briefly, prime minister.




There are limits, of course, to the comparison between Ottawa in 1995 and Washington in 2012. Some important factors that helped Martin achieve Canada's economic turnaround are not present in Washington today. One is the differing structures of government. In a parliamentary system, a finance minister supported by a large majority in the House of Commons has almost unchallenged power to set federal spending priorities. “There's no equivalent anywhere in the United States that relates to that,” Courchene said. Canadian-born panelist Chris Edwards, a scholar at the Cato Institute, asserted that a prime minister with a large parliamentary majority can have near-dictatorial power.

Moreover, in Canada, senators are appointed rather than elected. Lawmakers only leave the Senate when they reach the mandatory retirement age at 75. Because the voters have no check on senators' decisions, they are arguably a more dispassionate, solution-oriented group.

Another contrast involves elections and campaign funding. With ultra-low-cost campaigns for the House of Commons, and thus with no need to raise money from special interests, lawmakers have the flexibility to defy entrenched interest groups and shun lobbyists' arguments. In the United States, by comparison, Courchene finds that the soaring cost of campaigns, and the influence of lobbyists who provide campaign funds, gives Americans “the best government money can buy.”

Yet another contrast between Canada in 1995 and the United States in 2012 involves the factor of economic urgency. Politically, it was easier—and more urgent—to argue for an austerity budget in Ottawa in 1995 because Canada, at that point, faced an immediate financing crisis: The international capital markets had lost faith in Canada's currency and bonds. The Canadian dollar had fallen from an exchange rate of 89 cents per U.S. dollar in 1991 to 73 cents—and, just before the 1995 budget was drawn up, ratings agencies put Canada on a “credit watch,” which, at that time (when ratings agencies' accuracy seemed unquestionable), was a fearsome warning.

Those dramatic Canadian conditions of 1995 are different from the U.S. situation today, noted panelist Edward Alden of the Council on Foreign Relations. The global financial crisis has now led nervous international investors to flee the euro and buy U.S. dollars and treasury bonds. The very absence of an economic emergency today, the think-tank panelists suggested, may have lulled the American public into a false sense of security.

Perhaps the most significant contrast of all, Courchene said at the symposium, was that Martin “had the wind at his back.” Martin was finance minister at the time when an economic boom across North America was just getting started. In the mid-1990s, productivity gains were leading to brisk job growth, and buoyant spending fed sustained federal revenue increases. By contrast, since the economic crash of 2008, the economy's stagnation has depressed confidence, job growth, consumer spending and federal revenue.

Courchene also points out that Americans' discipline for raising revenue simply isn't keeping up with their appetite for spending. The United States has recently been amassing deficits equivalent to 10.1% of GDP—but if the country had been bringing in German levels of revenue, Washington would have a 1.9% budget surplus (and, with Eurozone levels of revenue, Washington would have a 3.5% budget surplus). “The problem Americans have is they're really trying to run European [levels of] spending on American [levels of] tax rates. Eventually, one of those has got to give,” Courchene said at the symposium. “The answer is probably in the middle somewhere.”




In the short run, the answer for Americans is a tax hike, Courchene says. Americans need tax revenue, and the most effective way to raise revenue, while remaining internationally competitive, is by adopting what Canada first embraced in the 1980s and then expanded in 1995: a value-added tax, designed in a way that is “export-import-neutral,” to tax consumption. The revenue collected through a value-added tax (VAT) would then be used “to drive down your corporate tax rates and individual income taxes.”

Yes, VAT is “a tough sell, politically,” Courchene says. Grover Norquist, president of Americans for Tax Reform, is famously quoted as saying, “'VAT' is French for 'big government'”—but Courchene said that, in his view, “'VAT' is American for 'growth and competitiveness.'”

A tax-policy trade-off can be constructive, if it is done right, said the Cato Institute's Edwards. He noted that, as part of Canada's 1989 budget package, the increase in the federal goods and services tax on consumption was accompanied by the elimination of the onerous manufacturers sales tax, which had hobbled manufacturing industries. Thus the trade-off made it “sort of a conservative move” that encouraged investment and employment.

For the governments of both the United States and Canada, “there really is no easy way out,” Chera says. “It's going to take tough choices, and everyone is going to have to take a share of the pain.”

Martin echoed that thought at “The Finance Crisis” conference: “I cannot believe that whatever administration takes [office in Washington after the 2012 elections] is not going to see that there's reason to act [to get the U.S. budget in order],” Martin said at a symposium. “And that will have to include taxes.”

Of course, the public will want a fair combination. “There's going to have to be give-and-take there,” Chera says. “We can't do everything overnight. But people are smart enough to realize that when we're in bad shape, we have to take action.” Perhaps part of that action will be taking a very close look at Canada's successful deficit-reduction history for ideas that can help strengthen North American prosperity.