How we really beat the deficit: or, revisionism revisited

Andrew Coyne on why spending cuts played a bigger role than economic growth

Once again my colleague John Geddes has written a sensible, sober reminder that not all is as we imagine it to be, that things are not as simple as they appear. And once again it falls to me to point out that, actually, they are.

Last time out, John convincingly demonstrated that cutting spending is not as easy as certain ideologues would have you believe. Except, as I later showed, it is in fact quite easy.

This time, John’s point is not that spending can’t be cut, but that it wasn’t cut. Or not as much as people say. Contrary to the received wisdom, much repeated these days by our admirers in other countries, that Canada balanced its books in the late 1990s through deep spending cuts, John argues that in fact economic growth did most of the job. To be sure, “spending was restrained,” but “by far the main reason the red ink evaporated… is that the Canadian economy grew smartly year after year during that period, and tax revenues more than kept pace.”

“The real history of the Canadian fiscal reversal,” he summarizes, “is that firm but hardly harsh spending restraint proved sufficient because the economy cooperated by expanding steadily and rendering up taxes.”

Okay. But this formula — moderate restraint, coupled with steady growth and rising revenues — why wasn’t it tried before? Why did we wait until the mid-1990s to apply it, after twenty years of deficits? Answer: it was tried. That was exactly the approach used by the Mulroney government — the one that left office with the deficit still at $39-billion, or 5.3% of GDP.

If “firm but hardly harsh” restraint plus a strong economy were the ticket, it should certainly have been sufficient in Mulroney’s case. Indeed, the economy grew faster in the first five years of Mulroney’s government than it did in the same period under Jean Chretien. From 1985 through 1989, real growth averaged 3.8% per year; from 1994 through 1998, it was 3.6%.

Morever, revenues grew even faster than the economy under Mulroney: from 16.2% of GDP in 1985 to 17.6% by 1990. In Mulroney’s first five years, revenues grew by one-third after inflation. In Chretien’s first five years, real revenues grew by only one-quarter.

And yet by year five the Chretien government was running surpluses. In fact, they were doing so by year four. By contrast, after five years the Mulroney government had only reduced the deficit to 4.5% of GDP, the lowest it would get, before the 1990-91 recession drove it higher again.

Well, we know why that was, right? The Mulroney government spent like sailors. Or certainly didn’t cut spending. Actually, they did: from 19% of GDP when it took office to 15.9% of GDP in year five — the lowest it had been since 1970. Real per capita spending — my preferred measure — was held more or less level throughout the period. By the standards of the day — by the standards of just about any day — that counts as restraint: not harsh, perhaps, but firm.

And yet they failed. Why? Because the deficit, by then, was no longer about spending and revenues. It was about interest. Muroney actually ran small operating surpluses from his third year in office on. But these were drowned in a sea of debt service costs. After a decade of deficits, the debt had grown so large relative to the economy that whatever restraint was imposed could be instantly undone with every uptick in interest rates. And had the incoming Chretien government persisted in the same gradualist strategy — as it vowed it would, and as it did in its first budget — it would have met the same fate.

What made the difference, then? Why did Chretien succeed where Mulroney failed? Because, after the shock of the 1995 Mexican peso crisis, and the glimpse it provided of the truly ruinous debt spiral toward which we were headed, they abandoned gradualism. The only way to beat the remorseless arithmetic of compound interest, they realized, was to make deep, quick cuts in the deficit — so deep and so quick as to get the rate of growth in debt below the rate of growth in the economy, and turn the debt spiral in reverse. And the only way to do that was to make deep cuts in spending.

How deep? From $122-billion in the year they took office, and $123-billion after their first budget, spending was slashed over the next two years by $12-billion. Even as late as fiscal 2000, program spending remained below $120-billion. Adjusting for inflation and population growth, spending was cut by nearly 20%, and held there for another three years. That’s restraint. And that — not economic growth — was the key to their success.