...against fictions and other tall tales

Sunday, 2 December 2012

Austerity in Canada: Then and Now

Canada's economic accounts for the third quarter of 2012 were released last week.  They show a very weak quarter.  Real gross domestic product barely stayed positive, growing by a mere 0.1 percent (see chart 1).  The details can be found here, courtesy of Statistics Canada (click on charts to expand).

Chart 1 Real GDP growth, quarterly % change

Many reasons have been given to explain the economy's weak performance, including the slowdown in China, the fiscal and financial situation in Europe, as well as tepid growth in the US during the summer months.

Of course, as usual, no one is pointing to the fact that Canada is currently undergoing its second most important (i.e., longest and sharpest) bout of public sector austerity in half a century.  One would think that commentators would highlight this reality in their analyses.

As you can see from the chart below, real (consolidated) government expenditure (excluding transfers) has been in decline since the fourth quarter of 2010.  Historically, such a decline in real government spending has only occurred once: during the period of fiscal restraint of the mid-1990s.

Chart 2: Real government expenditures, Source: Statistics Canada and author's calculations
The reason why commentators don't think of austerity as the potential cause of the current weak performance is that Canadians live under the illusion that government spending cuts have little or no impact on the economy.  This stems from the fact that the fiscal austerity put forth during the 1990s gave Canadians (and especially their political leaders) the false impression that cuts in government spending generally help to boost the economy.

Visually, this is how most commentators interpret Canada's experience with austerity in the 1990s (note: I'm not seeking to show a correlation between the two series. I'm simply overlapping both sets of data on a common timeline):

Chart 3: The vanishing deficit and the road to surpluses, Source: Statistics Canada
The standard view holds that fiscal austerity during the 1990s helped to shrink the deficit, thus enabling Canada to run a series of budgetary surpluses throughout the early- to mid- 2000s.  Also, this view holds that fiscal austerity played a crucial role in helping Canada recover from the recession of the early 1990s and contributed to Canada's strong economic performance during the period from the mid-1990s until the financial crisis. 

The problem with this interpretation is that it completely disregards the fact that the Canadian economy during the mid-1990s was impacted by a massive increase in demand stemming from the domestic household and external sectors.  Consider the following charts showing that, as fiscal austerity was undertaken, net borrowing by both the household and external sector exploded in Canada during that period:

Chart 3: Household sector falls into net financial deficit, Source: Statistics Canada and author's calculations

Chart 4: Increased foreign demand to the rescue, Source: Statistics Canada and author's calculations

Net borrowing is the difference between a sector's total spending and income.  It is a key indicator of the demand generated by any sector of the economy. 

Supported by a much easier monetary policy and falling exchanging rate (a consequence of US President Clinton's desire to "have a strong dollar"), the increased net borrowing generated by these two sectors was effective in offsetting the decline in net borrowing of the government sector caused by fiscal austerity.

The increase in net borrowing by the household sector between the mid-1990s and the mid-2000s was unprecedented.  Between 1995 and 2007, net borrowing by the household sector increased by close to 10 percent of GDP (see arrow going down).  As for net borrowing of the foreign sector, it increased by approximately five percent of GDP.  Combined, this additional demand was more than sufficient to offset the decline in demand caused by fiscal austerity.

Today, unlike in the 1990s, the household sector is seeking to reduce its level of borrowing.  And the foreign sector, due to the strength of the Canadian dollar and the weakness of the world economy as a result of global austerity, cannot be a significant source of demand at this time.*

As a result, any attempt by Canada's policymakers to balance the budget in such a context is self-defeating and actually exacerbating the problem given that it is taking away purchasing power from households and firms.  And, as we are witnessing now, it is taking its toll and slowing GDP growth as a consequence.

Economist James Tobin said it best several years ago:
Deficit reduction is not an end in itself. It's rationale is to improve productivity, real wages and living standards of our children and their children. If the measures to cut deficits actually diminish GDP raise unemployment, and reduce future-oriented activities of government, business and households, they do not achieve the goals that are their raison-d'être; rather, they retard them. This perverse result is likely if deficit reduction measures are introduced while the economy is as weak and as constrained by effective demand as it is now.
It's time to think more clearly about these issues.  What "worked" in the past need not be the appropriate course of action today.  The Canadian economy now is not like the one that existed back then.  It's time to move forward.  Trying to relive the "success" of the 1990s will only make matters worse. 


Chart 2 should be entitled "Real consolidated government expenditures (all levels of government) (millions of chained 2002 dollars)". The title and headings in charts 3, 4 and 5 are accurate.  All data comprises expenditures on goods and services, as well as on capital formation. They exclude transfers.

*  The critical point to remember is that, as I've explained before, the government deficit cannot be reduced in isolation from the other sectors of the economy.  Public sector deficits are from an accounting standpoint the equivalent of surpluses in the private sector, plus additional net imports.  The reason for this is that government deficit spending adds to the net accumulation of private holdings of households and businesses (and/or the foreign sector, where applicable).

In other words, any reduction in government spending or tax increase has a direct impact on the financial position of the private sector.  To believe otherwise is wishful thinking.  If external demand and/or increased demand from another domestic sector (households or businesses) are not high enough to offset the demand shortfall created by reduced government expenditures, continued attempts at fiscal austerity will impose additional deflationary pressure on the economy.


Tobin, J., "Thinking straight about fiscal stimulus and deficit reduction", Challenge, March 1, 1993


  1. Fantastic post. After going relatively unscathed by the global financial crisis, it appears Canada and Australia will drive growth downwards (and burst the housing bubbles?) in an attempt to reduce budget deficits.

    I used a couple of your graphs and recommended your post here http://bubblesandbusts.blogspot.com/2012/12/canada-catches-deficit-reduction-bug.html

    1. Joshua,

      Thanks for your support and comment. Your post is right on. One day policymakers in Canada will wake up and notice that relying on asset inflation as an economic driver was a mistake. The housing bubble, a real life game of musical chairs, is reaching its finale. The focus on oil commodity extraction is also misplaced. It's time to apply better economic thinking.

  2. Never too early to enjoy a smack of good insight. Very well done Circuit.

    Although the BoC has sensitized the public and the street with a new conceptual review of its calibers, Stats Canada has had to constrain its data output or has deemed it necessary to exclude certain impressive aggregate indicators. The former should be congratulated for its conceptual curiosity and integrity; to the latter, one should sympathize in having to bend to the 'slings and arrows of outrageous fortune' in government action that compels delimiting the quality of output of one of the most prestigious institutions in the global economic community: Statistics Canada. The debilitating consequence of austerity and budget reductions is that one inadvertently undermines pillars of the democratic process-in this case relevant economic information-the foundation of democratic deliberation and decision-making. It is a commendation that FRB pursues a mission of filling in the gaps that StatsCan has had to suffer. One can only praise the compendium of graphic innovation and pursuant insight that gets published in this blog. I think I commend on behalf of many.

    To the BoC, stay the course. The departure of Governor Carney will leave a charismatic void; it will not pejore the situation. To Mr. Carney one wishes the best of fortunes. Unfortunately, Mr. King will be a monumental act to follow-professionally and ethically. Few have stood up to their Governments and fewer have admitted their own shortcomings and resistances ( I do not include Greenspan among the latter-his was a caricature).

    On the other hand, Circuit and your audience have both demonstrated much empathy with and credence in Mr. Carney's leadership to date, and I share, within an equilibria, a similar disposition. However, the UK is in a squall similar to Canada, but we don't wish to recognize it. The question: do good captains navigate well or do they need good navigators. Europe is not an innoccuous shoreline; the UK is even less.

    1. Thanks Swells. It'll be interesting to see whether Mark Carney brings his analytical approach to the BoE. Certainly, he will make good use of it. More uncertain is whether the BoC will continue to view the challenges using the sectoral balances view.

      As for Statistics Canada, it is true that the last year has brought many changes in their products. I've had to adapt somewhat my 'craft'. Hopefully the rate of delimiting changes in their output will slow in the coming year. StatsCan has always employed the best in the country. I've learned much from the work of economists in the National Accounts group. As in the past, the pool of talent at StatsCan today is impressive. A fine institution, indeed.

    2. I suppose you are skeptical about Flaherty's ability to balance the budget within the next few years. Your article has convinced me, that's for sure. Very good, Circuit.

    3. Thanks TP: I actually think the federal government *could* balance its budget. But I seriously (very seriously) doubt that the government sector as a whole (all levels of government) could achieve a balanced financial position. In other words, the federal government could achieve a balanced budget by worsening the financial balance of the provincial governments. I doubt that household, business and foreign sectors will increase its net borrowing in any significant fashion to enable the federal to reduce its net borrowing. But federal deficit reduction could have the effect of increasing the net borrowing of provincial government. Remember that in Canada, unlike in the US, provincial governments are not required to balance their budgets.

  3. Very good article. I agree with the previous comments: your charts are worth a thousand words.