There is something farcical about the possibility of the Cameron-Clegg coalition breaking up over the referendum on preferential balloting. The coalition couple is having a domestic spat over setting the dinner table, while ignoring smouldering embers threatening to burn down the house. AV or no AV, your average Brit will be unaffected. But should the coalition’s radical fiscal policy fail to produce its promised results, hundreds of thousands more will be unemployed, homes will be lost, families’ dreams shattered and the nation’s economy left a shambles.
The warning signs are popping up all over. With rising inflation and slower growth, the UK could be facing higher interest rates and lower than anticipated tax revenue. Deficit targets, according to the National Institute of Economic and Social Research, will likely not be met. Unemployment is still rising and may surpass three million.
Yet, on the first anniversary of its election win, the Cameron-Clegg government shows not the faintest sign of reconsidering its extreme spending cuts and (more modest) tax increases. From whence did this unshakable determination arise?
Cameron and Clegg’s resolve is reportedly at least partly based on the example of Canada’s elimination of its deficit in the mid-1990s, an example that Cameron leaned on heavily in the run-up to the general election. But if the reasons for Canada’s deficit-cutting success were properly understood, the coalition would instead today be pedalling briskly backwards rather then doggedly pressing on. The secret of Canada’s achievement is to be found neither in the steely resolve of our politicians nor in the mechanics of our cutting exercise: deficit reduction worked in Canada because of the economic conditions prevailing at the time, including monetary policy, employment growth and rising exports. The lesson to be learned from Canada is this: UK fiscal consolidation will likely not work precisely because the conditions under which Canada succeeded do not exist in the UK today.
Like the UK, Canada undertook its fiscal consolidation in the wake of a deep recession and consequent exploding debt, but that is where the resemblance ends. Canada’s recession was not due to the collapse of the financial sector, as was that in the UK. In the late 1980s Canada was enjoying a mighty economic boom, which everyone in perfect hindsight can now see was a bubble. Jobs were plentiful. Then in response to rising inflation, which was creeping above five per cent, the Bank of Canada decided it was time the party ended. The bank jacked up interest rates, creating a prime rate over 14 per cent in 1990. This burst the bubble. Higher interest rates drove up the Canadian dollar, decimating exports. Canada dropped into an economic black pit of recession.
But by 1994 Canada had begun a robust recovery. Real GDP increased by 4.8 per cent with little inflation. Exports to the US were booming, fuelled by the beginning of the longest run of economic growth in modern US history. Over 400,000 net new jobs were created. Yet the central government remained saddled with a monstrous debt, spending 35 per cent of its revenue on interest payments. Canada’s total net public debt hit 70 per cent of GDP second only to Italy in the G7. It was then that the Chretien government decided to take action. In Chretien’s words, the time to reduce deficits was when the economy was growing. In Canada, unlike the UK, economic growth was a precondition of fiscal consolidation, not a hoped-for outcome.
Canada’s spending cuts were far from painless, but they occurred against a background of robust economic growth, a trade surplus, no inflationary pressure and easing monetary policy. The Bank of Canada was able to take interest rates swiftly down to historic lows. Between 1995 and 1997 prime rates fell from eight to three per cent. In contrast the UK begins its fiscal consolidation with interest rates already more or less at zero. UK interest rates have nowhere to fall, only to rise.
The Canadian dollar followed interest rates down as well. Exports into the US more than compensated for the contraction in domestic demand created by the cuts. American consumers generously substituted for Canadian consumers.
With unemployment falling and businesses expanding, the political fallout from cuts was minimized. The Chretien government won two subsequent elections. By 2008 net government debt in Canada had declined to 22 per cent – the lowest in the OECD. Due mainly to lower interest rates, interest payments on federal public debt fell from six per cent of GDP in 1995 to two per cent in 2008, taking up just 13 per cent of revenue.
Canada’s experience in the mid-1990s is one of the rare examples of a successful fiscal contraction. But Cameron has been blinded by this success story and has been too hasty in following the fiscal contraction creed. It was not the cuts that created economic growth: rather it was economic growth that created the room for cuts.
None of Canada’s economic conditions in 1995 apply in the UK in 2011. The UK is not currently experiencing vigorous economic growth, to say the least. Unemployment is high and rising, not falling as it was in Canada in 1995. The UK’s main export markets are anything but booming: the US, Spain and Ireland alone account for about 25 per cent of UK exports. These countries are not going on an import binge anytime soon. It is impossible for monetary policy in the UK to be deployed to counteract fiscal policy as occurred in Canada. Instead the very opposite may happen, with simultaneous fiscal and monetary contraction.
The lesson from Canada is not about how to cut the deficit: it is about when to cut the deficit. At its peril, this is a lesson the UK seems not to have learned. Should the Cameron-Clegg coalition survive the AV referendum, we shall see if it can also survive the much deeper malaise of failed economic policy in the coming years.