Hell or High Water

by Paul Martin

  I really believed in the virtuous circle: completely. My experience in business was that what made an economy go or not go was interest rates more than taxation. If you are going to make an investment, what you have to know is whether you are going to make a profit. If you have to pay taxes on that profit, of course you would rather have them lower than higher. But if you can’t make a profit, or you can’t expand due to high interest rates, then the level of taxation isn’t going to be your main concern. That’s why I believed deficit elimination should come before tax cuts. My fundamental aim was to get our balance sheet in shape in order to keep our interest rates low.

  I have always been an optimist about Canada, and in private conversations, I began to argue that if we stuck to our policies, Canada was on the threshold of an economic “Golden Age.” I really believed that to be true but followed Terrie’s advice never to say that in public, out of concern that it might strike some people as a less-than-sober attitude at a time when we were still struggling to eliminate the deficit. Then, one day, in an interview the forbidden phrase slipped out. Of course, it made headlines and evoked a furious response from columnists and editorials, accusing me of overreaching. It also evoked a furious response from Terrie. Still, in retrospect we were at the beginning of a Golden Age, the second-longest period of growth in Canadian history and the longest sequence of budget surpluses ever.

  Even I was astounded, however, at how quickly it all happened. After the 1995 budget, interest rates fell faster than anyone expected, which made it less costly to service the debt and easier to meet our fiscal targets. As investors saw that we were serious about meeting — and soon exceeding — those targets, it took a further premium off interest rates, which in turn made it easier for us to restructure our debt. Lower interest rates also made it easier for Canadian businesses and consumers to borrow money. Moreover, the Canadian economy was showing signs of having completed its sometimes-painful adaptation to the era of North American free trade. If any one of these factors had been missing, the virtuous circle might never have asserted itself — or at least it wouldn’t have spun us so quickly out of the mess we had been in.

  Somewhat mysteriously, the Canadian dollar remained unacceptably low. That made it easier for Canadian industries to sell their products abroad but understated our national wealth and weakened the incentive for Canadian business to invest in new capital equipment. I learned very early on as finance minister never, ever to comment on the dollar, even if I was concerned about it. The wrong note from me could easily upset the markets. On the other hand, David Dodge and I were convinced that the international investor community did not understand how effectively we had turned around our fiscal situation. On one occasion, David and I went down to Wall Street to talk up the dollar. As we emerged from the last meeting of the day, there were camera crews on the street outside and I steeled myself for what would come next. As was David’s habit, as soon as we cleared the building, he pulled out his pipe and lit up. I don’t remember precisely what I said when we were questioned by the reporters there, but I do remember being concerned that I might have overstepped the bounds in commenting on the dollar. I needn’t have worried. The controversy the next day was all about whether it was appropriate for the minister of finance to be seen in public in the company of a smoker!

  I knew economic growth alone would carry us a long way toward reducing the size of our debt in relation to the size of our economy: what is called the debt-to-GDP ratio. After all, by definition, it can be improved either by reducing debt or by increasing growth. I also wanted to reduce our interest payments on the debt, however, which at this time made up the biggest single category of spending for the federal government — more than health care, education, defence, or anything else. In fact, interest payments were eating up more than one-third of the federal budget every year! I also wanted to reduce the amount of Canadian debt held by foreigners. There was only one way to do both: chop away at the debt in absolute terms — paying it down, in other words. Once again, it was no surprise to me that this happened, only that it happened as quickly as it did.

  As I write these words, compared to the early 1990s when I became finance minister, our debt-to-GDP ratio is below 30 per cent com pared to 71 per cent at its peak, government interest costs are 15 cents compared to 36 cents on the dollar, and Canadian debt held by foreigners is 7 per cent compared to 44 per cent of GDP.

  Still, I don’t want to make it sound as if this positive momentum was entirely self-sustaining. Absolutely not. One of the most fundamental decisions we made in these years was what came to be called the “no deficit rule,” which sometimes became a source of tension between me and other ministers, and between me and Jean Chrétien — who had other priorities, as a prime minister must. As I’ve said before, economic and fiscal forecasts are often unreliable because they never foresee the unforeseen, and the unforeseen is a feature of economic life as it is of life in general. Whoever first announced that it is tough to make a prediction, especially about the future, had it right. Forecasts are not very robust in the face of surprising events, whether positive or negative. Furthermore, under the previous Tory government, the forecasts were usually overly optimistic. The fact is that private sector economists can and do change their forecasts every quarter, or even more frequently as new information comes in, while the government reveals its projections in the budget and then has them hanging out for the world to see for more than a year before the final numbers are known. For private sector economists, there are almost no consequences for getting a forecast wrong, or for changing it every quarter. For governments the consequences can be huge.

  I was determined that once we reached a balanced budget we would never again in my time fall into deficit. I believed this was the only way to maintain our credibility. What that meant was that if we ever got a forecast wrong, it was going to be wrong on the upside — meaning we would come in with a larger surplus — not on the downside, where we would risk falling back into deficit. If the economy performed worse than expected, then we had the built-in contingency reserve to protect our forecast; if it performed better, then we would run a surplus, which could be used in part to pay down more debt and reduce the interest costs for next year. More virtuous circle.

  It is important to understand that the no-deficit rule was a sharp break with tradition. In the postwar years, many economists argued that you did not need to be in the black every year, as long as budgets were balanced over the course of the economic cycle, so that deficits during slumps would be paid off with surpluses in good years. Whatever the economic rationale for that approach, it didn’t work in the real world of politicians. Once you break the spell — once governments find they can get away with borrowing instead of taxing to pay the bills — it is almost impossibly tempting for politicians to do it again and again until the debt is out of control. How many times have politicians talked about the three-year cycle as the time period to climb out of deficit, only to extend the cycle when the moment of truth arrives. The fact is, in most instances, going into deficit is simply a sign of bad fiscal management, the proverbial canary in the coalmine.

  We needed to do things differently for two very important reasons. First, the debt we had built up over so many years left us vulnerable to a financial crisis that could plunge us into a catastrophic downward spiral that might take decades from which to recover. Our debt was equivalent to 70 per cent of our annual gross domestic product! The no-deficit rule enabled me as finance minister to set a goal of getting the ratio of debt-to-GDP down to 30 per cent. Ralph Goodale, who succeeded me in that role when I was prime minister, went even further, setting the target at 25 per cent.

  The second reason for the no-deficit rule was a question of fairness among generations. If the government was borrowing to build infrastructure that would benefit the generations to come, that would not be a problem. As individuals, we borrow to buy a house knowing that we will be able to live in it for many years. But in the decades before I b
ecame finance minister, the federal government had been borrowing each and every year just to pay its current bills. That’s like having $40,000 in take-home pay but spending $50,000 and making up the difference by adding $10,000 a year to the Visa bill. You’d better win the lottery, because otherwise you are on your way to bankruptcy. When governments do this — running up debt to pay for current consumption — it is like asking their children and grandchildren to pay their grocery bills. That just isn’t fair.

  This made sense to me, but I did not realize how much it would resonate with others until I found myself talking with a group of seniors after the 1995 budget. One lady really took me to task over spending cuts, and the audience was completely with her until I answered her off the cuff by saying, “Ma’am, all you’re telling me is that your grandchildren should pay for your lifestyle. Don’t you think you owe them more than that?” The mood in the room instantly changed. I had won them over, and I used that argument a lot from then on.

  Was I saying then, or am I saying now, that a deficit should never be permissible? No, I am not. If Canada ever finds itself in a deep recession, balancing the budget by hiking taxes could make a bad situation worse. But what is unacceptable is to overspend or to cut taxes too much out of political expediency when times are good. That destroys the government’s room for manoeuvre when the inevitable economic slowdown occurs and threatens to throw the country back into the bad old cycle of unremitting deficits and growing debt. As I write, I fear that that may well be precisely what the Harper government is close to doing.

  Am I saying that governments should never cut taxes? Of course not. Once we had eliminated the deficit and set the debt on an in exorable downward track, I brought in the largest tax cuts in Canadian history. But cutting taxes must be weighed against our needs for health care, education, research, child care, and so many other services we depend on. Furthermore, nothing could be more unfair than making our children, already saddled with debt service costs that are properly ours, suffer tax increases in the future to pay for the tax cuts we enjoy today. Again, I fear that is precisely what the Harper government has done.

  The business community, here and abroad, has long contended that centre-right governments are better fiscal managers than centre-left governments. Historically, in Canada, it has actually been the reverse, as it has in the United States. This comparison is even worse, I fear, when instead of a centre-right government we have a government that is very far to the right.

  The Conservatives argue, in effect, that a federal government without fiscal elbow room is a federal government that cannot spend foolishly — especially in areas of provincial jurisdiction. What nonsense! A federal government that threatens to tip back into deficit weakens the whole country, at every level of jurisdiction. It is the strength of the federal government’s balance sheet that affects Canada’s interest rates — rates that in turn affect every province, every business, and every individual. And it is only the federal government that has the geographical reach to make sure that we have the money to ensure we are healthy, educated, and well cared for across the land, whether our particular region is in a boom or a bust or somewhere in between.

  From my perspective, one of the most important aspects of the no-deficit rule was that it implanted in the public’s mind the need for a sound fiscal policy so that politicians would pay a price at the polls if they started to stray. In fact, the growing public support for the no-deficit rule was crucial to our success. You only need to look south of the border to see what happens if the public does not impose this discipline on the politicians: in the United States, the mighty efforts of the 1990s to overcome the deficit hangover from the 1980s were quickly squandered in the first years of this century.

  When we made the no-deficit rule, it was beyond our wildest imagination that we would later be criticized for our cautious approach. But by the late 1990s, there were frequent complaints about the regularity with which we outperformed our budget predictions. Jean Chrétien was one of those critics, truth be known. This led to one of the few light-hearted elements in our relationship. Every year, he would make a bet with me that we would end up doing better than I predicted in the budget, and year after year he was right. Eventually he claimed that I owed him $700. I guess I do.

  As I was preparing the 1998 budget, I recall telling the prime minister that I expected that the fiscal year 1997–98 would be the one in which we eliminated the deficit, and I hoped to be able to announce as much when the final numbers came out, which would not happen until the fall. He persuaded me against my better judgment to make the announcement in the February 1998 budget instead, months earlier than I planned. That left me and my officials at Finance with the task of how to reveal our achievement to the public. We worked on all sorts of formulations. Finally, Larry Hagen, who was writing the budget speech, suggested: “We will balance the budget next year. We will balance the budget the year after that. And we will balance the budget this year.” It had a declaratory ring, and yet by leaving the current year to the last, it hinted at my own sense of caution. Nonetheless, I sweated bullets over whether it would turn out as we hoped till the revised numbers started rolling in that fall, making good on my promise.

  The no-deficit rule, plus some of the structural changes we put in place in the 1995 budget, created a cultural change in Ottawa. It became almost universally accepted that no new spending could be launched outside the rigid fiscal framework we had laid down in our budgets. Although the problem never entirely went away, I worried less and less about ministers trying to go round my back to the prime minister to plead for new spending. One potential problem that did arise was the prime minister’s commitment in the 1997 election to the “fifty-fifty formula.” The formula was that for every dollar in surplus that arose in the future, fifty cents would go to new spending and the other fifty cents would be devoted to a combination of tax relief and deficit reduction. I had no desire to have a straitjacket put on me as finance minister in this way. However, Jean Chrétien was probably the shrewder politician here. The promise conveyed the gist of his priorities to the public. Eventually I came to like the communications value of the commitment, but I didn’t like the balance it struck. In my government, Ralph Goodale altered the rule to allocate equal shares to new spending, tax cuts, and debt reduction.

  As we emerged from the era of deficits in the late 1990s and found ourselves entering a world of surpluses, we confronted a new problem, which was the pent-up demand from a governmental system that had been restrained for so long. Almost every department of government could naturally make a case — and often a good one — for restoring some of the programs that had been cut back or cancelled. The provinces had their own set of demands emerging from a combination of their own problems and the cuts we had made to the CHST. At the same time, many businesspeople and economists, not to mention the Reform Party, were arguing that our tax structure was out of whack compared with that of our competitors. For my part, as discussed earlier, I felt it was vital to make headway in paying down our debt because the costs of servicing it were so colossal.

  In this environment, it would have been easy on the spending side to spread a little pixie dust in every direction (a budgetary approach favoured by my successors in the Conservative Party) without creating the critical mass in any single area to make a noticeable difference in the lives of Canadians. I wanted to make sure that what funds we were able to free up for new spending were sufficiently concentrated to make a difference, and that each budget had a clear theme that the public could understand, even if it did try to address other needs as well. While there were many things that could be done with our newfound surpluses, nothing was more important in my view than helping Canadians to build up their knowledge and skills. Education is both a social and economic program. In fact it is the foundation for a country’s success in both areas. Although we specifically framed the 1998 budget around education, we began to nurture this theme as early as 1995. Over several years, our aim was to
address the issue of education at every point in the continuum, from early childhood learning through student debt to parents’ savings for their kids’ university education, scholarships once they get there, and assistance for the nation’s research institutions.

  I was lucky that I was able to rally a fair degree of consensus around the idea of a knowledge agenda at the time. David Dodge, Scott Clark, who succeeded Dodge as deputy minister, and the Department of Finance were on board, as were Terrie, Elly, David Herle, and Kevin Lynch, then the deputy minister at Industry. All of us recognized a growing public thirst to rebuild our educational system from top to bottom. At the PMO, Chaviva Hošek and Eddie Goldenberg were also enthusiastic. We had great support from the universities and teaching hospitals, as would be expected. Further, this was an area where we were able to forge a consensus with the provinces. It is only in retrospect that it seems strange to me that an initiative of this kind should have been led by the federal Department of Finance. The truth is that within a couple of years of the 1993 election, we had pretty much got accustomed to dominating most policy debates (with the exception of Quebec). It may have seemed peculiar to Mitchell Sharp, but it didn’t to me.

  We took the first step on this agenda in early 1996. Although we had not yet eliminated the deficit, we had done better than we had hoped. There was some money left over even after putting our contingency reserve toward paying down debt. The department, led by Scott Clark, came up with the idea of the Canadian Foundation for Innovation (CFI). It was clear to us that Canada was slipping badly on the international intellectual table because of the stresses on our great research institutions, which included, of course, our own cutbacks in both direct spending and transfers to the provinces. Although we did have some niches of excellence, they were dwindling. We didn’t have adequate facilities for cutting-edge work in biology, genetics, physics, chemistry, and geology; and increasingly we were having trouble retaining the top brains in these fields, much less attracting new ones.