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Chapter 2: Future Fiscal Targets


The principal challenges the country faces continue to be defined by the over-arching objectives set out by the Government as it began its mandate -- durable economic growth and job creation.

Durable economic growth and job creation depend on maintaining the low-inflation, low-interest rate environment and rapid fiscal progress that have made Canada one of the most attractive investment locations in the world over the past three years.

"It's not a bad world we're living in right now. However, I think there are some significant risks out there, and it is because of those risks that I believe it is far too early to say we've won."

Mr. D.J. McIver (Chief Economist, Sun Life Assurance Company of Canada)
In his appearance before the Committee on October 9, the Minister of Finance said that "success is much closer than we had hoped, far less distant than many had feared."

The Minister announced the Government's deficit target for 1998-99, $9 billion and set out the budgetary assumptions the Government proposes to use in its 1997 budget.

A. The 1996 Economic and Fiscal Update

The private sector average forecast, as of September, for key planning numbers includes the following for 1997:

Previous governments used internal forecast models as the basis for establishing budgetary assumptions.

On the Committee's recommendation, the Government has applied a "prudence factor" for budgetary planning purposes since its 1995 budget.

The prudence factor for the next fiscal year, 1997-98, is set out below.

B. Fiscal Actions Required

The 1994 budget, this Government's first, put the federal deficit on a downward track.

The 1995 budget resulted in the most far-reaching fiscal reforms of the post-war years and accelerated the pace of deficit reduction so it would be sustainable, reasonable and achievable. It established the on-going Program Review process, a dollar-by-dollar scrutiny of every discretionary expenditure, began the transformation of government itself into a less burdensome, more efficient instrument for achieving public policy objectives.

"We must support and rebuild the research infrastructure ... It is a national tragedy when Nobel laureate Sir Harold Kroto returns to Canada to find that the National Research Council, the vibrant government research laboratory that actually worked, is a shadow of what he knew in the 1960s and 1970s."

Mr. Bruce More (Confederation of University Faculty Associations of British Columbia)
Program Review will have reduced spending by almost $6 billion in 1996-97 relative to where it would otherwise have been. In 1997-98, Program Review will add another $7.5 billion in reductions, followed by an additional $1.9 billion in 1998-99.

By 1998-99, as a result of the actions already taken in these budgets, program spending by the Government will be at its lowest level relative to GDP since 1949-50, and almost 90 per cent of the deficit reduction will have come from expenditure reductions. By 1998-99, departmental spending will be 21.5 per cent lower than in 1994-95, having been cut from $51.7 billion to $40.6 billion over that time.

In terms of specific departments, Defence spending in 1998-99, compared to 1994-95, will be down by $2.5 billion (22 per cent lower), Transport by $1.6 billion (69 per cent lower) and Foreign Affairs and International Assistance by $1.1 billion (26 per cent lower). At the same time, departments concerned with social and justice issues have been relatively protected reflecting the continuing priority given to these services and programs by the Government.

As these actions have pulled Canada back from the brink, the focus must turn increasingly to reducing the size of the national debt relative to the size of the national economy.

The decline in the deficit-to-GDP ratio now underway is expected to continue as government declines in size relative to the size of the economy and growth becomes more robust under the influence of low interest rates. This means that a decreasing share of national revenues will be needed to service the national debt.

And as growth in the economy in 1996-97 exceeds growth in the national debt, the debt too will stabilize relative to the size of the national economy. If now-rising growth predictions are borne out, the debt will begin to decline as a percentage of GDP. It will nonetheless remain high by both Canadian historical and international standards. A sustained period of large operating surpluses -- basically revenue minus all expenditures other than interest on the debt -- will be needed before the debt-to-GDP ratio begins to decline significantly.

Sustained budgetary surpluses will be necessary before the debt can fall in absolute terms and accelerate the "virtuous circle" dynamic now poised to take hold.

The measures now in place will give the next Parliament a broader range of policy choices than the present Government has enjoyed and will give the next Government the opportunity to finish the job begun in 1993.

"The federal government will largely surpass its objectives in the next fiscal year, in the order of $5 billion.

What we are proposing is that part or all of this sum be used on the one hand to postpone the reduction in federal transfer payments to the provinces for health care and social programs.... we think that the provinces, particularly Quebec and Ontario, need a bit of breathing space to allow them to achieve their deficit reduction objectives."

Mr. Yves Morency (Vice-President, Public Affairs, Confédération des Caisses populaires Desjardins)
The Committee believes it is vital to the long-term health of the Canadian economy, and especially the prospects for enduring growth and employment, to resist the pressures to detour from the fiscal course that the government is now on. This is not the time to respond to the siren call for overall tax cuts or proposals to abandon spending cuts already decided.

The Committee reiterates its basic recommendation: Finish the job.

C. Foreign Borrowing Requirements

The result of persistent and rising deficits and debts was an inevitably growing reliance on foreign markets for the capital to finance Canadian borrowing because Canadian savings were insufficient to do so.

In 1995, for example, private savings fell $11.2 billion short of meeting total national borrowing needs. This was a marked improvement over 1993 when savings fell $28.8 billion short of borrowing needs. But it still had to be provided from foreign lenders, increasing the stock of Canadian debt held by foreigners in 1995 to $340 billion.

On-going debt financing in this way over the past 20 years resulted in a run-up of foreign-held debt to the extent that Canada now has the highest external debt-to-GDP ratio of any G-7 country. Servicing this debt had resulted in an increasing share of Canadian income flowing abroad and was a principal reason for Canada having to be concerned with winning the approval of foreign capital and exchange markets, as well as analysts, credit rating agencies and others.

While this worked against Canada in prior years and helped to drive the vicious circle of debts, deficits and debt servicing, the approval of Canada's performance in foreign markets and optimism about Canada's prospects is working in the opposite direction toward a virtuous circle based on declining debt servicing costs, deficits and debts.

In the second quarter of 1996, Canadian sources of savings exceeded Canadian requirements for savings for the first time since 1984. This enabled the stock of net foreign indebtedness of the economy to decline for the first time in more than two decades.

In large measure, this was due to reduced government borrowing requirements, a trend forecast to continue. As the trend continues, and Canada's stock of foreign indebtedness continues to decline, net interest flows to non-residents will fall.

This declining need to rely on foreign savings to finance Canadian borrowing is one of the critical payoffs of the Government's decisive action to turn around Canada's national finances. If this track can be maintained, it will also increase Canada's economic sovereignty and ultimately provide the Government with a broader range of policy choices with which to respond to Canadians' investment, social and other needs.

D. Financial Requirements

The deficit target proposed for 1998-99 of $9 billion will virtually eliminate the requirement that the government go to financial markets for new borrowing, other than that required to refinance existing debt. This has not happened since 1969-70.

As distinct from financial requirements, the Government's Public Accounts deficit reflects the amount by which the net debt grows from one year to the next. This net debt constitutes financial liabilities of the Government less its financial assets, such as loans and investments. Financial requirements, on the other hand, are a measure of the difference between cash flowing in and cash flowing out and consequently represent the extent to which the Government must go to financial markets to borrow. Financial requirements are lower than the deficit to the extent that the Government can borrow against internal financial sources, primarily employee pension accounts.

Financial requirements are widely used in other countries, including the United States, as the benchmark measure of their "deficits". Canada's public accounts approach produces a higher deficit number.

"From the cattlemen's point of view...we are also a major exporter to the United States, so we like the lower dollar. However, on balance I think we'll take the lower interest rates."

Mr. Jim Caldwell (Director of Government Affairs, Canadian Cattlemen's Association)
The Canadian deficit also understates Canada's success in comparison to other countries. Canada, as measured by financial requirements, is substantially ahead of the United States. On the basis of existing planning and legislation, the United States will not eliminate its financial requirements, what it describes as its deficit, until two to four years after Canada.

Compared to the rest of the G-7 economies, Canada has gone from the second worst performer in the G-7 on the basis of financial requirements -- ahead of only Italy -- to the best performer.

The policy decisions necessary to entirely eliminate financial requirements on the part of the federal Government in 1998-99 have now been taken. The critical requirement now is to keep these measures in place so that the objective that is in sight will in fact be achieved.

E. Monetary Policy

(a) The Inflation Targets

"The GDP, the CPI, interest rates, the TSE 300, the exchange rate, are all important. But if we don't legitimize and standardize some measures of child and adult health, of income distribution, of civic vitality, and of educational achievement, if we don't hold those right up there with these other indicators, then we won't have any long-run prosperity.

Mr. David P. Ross (Executive Director, Canadian Council on Social Development)
In light of the strong fiscal performance of the Government, the Bank of Canada's task has been made easier, allowing financial conditions to be more accommodating to durable growth and job creation. It has done so, maintaining a target for inflation in the 1 per cent to 3 per cent range. The Bank has also adopted a reasonable and balanced approach to the management of its central banking function, declaring its concerns for both the danger of increased inflation and the destructive effect on the Canadian economy should a deflationary spiral set in.

Economist Pierre Fortin, however, disagrees with this policy, claiming that maintaining inflation within a 1 per cent to 3 per cent range explains virtually all of our poor labour market performance in the 1990s. He believes that employers are reluctant to cut wages. With high inflation, a wage increase below the rate of inflation is a cut in real wages, but is still acceptable, he argues. On the other hand, with low inflation, a cut in actual wages is not acceptable to employers or employees even though it may mean only a small loss in real wages. Accordingly, when inflation is low, workers are laid off instead of having their wages restructured. The United States, with an inflation rate of about 3 per cent, has lower unemployment than Canada because labour costs can be adjusted without cutting actual wages. He concludes that the monetary policy keeping the Canadian inflation rate near 1 per cent has led to a permanent loss of about 500,000 jobs and recommends that Canadian inflation targets be raised to a range of 2 per cent to 4 per cent.

Gordon Theissen, the Governor of the Bank of Canada, rejects Professor Fortin's thesis. In his view, higher inflation will facilitate wage adjustments only if workers are fooled by the consequences of inflation. He believes that individuals and firms come to recognize over time that wage cuts in a low inflation environment have the same effect as wage increases below the rate of inflation in a higher inflation environment.

Other economists were also sceptical of the Fortin thesis. The study presented to the Committee by Andrew Sharpe indicated that monetary policy was a minor reason, at best, for the current Canada-U.S. unemployment gap. Tim O'Neill of the Bank of Montreal suggested that the Fortin argument required some irrationality on the part of workers and employers. In his view, low inflation has not been around long enough to know for certain that labour markets would not take it into account. The effects that Professor Fortin sees as permanent are more likely to be temporary.

Professor David Laidler, a supporter of the Bank's policy, is also a critic of its tactics, arguing that it has pursued tight monetary policies too vigorously on several occasions, especially during the last recession. While he argues this has raised the unemployment rate, he believes in contrast to Fortin that this is temporary. He also points out that Canadian fiscal policy has only recently enjoyed a high degree of credibility and that changes to unemployment insurance are too recent to have any beneficial impact on unemployment. Finally, he questioned the validity of Professor Fortin's empirical evidence, noting that 60 per cent of the wage settlements cited were public sector contracts. In the absence of a cast iron case for changing the inflation targets of the Bank of Canada, such a change should be resisted because it could adversely affect the bank's credibility and lead to higher interest rates. Maureen Farrow stated that Canada "would lose all credibility if these inflation targets were allowed to drift." Many of the other witnesses had a similar concern that any premature upward revision of the inflation targets would send the wrong signal to financial markets.

The debate that took place during our roundtable discussion indicated that monetary policy is a complex issue and that the inflation targets of the Bank of Canada should be scrutinized carefully when they come up for review in 1998 by the Finance Minister and the Governor of the Bank of Canada. Meanwhile, the Committee opposes any revision to Canada's current inflation targets. Credibility is important. It must be earned and does not come easily. But once acquired, it can provide significant benefits. Twenty consecutive bank rate declines since March 1995 are evidence of this. The Committee does not wish to put these achievements at risk. Our recommendation for monetary policy, as for fiscal policy, is to finish the job.

(b) Bank of Canada Holdings of Government Debt

On several occasions, witnesses have suggested that a painless solution to the Government's fiscal problem is to have the Bank of Canada hold a larger proportion of the federal Government's outstanding debt. In 1976, for example, the Bank of Canada held 20 per cent of the federal outstanding debt whereas its holdings today are under 6 per cent. If the rate were doubled, the Bank of Canada would hold an additional $25 billion in government debt.

To acquire this debt, the Bank would simply print the money, causing massive inflation. To counter this, these monetary critics suggest that banks be required to maintain non-interest bearing deposits with the Bank of Canada as mandatory reserves. They also note that such reserves were required of banks prior to 1992. However, these reserves were used, not to sterilize the monetization of government debt, but as a means of conducting monetary policy. They were abandoned because they were rarely used for this purpose and because other and better instruments evolved.

Mr. Thiessen stressed the inflationary effects that would result from such a policy. He reminded the Committee that when the bank held a large part of the federal debt, that debt was small in absolute and relative terms. Today the debt is much larger. He noted in addition that reserve requirements on banks are effectively a tax that will then be passed on to bank customers. Those who feel they earn too little on their savings accounts would earn even less. Those who complain they pay too much for loans would pay even more. Consumers would search out alternatives from institutions not subject to such a costly reserve requirements, including non-Canadian institutions.

The Committee rejects this approach to fiscal and monetary policy. This allegedly painless solution would be a destructive monetary experiment, damaging our fiscal and monetary credibility in ways that would be difficult to reverse.

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