FINA Committee Report
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CHAPTER 1
A. THE FISCAL ENVIRONMENT: PAST EXCESSES AND CURRENT SUCCESSES
1. Crisis at the Federal Level
"The problem was clear to everyone: it was the deficit, which was growing every year, and resulted in a debt that compromised our future and restricted our latitude."
Mr. Benoît Latulippe (Fédération des étudiants et étudiantes universitaires du Québec)In the latter part of 1993, it became apparent that the Government of Canada was in a fiscal crisis, both as a result of the recent recession and because of the large debt accumulated in the previous decade. In 1992-93, the deficit exceeded $41 billion, and grew to $42 billion the following year. These were the largest deficits in Canadian history,1 and far exceeded the projections contained in the previous government's 1993 budget ($35.5 billion for 1992-93 and $32.6 billion for 1993-94).
While these large deficits were of obvious concern, more worrying were the longer-term trends in the fiscal position of the government. Public debt charges at the start of the 1990s were four times as high as at the start of the 1980s, and were consuming more than one-third of government revenues. Interest payments on the Government of Canada's debt were consuming between 5% and 6% of the total output of the Canadian economy. Rising debt had put the government at the mercy of financial markets, hampering its ability to focus its budgets on the economic and social priorities of the country.
In 10 years the net debt quadrupled to over $400 billion.
"We do well to remember that today's debt is the tax we choose to impose on our children and grandchildren.''
Mr. David Thibaudeau (President, Life Underwriters Association of Canada)Despite the commitments and actions of governments in the 1980s, the debt continued to grow. Since 1982-83, the federal deficit had never fallen below $27 billion. Indeed, in more than half of this period, tax revenues were not even sufficient to finance program spending. The net debt of the Government of Canada was just under $100 billion at the start of the 1980s, amounting to about 30% of GDP. One decade later the net debt had quadrupled, representing closer to 60% of GDP. It would eventually grow to $583 billion, equalling close to three-quarters of annual GDP.
2. Provincial Governments' Deficit Challenge
Compounding the federal challenge was a similar lack of resolve at the provincial level. This was most evident in Ontario, where a $90 million surplus in 1989-90 turned into a $3 billion deficit the following year, and an $11 billion deficit the year after that. Ontario's deficit eventually peaked at $12.4 billion in 1992-93.Other provinces followed a similar path. Alberta had a $3.4 billion deficit in 1992-93, while Quebec's deficit was $5 billion. Provincial and territorial deficits totalled $25.2 billion in 1992-93, more than five and one-half times what they were only three years earlier. And just as the federal net debt-to-GDP ratio grew on account of the recession, so did the aggregate ratio for the provinces, from 16% just before the recession in 1989-90 to 24.3% in 1992-93.
What mattered was not which level of government was responsible for the accumulation of the debt - they both were - but what cumulative effects all these government deficits had on financial markets, Canadian interest rates, and ultimately the Canadian economy.
3. An International "Basket Case"
By 1993 Canadians came to realize that their public finances were in disarray, at both the federal and provincial levels. There was an apparent inability on the part of all Canadian governments to solve their fiscal problems. Even though government deficits were a worldwide phenomenon, the situation in Canada was worse than that seen elsewhere. We ranked poorly in relation to other industrialized nations - of the G-7 nations, only Italy had a worse fiscal record. More importantly, however, our deficit record was consistently and substantially worse than the United States, a nation with which we have a very open border with respect to the movement of goods and capital.Unlike Italy, however, Canada had traditionally relied heavily on foreign sources of capital. Thus we had a high degree of foreign ownership of our debt. Twenty-five per cent of outstanding federal debt was held by non-residents, and Canada's total net indebtedness to non-residents was equal to about 45% of GDP in 1993. With open capital markets, large foreign debt and poor fiscal performance, we were at the mercy not only of worldwide fluctuations in interest rates but also of changes in how the market assesses the risk associated with Canadian financial securities.
4. The 1995 Federal Budget: Turning the Tide
It was with this fiscal background that the Minister of Finance presented his first economic and fiscal update in the fall of 1994. The fiscal strategy and the interim deficit targets announced in the 1994 budget were put at great risk by the escalation of interest rates that started in the spring of 1994 and continued into 1995. To a certain extent this was an international phenomenon, as short-term American rates increased from 3% to 6% during this period. But rates rose even more in Canada, from 4% to 8%, with a resultant widening of the spread between Canadian and American interest rates. With approximately half the outstanding federal debt being held in short-term securities, this dramatic rise in interest rates had a considerable and negative impact on debt servicing costs. At that time, it was estimated that a sustained 100 basis point increase in interest rates added $1.8 billion to the deficit in the first year and $3.1 billion in year three. Given the 400 basis point increase in Canadian short-term rates, the potential impact on public finances was of very real concern.To see a deficit grow on account of unforeseen circumstances is not unusual. But in Canada's case, unexpectedly high shortfalls had become the rule rather than the exception; another repetition threatened to take away any credibility that the federal deficit targets might still have had. The Minister responded to the circumstances by stating that the government's deficit target would be met, "come hell or high water," and the subsequent budget reflected this attitude. The 1995 budget truly marked a turning point in Canadian fiscal policy.
"Government must be commended for having surpassed its deficit reduction target through the virtuous circle of restraint measures, lower deficit, lower interest rates acting further to reduce the deficit."
Dr. Barry McLennan (Coalition for Biomedical and Health Research)The measures adopted at that time were estimated to have had a cumulative reduction of $29 billion in deficits over three years. Over the three-year period, spending cuts equaled $6.90 for every $1 in revenue enhancement, with no increase in personal income tax. Program review, reductions in transfer entitlements to the provinces under the newly-established Canada Health and Social Transfer (CHST), and the reformed Employment Insurance (EI) Program all contributed to the fight against the deficit. It should be noted, however, that the $8 billion Equalization Program remained intact.
The 1996 and 1997 budgets added additional restraint measures, which reinforced the actions taken in 1995, but they were secondary in importance. What the 1995 Canadian experience demonstrated is that one decisive budget could completely reverse the trend of fiscal policy and set a standard of prudence and fiscal responsibility that had not been achieved for many decades.
5. The Benefits of Fiscal Restraint
The fiscal situation of Canadian governments is very different today. As outlined above, the federal government has succeeded in putting its finances in order. The deficit, which amounted to almost 6% of GDP in both 1992-93 and the following year, fell to 5% of GDP in 1994-95 and 1.1% in 1996-97. The last time the deficit was this low in relation to the economy was 1970-71. To achieve this result, the government has had to run a very large operating surplus. Last year it was $36 billion, twice what it was the previous year.
"The Canadian government took the right options that were available to them in reducing the deficit. We commend the government for reducing the deficit as much as they have..."
Mr. Francis Reid (General Manager, Construction Association of Prince Edward Island)Program spending has been substantially reduced. At 13.1% of GDP, federal program spending is now 25% smaller in relation to the size of the economy than it was just four years ago. In dollar terms, it is almost $18 billion less than four years ago. Such a substantial and sustained drop in program spending is unprecedented in the post-war period. Public debt charges have declined from their peak, last year, and are also declining as a percentage of GDP.
"Reducing the deficit was a big thing last term, but another big thing that happened was the restoration of the credibility of the finance department and the Minister of Finance in terms of their commitments regarding fiscal policy."
Professor Paul Boothe (Department of Economics, University of Alberta)Fiscal year 1997-98 is expected to be equally as impressive. The government has achieved a $1.7 billion surplus for the first six months of the fiscal year, compared to a $7 billion deficit in 1996-97. While the Department of Finance reminds us that one-time events and changes in the timing of certain revenues account for part of this improvement, it is clear that the federal government is on track to match the laudable performance of 1996-97.
``Finance Minister Martin really needs to be commended from a fiscal control perspective. He's the first Finance minister in a long time who has listened to wise budget-crafting advice."
Mr. Anthony Toth (President, B.C. Road Builders and Heavy Construction Association)Enhanced revenues also played a role in turning around the federal deficit, both in Canada and the United States. Total federal revenues have increased dramatically since 1993-94. By far the largest part of the increase was due to economic growth. The revenue enhancing measures that the Government of Canada adopted in its various budgets were quite small, accounting for only $2.6 billion in extra revenues in 1996-97. The vicious circle of high deficits, high interest rates, slow economic growth and high unemployment has been broken. Replacing it is a virtuous circle of lower deficits leading to lower interest rates, stronger economic growth and greater job creation, which in turn create higher government revenues and even lower deficits.
However, it should be noted that federal revenues have grown only slightly as a proportion of GDP in the past few years, and only last year did they recover the ground lost since the last recession. Furthermore, the large increase in revenues last year was affected by some one-time factors as well as some changes in the timing of tax collections. Thus the rate of growth of revenues experienced last year is not indicative of revenue growth that can be sustained in future years.
A similar reversal of fiscal trends is occurring at the provincial level, although some provinces are far more advanced than others in this respect. The provinces' total deficit was under $12 billion for 1995-96, representing only 1.5% of GDP. This was less than one-half the total deficit for this sector three years earlier.
At the provincial and territorial level, governments are, in aggregate, running operating surpluses (which have been growing for several years), are reducing program spending and, as noted above, reducing their deficits.
"I think the good news is that we're going to have the first surplus in about 20 years but that's also the bad news in the sense that the intervening 19 or 20 years have resulted in deficits which have driven up our gross debt to GDP to an amazing level."
Mr. Leo de Bever (Vice-President, Research and Economics, Ontario Teacher's Pension Plan Board)Various governments in Canada have chosen very different ways to solve their fiscal problems. Alberta uses very cautious revenue estimates. The dominance of the natural resources sector in that province makes its economy, and hence government revenues, subject to large cyclical swings. As Alberta is already a low-tax jurisdiction, the government has chosen not to reduce taxes but to use excess revenues to pay down debt. While Alberta turned its finances around via reduced expenditures, Saskatchewan used both spending restraint and tax increases to eliminate deficits.
The government of British Columbia has established targets for real per capita spending and debt servicing costs. In Ontario, the focus is tax reduction and drastically reduced program spending. While Ontario's 30% cut in personal income taxes is by far the most significant, other provinces have also reduced a variety of taxes. Every provincial government expects to have eliminated its deficit by the end of the decade.
In 1996-97, the federal government produced a deficit slightly larger than the combined provincial/territorial deficit. This year its deficit should be lower than that of the provinces and territories. Such a result has not been seen for many years. It illustrates the very dramatic turnaround in federal finances, coupled with the fact that the largest provinces have been relatively slow in reducing their deficits.
"We are not out of the woods yet, but are at least on the path out of the woods."
Mr. Dave Neal (Fredericton Chamber of Commerce)The most compelling evidence of the new fiscal environment is the net debt-to-GDP ratio of the federal and provincial governments. This ratio (total government debt-to-GDP) grew by about 50% since 1987-88, with provincial debt growing at a faster rate than federal debt. The combined total slightly exceeded 100% of GDP in 1995-96, when measured on a Public Accounts basis. It was only last year that federal net debt, and total net debt, declined as a proportion of total output.
6. From "Basket Case" to International Success Story
"As a taxpayer I would first like to congratulate the Finance Minister and the government of Canada for showing such discipline and leadership in the fight against the deficit and for having eliminated this burden which was slowing down the country's medium- and long-term growth."
Dr. Rafick-Pierre Sékaly (Laboratory Director, Institut de recherches cliniques de Montréal; Council Member, Council for Health Research in Canada)Another way to assess the Canadian fiscal achievement is to compare it to the performance of our international peers, the G-7 nations and particularly the United States. Using the National Accounts measures, the total government sector in Canada has seen a faster decline in spending and deficits than any other G-7 nation. In 1996, the total government deficit in Canada comprised essentially the same proportion of national output as it did in the United States. For 1997, however, the Canadian figure is below its American counterpart. These ratios in Canada and the United States are less than one-half the average of the other five G-7 nations. This stands in sharp contrast to the situation in 1990, when the Canadian figure was almost double the G-7 average.
"I am extremely encouraged, as are my colleagues in the Business Council, with the progress and success to date on deficit reduction. For this the Minister of Finance deserves great praise, "
Mr. Thomas d'Aquino (President and CEO, Business Council on National Issues)However, Canada's triumph is not yet complete. Whether one examines Public Accounts data for the federal and provincial governments, or whether one looks at internationally-consistent data based on the National Accounts, one conclusion is inescapable: Canadian governments have accumulated too much debt. While these governments have finally come to grips with excessive spending and irresponsible deficits, they have not yet resolved their debt problems. To date, they have succeeded in stopping the growth of the debt relative to the economy. While this is a major accomplishment, the task that remains is to substantially lower the ratio of debt to GDP.
"Getting ourselves to a balanced budget is not going to do anything with respect to the debt at all."
Mr. Robert O'Rourke (President, Simscape Development Corporation)Our net debt is almost 50% higher than the G-7, and American, average. Only Italy, among G-7 nations, has a worse record. Thus, while fiscal policy is today prudent and responsible, it must still repair the damage caused by imprudent fiscal policies in the past.
B. BUDGET MAKING INNOVATIONS: KEY TO RESPONSIBLE FISCAL POLICY
"People keep talking about the deficit. ...No one ever talks about the $600-billion debt we have out there, and I think we seriously have to come to grips with paying that down."
Mr. Terry Moorehead (Treasurer M.F. Schurman Co. Ltd.)Federal budget making is today very different than it was only five years ago and this reform was a key factor in achieving the recent reductions in the federal deficit. Witness after witness told the Committee how important it was for the government to consistently beat its deficit targets and how this fact has greatly enhanced the credibility of the government in the eyes of financial markets. Credibility is important in enabling the government to signal its intentions to the private sector. More importantly, a credible and prudent fiscal policy helps to keep interest rates low, which in turn enables the government to avoid increasing taxes. Low interest rates also help Canadian families because they reduce the cost of home ownership and lower financing costs associated with the purchase of other consumer durables.
``We do need to start off by reducing our debt load as a way of giving us flexibility and allowing us room as we move forward."
Mr. Josh Mendelsohn (Senior Vice-President and Chief Economist, Canadian Imperial Bank of Commerce)The budgeting innovations undertaken by the government include: the establishment of two-year rolling targets instead of the five-year projections used in the past; the use of private sector economic forecasts, adjusted to add a measure of caution, instead of economic forecasts produced by the Department of Finance; and the explicit use of a Contingency Reserve to protect against interest rate increases, other unforeseen negative economic developments, and forecasting errors that often affect budgeting.
This Committee's pre-budget consultations represent another innovation in budget making. Having heard from over 2,000 Canadian individuals and organizations, we, as a Committee, believe we are not only opening up a traditionally secretive process, but also ensuring that the recommendations we put forward reflect the multifaceted make-up of this great country.
1. Two-Year Planning Horizon: Hitting the Target
``The budget has to have a target."
Ms. Maureen Farrow (Loewen, Ondaatje, McCutcheon Ltd.)The five-year forecasts were abandoned because of the inability of the government to accurately project that far into the future. The consistent inacurracy of the eventual results deprived the entire process of longer-term projections of any credibility and usefulness. Two-year rolling targets, on the other hand, are sufficiently immediate that only extraordinary events would excuse any failure to meet them. This practice also prevents the government from delaying required action until later in the planning period. As the Minister has stated on numerous occasions, these targets help to provide a standard to which the public can hold the government accountable.
2. Prudent Assumptions: Erring on the Side of Caution
``The budget should always be put together based on very conservative economic assumptions."
Ms. Maureen Farrow (Loewen, Ondaatje, McCutcheon Ltd.)The prudent economic assumptions used in the budget are established in the following manner. Prior to the preparation of the budget and the publication of the Economic and Fiscal Update, private sector forecasters are surveyed with respect to their economic forecasts. In recent years, this sample has comprised 15 to 21 respondents. In 1997, the prudent assumptions used by the government added 80 basis points to the private sector average forecast for short-term interest rates and 50 basis points to the private sector average for long-term interest rates. This Committee recommended in its first consultation report that the prudence factor be between 50 and 100 basis points. Prior to that, the government used a 50 basis point prudence factor for short-term rates.
This practice has two significant positive effects. The government's calculation of its debt servicing costs is higher and, along with it, estimates of the size of the deficit. For example, a 100 basis point increase in interest rates is estimated to add $1 billion to the deficit in the first year. The assumption of higher interest rates also reduces the government's estimates of economic growth, leading to lower revenue and higher spending estimates. The 1997 budget contained prudent assumptions about nominal GDP growth that were 20 basis points lower than the private sector average for 1997 (4.7% vs. 4.9%) and 60 basis points lower for 1998 (4.7% vs. 4.1%). Sensitivity analysis contained in that budget indicates that a one-percentage point decrease in the nominal growth rate increases the deficit by $1.3 billion. For the second year of the government's planning horizon, these prudent assumptions increase the government's estimate of the deficit by about $2.5 billion.
3. Contingency Reserve: Guarding Against the Unexpected
The third component of prudent budgeting is the inclusion of a Contingency Reserve. Initially, the government used a $2.5 billion Contingency Reserve for year one in its two-year planning horizon and a $3 billion reserve for year two. The higher reserve was justified because of the greater uncertainties faced as one plans further into the future. This approach was changed slightly in the 1997 budget, with a $3 billion Contingency Reserve used for both years of the planning period.A $3 billion Contingency Reserve protects against the first year effects of a 300 basis point increase in interest rates or a 2.3 percentage point decrease in nominal GDP growth. Prudent economic assumptions and the Contingency Reserve combine to provide a $4 billion deficit cushion in year one of the budget horizon and a $5.5 billion in year two.
The government's current policy does not allow the Contingency Reserve to be used to finance program spending. If it is not needed, it is used to reduce the deficit. The Minister of Finance told the Committee that the same principle would apply to a Contingency Reserve in an age of budgetary surpluses. If it is not needed, it will be used to reduce the net debt of the Government of Canada.
The Contingency Reserve serves a number of purposes, not the least of which is as a cushion to ensure a balanced budget. Not since 1969 has a government delivered back-to-back balanced budgets.
C. ECONOMIC GROWTH: THE ROLE OF STRONG FUNDAMENTALS
Any government has only an indirect impact on the economy. While it has a variety of tools at its disposal, the federal government cannot easily manipulate economic variables so as to direct where the economy will go. But it can work to "get the fundamentals right" and thus let the private sector accomplish that which is within its competence.
1. The 1990-91 Recession and Unemployment
``The last recession was relatively mild in the United States. In Canada, it was extremely severe. The United States recovery was much faster. The Canadian recovery has been much slower. Has this had anything to do with the Bank of Canada?"
Mr. David Laidler (Department of Economics, University of Western Ontario)The fiscal problems of Canadian governments cannot be properly understood without taking into account the economic conditions that marked the start of the decade. The Canadian economy declined for four consecutive quarters in 1990 and 1991. The recovery that followed was anemic and it was not until late 1993 that Canada started to see acceptable growth rates. But this expansion lasted only two years, with growth again faltering and remaining weak until the middle of 1996.
The recession was clearly more severe in Canada than in the United States. When measured against potential output, the American economy declined by only about one-half as much as Canada's, and recovered much more quickly. As of 1995, the US economy was once again producing beyond estimated potential. In Canada we are still about 2% below the IMF's estimate of our economy's potential. The economic performance of other industrialized countries, however, resembled the Canadian experience more than the American one. The UK recession/recovery cycle closely followed the Canadian pattern. The French, German, Italian and Japanese economies seem to be stuck in the trough of the business cycle, being a bit further from potential than Canada and showing no signs of marked improvement. They are not expected to grow as rapidly as the Canadian economy in the short term.
"The unemployment rate today remains stubbornly and unacceptably high at 9%. Still, there has been improvement in employment growth, with seven consecutive monthly gains in employment... Youth employment has in fact increased by more than 50,000, with at least three consecutive months of growth since May, the largest sustained increase since 1994."
Mr. Thomas d'Aquino (President and CEO, Business Council on National Issues)The most telling sign of our slow and hesitant recovery is reflected in labour markets. While it generally takes several years after the end of a recession for the unemployment rate to recover lost ground, the current recovery appears to be slower than usual; the unemployment rate has still not declined below 9%. Another way of looking at the labour market is to consider the employment rate, which measures total employment as a proportion of the working age population. At the peak of the last economic cycle, about 62% of the working age population was employed. This ratio fell to below 59% as a result of the recession, and has stayed in that range since 1993. A large part of this decline was due to a fall in the participation rate, which is often cited as the "discouraged worker" phenomenon. Although this recovery also saw the Canadian economy adjusting to the new free trade environment and the low inflation environment, there is a perception that the cyclical recovery has been weak. This is due to the fact that the recession ended in 1991 and Canada's unemployment rate remains at 9%, which is about four percentage points above its American counterpart.
"The bottom line is that our recovery will last only 18 more months instead of the four years we would need to return to full employment as the U.S. has done."
Mr. Pierre Fortin (Department of Economics, Université du Québec à Montréal)
One factor distinguishes this period from previous ones, however, and might explain part of the apparently poor labour market performance. That is, we are still experiencing the effects of fiscal restraint on the part of Canadian governments, combined with substantial declines in public sector employment. From the beginning of 1993 to early 1997, public sector employment had fallen by more than 5%.
Since the latter part of 1993, the private sector has created over 1 million net new jobs in Canada.
Nevertheless, it is encouraging to note that private sector employment has grown by about 10% in the same period. Total Canadian employment grew by 426,000 since January 1996 and 268,000 in the first ten months of this year. Since the fourth quarter of 1993, the private sector has created over one million jobs.
Employment growth for women has slightly outpaced that for men since 1993.
"The government must transform its success with the budget into healthy economic growth and the creation of sustainable jobs."
Mr. Manuel Dussault (Director of Research and Analysis, Alliance des manufacturiers et des exportateurs du Québec)Clearly, the unemployment rate paints a bleaker picture than that indicated by job growth figures. Still, the less than satisfactory labour market performance requires continued attention.
2. Recent Economic Growth: Exceeding Expectations
The Canadian economy grew very slowly in the aftermath of the last recession. That seems to be changing now, as a variety of factors have recently combined to produce strong economic growth in Canada. Starting in the second half of 1996, the economy has been growing at rates in excess of 3% annually - in July 1997 alone, the economy grew by 0.8% - and has surpassed the predictions of most forecasters. As reported in the budget, private sector forecasters in 1996 were expecting 1997 growth to be less than 3%. By February of this year, their expectations were revised upward to 3.3% and the forecasters now think that growth will be as high as 3.7%.The Royal Bank's Economic and Financial Market Outlook: 1998-99 indicates that, when it comes to economic growth among the G-7 countries, the years 1997 and 1998 clearly belong to Canada. Canada's growth is expected to be either at the top or very close to it in each year and the Canadian economy is the only one expected to experience consistently strong growth. The economists at other chartered banks are generally in accord - for example, the Bank of Montreal's Medium Term Outlook for the US and Canadian Economies, released on October 22, is forecasting growth of 3.8% in 1997 and 4.3% in 1998. In July, the bank's economists were forecasting growth rates of only 3.5% and 3.7% respectively. And the most recent survey by Consensus Economics Inc. is equally upbeat. That survey shows improved expectations about the economy's performance, this year and next. Strong growth and low inflation are expected to characterize the Canadian economy until the end of this decade, at the very least.
Private sector forecasters expect growth of about 3.7 per cent in both 1997 and 1998 - the strongest back-to-back growth in almost 10 years.
There is still the potential for significant reductions in Canadian unemployment, although its impact will not be spread evenly across Canada, according to a recent Nesbitt Burns study.2 It notes that, with continued economic growth at the current pace, unemployment should fall to 7.5% within 12 to 18 months. Thus the labour market picture should soon fall in line with other indicators of the economy. According to the study, further fiscal and monetary stimulus is not needed to get us there and cannot generate even lower unemployment rates.
``It is the nature of the local labour force that determines a lot of the critical decisions about not only where jobs are located but what kinds of jobs are being created."
Ms. Judith Maxwell (President, Canadian Policy Research Networks Inc.)The study adds that Canada's unemployment problem is no longer a macroeconomic problem, but a "micro" problem. Excess demand for labour exists in provinces such as Manitoba, Saskatchewan and Alberta, while excess labour supply exists in places such as Quebec and Atlantic Canada.
A similar trend can be found in the International Monetary Fund's assessment of Canadian prospects. In May 1997, it revised upward its own expectations of Canadian growth and concluded that Canada would lead the major industrial nations in growth in both 1997 and 1998, with rates of 3.5% and 3.4% respectively.3 And it would do so with inflation well below 2% per annum, lower than that found in most of the major industrialized nations. According to the IMF's survey of inflationary pressures, there was no indication during the early part of the year that inflation would increase.
"I think that buoyant growth over the next few years puts us in a superb position to pay down debt."
Mr. William Robson (C.D. Howe Institute)The reduction in government deficits, the return of business and consumer confidence and the government's monetary policy have all contributed to current strong growth, according to the IMF report. In the opinion of that organization, "the strength of fundamentals in Canada bodes well for continuing recovery in 1997-98, with inflation remaining within the target range."4
3. Low Inflation Benefits Everyone
``The most accomplished and the most respected central bank in the world... has, against enormous odds from the point of view of the conduct of fiscal policy, saved Canada from really terrible economic consequences.... John Crow really is a kind of Canadian hero. We now see the results of John Crow's work. We see it in terms of the interest rates that are lower than are achieved in the United States."
Dr. Michael Walker (Executive Director, Fraser Institute)As noted above, the recent strong growth in Canada is being achieved while inflation remains at historically low levels. The beneficial effects of low inflation are clear for all to see. One of these is low interest rates. Canadian interest rates are at levels that have not been seen in decades. This year, the 3-month Treasury Bill rate has averaged 3%, compared to almost 11% in 1990. The prime rate is under 5% versus 14% in 1990, 5-year mortgages are 7.2% versus 13.4% in 1990; and 10-year Government of Canada bonds are 6.3% versus 10.7% in 1990.
Canadians paid a high cost to achieve low inflation and they told us they do not want to see a return to the high rates of the early 1990s.
"Canadian interest rates are now lower than interest rates in the United States, all the way out to 30 years. That is the consequence of sound fiscal and monetary policy in Canada."
Mr. David Laidler (Department of Economics, University of Western Ontario)Not only have Canadian rates fallen, they are now below American rates for similar maturities. This is now true for both the short-and very long-terms. While Treasury Bill rates in Canada have been below their American counterparts since early 1996 and have been more than 200 basis points below American rates for a year now, Canadian 30-year rates have recently fallen below their American counterparts as well, a development which would have been hard to believe only a few years ago. All of this indicates that expectations of low inflation have now taken hold in Canada. Investors are willing to accept lower returns than those available in the United States because of their confidence in the purchasing power of the Canadian dollar.
"The rate of money growth that's compatible with the Bank of Canada and the government's own inflation target in the long run is probably somewhere in the region of 3% to 6% per year."
Mr. David Laidler (Department of Economics, University of Western Ontario)This low inflation and the resultant low interest rates are the direct result of the commitment by the government and the Bank of Canada to maintain inflation within the fixed bounds, namely 1% to 3% per year. Since the establishment of inflation targets in 1992, Canadian inflation has never exceeded the target range and has generally been in the lower part of the range. Also, since that time, Canadian inflation has consistently been below the American rate, the gap often being close to 200 basis points.
Until a few years ago, the credibility of Canada's inflation targets suffered from the fact that the fiscal policy of the Government of Canada was not consistent with, and not supportive of, a policy of low inflation. The temporary increase in interest rates that comes about from additional monetary restraint tends to increase the debt-to-GDP ratio of any government running operating deficits, or small operating surpluses. Continued growth in the debt-to-GDP ratio is ultimately unsustainable, and such a fiscal policy is inconsistent with a monetary policy of low inflation. Thus some might come to doubt the ability of a central bank to achieve its inflation goals in such a circumstance. Today, Canada's credibility in this area is well established. With large operating surpluses, Canadian fiscal policy is entirely compatible with a monetary policy of price stability.
Not only is the fiscal policy consistent with the monetary policy that is reducing inflation and interest rates, but the fiscal policy is itself responsible for lower interest rates, today and in the future. The higher the debt-to-GDP ratio of a government, the higher the interest rate it must pay on its debt. Now that the debt-to-GDP ratio of the government sector in Canada is in decline, the risk premiums associated with such debt should continue to decline.
The effects of low interest rates are felt most dramatically in the housing market. Housing affordability indices, which measure the proportion of household income consumed by home ownership costs, are now at the lowest level in a decade. At about 30% of household income, this index is 40% below its peak, reached in 1990, and 20 to 25% below levels in the mid-1980s. With this improved affordability has come a sharp increase in housing sales and new home construction in the past three years.
Spending on consumer durables in general is expected to rise. While such spending grew by only 3% in 1996, it is expected to grow by almost 11% in 1997 and over 7% in 1998.
Low interest rates are also good news for households and their ability to carry their own debt burden. Household debt has grown steadily over the past ten years and now exceeds 100% of personal disposable income. (Part of the recent rise is due to the acquisition of financial assets by households.) As a result of low interest rates, only 7% of income is required to service the debt, versus more than 10% in 1990.
All of this adds up to a marked improvement in the economic fundamentals of the Canadian economy. The past year has been a good one and expectations are that this will continue. One measure of these fundamentals is the state of consumer and business confidence. In October, the Economic and Fiscal Update remarked that the Conference Board of Canada's measure of consumer confidence was at its highest level in eight and a half years. Less than two weeks later the Conference Board reported that consumer confidence was near a ten-year high.
While consumer confidence has been slow to manifest itself until recently, business confidence has moved upward through much of this decade. The most tangible evidence of this is changes in business non-residential investment. This measure of investment has been growing since 1993, but it has recently jumped to very high levels. The most recent data indicate investment growth rates of 20% per year.
Evidence that consumer confidence is improving comes from the fact that domestic demand is now strong and is the source of much of our economic expansion. For much of the post-recession period, any improvement in the Canadian economy was largely driven by exports, fuelled primarily by the strong growth of the American economy. With that economy far into its expansion, there was always the fear that an American economic slowdown would take the wind out of the Canadian recovery before it ever got going.
There is less fear of that happening now that the various factors supporting the Canadian economy are more in balance. While the export sector continues to enjoy growth, low interest rates and increasing employment are giving Canadian families the confidence to spend.
Not only is improved consumer confidence an indication that the sources of economic growth are becoming more balanced, it is also an indication that the benefits of a better functioning and expanding economy are more evenly distributed as well. Business confidence, at record levels today, had recovered quite early in the economic recovery. At the same time, consumer confidence was lagging. Today's increased consumer confidence indicates that families are beginning to enjoy a greater sense of economic well-being.
1 As a percentage of GDP, the deficits of the mid-1980s were larger. For example the $38 billion deficit for 1984-85 exceeded 8% of GDP, whereas the 1993-94 deficit was only 6% of GDP.
2 S. Cooper and A. Araujo, Regional Diversity: The Canadian Unemployment Story, Special Report, Nesbitt Burns, Toronto, November 14, 1997.
3 International Monetary Fund, Globalization: Opportunities and Challenges, World Economic Outlook, May 1997.
4 Ibid. p. 23.