David Dodge Article
Right now, confidence in Canada is intact. But confidence, as I witnessed firsthand as deputy minister of finance in the 1990s, can evaporate pretty quickly. Suddenly, investors seek greater assurance to cover our debts. That puts downward pressure on the dollar – making both direct investment and consumer goods more expensive – and raises the risk premium on our interest payments, something we can ill-afford. When confidence waned in the mid-1990s, the rising risk premium added $4-billion in interest costs in a single year, squeezing out better spending.
Given that I have severe doubts about any risk premium estimates, I would question the false precision of the $4 billion figure. That said, that is what he and (probably every other member of the Canadian Establishment) believes that number.
The other angle is the collapse in the Canadian dollar. This was the other leg to the fiscal crisis. (The only useful piece of data I could get on the crisis when talking to one ex-Bank alumnus was that the Wall Street Journal called the Canadian dollar "the Canadian peso" -- which caused the Canadian Establishment to flip out.)
Their flipping out was no accident. Even though Canada had a mere four decades of experience with a floating currency, pretty much every country was fooling with pegged currencies relatively recently. Even after the United States threw in the towel on Bretton Woods, various hare-brained schemes to manage currency volatility were implemented (Plaza Accord, etc.). One of the most-followed indicators in the Bank of Canada until the late 1990s was The Monetary Conditions Index (MCI), which was a mixture of the policy rate plus 10% of the change in the Canadian dollar. Given the volatility of the currency, the currency component often contributed more volatility than interest rate changes.
That said, by the late 1990s, discontent with the Monetary Conditions Index was setting in, and the indicator was taken behind the barn and shot. New variants may have appeared (often labelled the Financial Conditions Index, to distance it from past failures), but the currency weighting was greatly reduced (and things like spreads added). The empirical reality that domestic inflation did not budge in response to even large swings in the currency had been accepted. (Update: Fixed the indicator naming! The burying of the MCI was so complete that I temporarily forgot that is what it was called.)
There are two interpretations to the Canadian Fiscal Crisis.
- The establishment was correctly scared, and fiscal policy needed to be tightened to stave off catastrophe.
- Neoliberal politicians and bureaucrats seized on an opportunity to slash the Canadian welfare state, egged on by headlines in the Wall Street Journal, and obliging Bay Street economists and bond traders.
r and g? Mais Oui!
A lot of people are asking whether we can manage our ballooning budget deficit. The answer is yes we can, if we act prudently. How so? We need to ensure our growth rate (which determines government revenue) remains higher than interest rates – the critical G-R equation. Interest rates have been running about one percentage point below growth so far this century, and, assuming no sudden loss of confidence, should continue to do so. This is dramatically different from the 1990s, when government borrowing costs exceeded revenue growth by about four percentage points, a negative G-R.
New Fiscal Rule
I would suggest that a 10-per-cent debt servicing target should become the federal government’s new fiscal anchor, providing assurance to the marketplace and transparency to voters that the government is tied to the discipline of a fiscal plan over future borrowing, expenditures and revenue.
There is a stipulation, however. For G to remain greater than R over the medium and long term, government borrowing must be primarily used to finance investments that will augment the growth of domestic production and the global competitiveness of Canadian industry – thus shoring up the current account and warding off the penalties of diminished confidence. Following this course will allow us to get the twin deficits under control without resorting to the drastic measures of 25 years ago.