I. Introduction........................................1II. The Nasty Arithmetic of the Debt and the Deficit....2
III. High Interest Rates and the Deficit: Cause or Consequence?...............................6
IV. The Deficit and Social Welfare Reform: Putting Capital Back to Work.......................11
V. Alternative Monetary Policies for Debt Control.....13
VI. High Interest Rates and Canada's Controlled Recession...............................20
VII. Other Specific Recommendations.....................22
VIII. Conclusion.........................................25
I. Introduction:
The CAW-Canada appreciates this opportunity to present a summary of our views on Canada's economic and fiscal situation to the House of Commons Standing Committee on Finance.
The CAW is the largest private-sector trade union in Canada. We represent over 205,000 members, working in a wide range of different Canadian industries: auto assembly, auto parts, aerospace, specialty transportation equipment, electronics and telecommunications manufacturing, airlines, railways, trucking, marine transportation, mining, fisheries, hospitality services, and a range of other manufacturing and services industries. Next year will mark the 10th Anniversary of our founding as an independent Canadian union. The first Canadian locals of our predecessor organization, the United Auto Workers, were organized in the late 1930s.
We are vitally concerned with the health and future direction of our nation's economy. The general state of employment, economic growth, income distribution, and productivity is crucial to the physical and social well-being of our members, and that of the millions of other Canadians who work for a living.
We do the best job that we can as a union to fight for just remuneration for the work that our members perform, to enhance the safety and comfort of our workplaces, and to implement innovative programs (such as daycare, anti-racism programs, or health promotion initiatives) that benefit our entire communities. But our work as a union hinges not only on the hard volunteer activism and unity of our members; it also depends strongly on the state of the economy. When the economy falls apart around us, we cannot hope--no matter how innovative or unified our organization--to protect and improve the economic and social well-being of our members.
The chronic near-depression that has gripped Canada's economy for much of the last decade has been incredibly bitter and destructive for most of our members. More than 40,000 of our members lost their jobs between 1984 and today, due to plant closure or lay-off: this equals one-third of our 1984 membership.(1) Even those members who have been lucky enough to keep their jobs have felt the painful effects of tough economic times--due to stagnating wages, due to increasingly strident demands from employers for speed-up and work intensification, due to unemployment amongst our families and neighbours, due to the impact of high interest rates on mortgage payments and car loans, due to the generally chilling impact of chronic economic uncertainty on family and social life.
Minister Martin's two discussion booklets outline Canada's economic plight in charts and graphs, using jargon about "continued fiscal discipline" and "total factor productivity". But we see Canada's economic plight outlined graphically every day in the faces of our members. Nobody knows better than our membership the brutal consequences of the stagnant economy in human terms.
This submission will outline the CAW's views on a number of the economic issues facing Canada, and which are addressed in the discussion documents released by Finance Minister Martin. We would also like to add our support, however, to the more comprehensive and wide-ranging submission which you received earlier today from the Canadian Labour Congress (CLC) and its President, Mr. Robert White. The CLC brief covers a wide range of topics with more breadth and detail than we are able to, and is an eloquent statement of views which are energetically supported by our union.
II. The Nasty Arithmetic of the Debt and the Deficit:
Like many Canadians, we are struck by the scope of Canada's emerging public debt problem. We emphatically reject the arguments of many business and political leaders that the only possible solution to this debt problem is to harshly reduce public spending on social programs. And we think that the alleged economic consequences of the deficit and the debt are often misrepresented and vastly overstated.(2)
Nevertheless, we recognize that the recent growth of the public debt is unsustainable, and that it must be brought under control. In fact, there are some progressive, pro-labour arguments about why government deficits, and the accumulating debt which they cause, should be eliminated as soon as is economically and socially feasible. The high interest payments which accompany the debt are highly regressive, shifting income from Canadian taxpayers to bondholders and financial investors who are wealthier-than-average. They also, as the discussion paper "A New Framework for Economic Policy" quite rightly points out (pp. 76-77), tend to "crowd out" public sector spending on more socially useful projects, and rob public spending of much of its stimulative economic effect (since a large and growing share of public spending goes to the bond accounts of financial investors, who do not tend to re-spend that income).
In short, there is nothing "progressive" about deficits, and we think it is quite artificial that debate on this issue has been framed in left-right terms: as a battle between deficit-fighting "conservatives" and an allegedly deficit-friendly "left". The most advanced social-democratic societies of Europe have had among the most consistently balanced budgets in the industrialized world. They provide extensive quality public programs, yet simultaneously have not been saddled to the same degree as other countries with expensive, regressive interest payments.(3) There is no contradiction between public programs and fiscal responsibility.
In short, Finance Minister Martin is not paying attention to his own "deficit arithmetic". "A New Framework for Economic Policy" provides a useful overview of the mathematics that lie behind the problem of compounding, exponentially accumulating debts (p. 82-83). And there is one formula contained in this overview that we want to bring to the attention of Mr. Martin and this committee, because we do not think he has fully understood its implications.
When the real rate of interest exceeds the real rate of economic growth, and when the country is burdened with an accumulated stock of debt, then the stock of accumulated debt will rise exponentially as a share of GDP, unless the government establishes a large and permanent operating surplus (ie. tax revenue less current operating expenditure). This relationship can be summarized in the following equation:(4)
% DELTA D/GDP=(I - G) * D/GDP - OB/GDP
As the discussion paper makes clear, the larger is the initial stock of debt (relative to GDP), the larger must the operating surplus be in order to offset the impact of high interest payments on that stock of debt.
Given the current federal fiscal predicament, and the current imbalance between the real interest rate and the real growth rate, an operating surplus of about $20 billion must be attained, just to stop the accumulated debt from growing any larger as a share of GDP. For the present fiscal year, the federal government expects to fall short of that goal by perhaps $15 billion.(5) That means next year the problem is even worse, because the accumulated debt will account for an even larger share of GDP. Thus by next year, we would need an operating surplus of $20.5 billion (yet another half billion dollars in cuts, assuming no change in interest and growth rates), and so on each year thereafter.
Let us state bluntly what this implies. Given the current accumulated debt, if we accept the current relationship between interest rates and the growth rate, then we would have to cut $15 billion from the government's existing net current annual spending, and sustain that cut forever. But we would not pay off the debt, we would just keep it from rising as a share of GDP. An extra $15 billion in annual cuts, to generate a permanent $20 billion operating surplus, just to service the current debt in perpetuity. This sounds a lot like the whole nation being sentenced to perpetual stoking of the furnaces of hell: a very painful sentence, and one that never ends.
Ministers Martin and Axworthy have both suggested that a large share of the fiscal savings to address the debt problem will have to come from cutbacks to Canada's social programs. To put this in perspective, consider that the entire envelope of social programs being considered by Minister Axworthy currently costs the government some $38.7 billion per year.(6) If the government cut every one of these programs in half--unemployment insurance, support for provincial welfare programs, post-secondary education, child tax credits, and others--it might optimistically expect to achieve the required $15 billion savings (since a share of the immediate savings of cutbacks are offset by lost federal tax revenues due to the resulting lay-offs and lost consumer spending). Even the wildest budget-cutters in the Finance Department would not dare suggest that the Axworthy envelope of programs should be cut in half: huge hardship and social turmoil would result. It is impossible to expect that the needed cuts can come from social programs.
But the picture is even bleaker, because the initial relationship between the real interest rate and the rate of real economic growth is likely to get worse in the near future, not better. Rising interest rates in the U.S. are putting upward pressure on Canadian rates; it is almost universally expected that the U.S. Federal Reserve will significantly increase interest rates in the near future, and this(7) will swamp Canadian financial markets. Rates will definitely increase in Canada,(8) and we may even experience the type of over-exaggerated interest rate spike that we suffered when the U.S. Federal Reserve raised its rates earlier this year.
At the same time, given the continued monetary stance of the Bank of Canada, there is no hope that Canada's vibrant 4% economic growth rate this year can be replicated for much longer. Already there are signs of slowdown: for example, the most recent Statistics Canada data shows that aggregate labour income and housing starts have both declined.(9)
So the structural problem of debt servicing will get worse. Suppose that the real interest rate increases by one point, while the real growth rate slows by one point. Suddenly, the required operating surplus (just to keep the debt-to-GDP ratio from growing) has grown from $20 billion to $32 billion. The required additional cut virtually doubles from $15 billion to $27 billion or more (since the decline in economic growth will simultaneously decrease the government's initial operating surplus, thus necessitating an even larger incremental cut to meet the target operating surplus). If the solution is to be found in cutting social programs, then the envelope of programs being considered by Minister Axworthy would have to be virtually wiped off the government's books.
Using Minister Martin's own arithmetic, therefore, it is clear that the only possible solution to Canada's fiscal quandary is to be found in strategies to reduce the real interest rate. It is the rise in interest rates since 1980 that is at the root of Canada's debt and deficit problem, as his discussion paper implicitly admits.(10) But he has taken this rise in rates for granted, and turned his attention to fruitlessly trying to create a huge operating surplus in a desperate attempt to offset these high rates.
The Finance Minister's mathematical warnings about the looming debt crisis are correct, and we heed them. But he is barking up the wrong tree about where to solve the problem. Quite apart from the unjust and unnecessary social hardship that will be created by a slash-and-burn approach to resolving this problem, it simply cannot work in economic and fiscal terms. Even Preston Manning's slash-and-burn strategy could not create an operating surplus large enough to stabilize the debt as a share of GDP, when real interest rates exceed the rate of economic growth by 3.5 percentage points or more.
III. High Interest Rates and the Deficit--Cause or Consequence?
The conventional wisdom regarding this difficult debt trap that we find ourselves in is to argue that the high interest rates are themselves a consequence of our debt. Interest rates are determined by supply and demand for financial capital, it is assumed. Government deficits suck up available capital, and also lead lenders to demand a higher risk premium; both effects push up interest rates. Thus while high interest rates are indeed painful (as illustrated above), they are the necessary price we must pay for our past profligacy. The only way to bring them down is to first bring down our debt through painful spending cuts (although as also discussed above, the necessary size of those cuts has been vastly underestimated). Then, we will be rewarded by financial markets through lower interest rates, which will make our subsequent debt reduction all the easier--turning a vicious circle into a virtuous one.
One of Minister Martin's discussion papers states this optimistic conclusion as follows:
The problem with this argument is twofold. First, the evidence is overwhelming that high interest rates are not a consequence of deficits and debt, but that they in fact caused our debt crisis. Second, and even more dangerous for Canadians, there is absolutely no evidence to support the conclusion that interest rates will come down if our deficit comes down. Minister Martin's strategy is thus fundamentally unconvincing: a desperate attempt to buy off financial markets with promises of lower deficits. We saw above that it is essential that Canada's debt problem be turned around, and turned around immediately (because each passing year makes it all the more difficult). But social cutbacks alone cannot do the job. And there is no guarantee that "free" financial markets would respond to partial budget cuts in the way that Martin hopes -- by rewarding initial cuts with lower rates that make subsequent budget balancing easier.
The Finance Minister is gambling with Canada's economic future--betting the whole country on his desperate and unproved hope that he can bring down interest rates by bribing financial markets with some symbolic slashing and burning.
We present a variety of evidence which questions the conventional assertion that high deficits, and even the alleged political risk posed by Quebec separatism, are the cause of high interest rates. This evidence simultaneously throws into grave doubt the happy conclusion that interest rates will automatically fall once we demonstrate our fiscal discipline, or once Quebecers demonstrate their renewed commitment to Canada in the upcoming referendum.
Figure 1 indicates the historical path of real interest rates in Canada, and the federal government's deficit as a share of GDP. To the extent that there is even a weak correlation between the two,(11) it is clear that increases in the interest rate have tended to lead increases in the deficit, not vice versa. This was quite convincingly the case with the interest rate spikes of 1981 and 1990, and seems reasonably the case with the other recent episode of high interest rates which began in 1984. Obviously, high interest rates cause deficits by directly increasing the government's debt servicing costs, and more importantly by negatively impacting on economic performance--thus simultaneously increasing government spending on social programs, while reducing revenues from income and sales taxes.
To test the argument that high interest rates result from the political instability caused by Quebec separatism, Figure 2 plots Canadian real interest rates against the percentage vote attained by the Parti Québécois (in provincial elections and in the 1980 referendum). Only in the 1981 provincial election did a surge in separatist sentiment have any correlation whatsoever with a rise in the interest rate--and it is hard to believe that this election, which followed by one year a convincing rejection of sovereignty in the referendum, could possibly have scared bond-holders into fearing for the future of Canada. This correlation is thus coincidental, and there is no other instance in which the rise or fall of separatism was matched by movements in the interest rate.(12) There is therefore no evidence that a pro-federalist vote by Quebecers can hope to reduce the interest rate.
There is thus little evidence within Canada that interest rates would decline even if the deficit or our so-called political instability declined. The evidence is even weaker from other industrialized countries.(13) Figure 3 plots the average government deficit (as a share of GDP) versus a weighted average real interest rate for the G-7 industrialized economies. Here it seems the relationship is equally unclear. If anything, large deficits have tended to be associated with lower real interest rates, indicating that foreign central banks have done a better job than Canada's of reducing interest rates to create jobs during recessions (when government deficits automatically increase).
Similar questions are raised by Figures 4 and 5. It has often been argued this year that the recent rise in global interest rates (which it is generally admitted had nothing to do with government deficits, but was driven by U.S. monetary policy) was felt differently in different countries, according to their degree of fiscal discipline. Canada, it is assumed, was hurt worse than other countries because of our large deficit (and Quebec separatism).
To test this hypothesis, Figure 4 plots the rise (between January and October of this year) in the interest rate paid on long-term government bonds in the 13 largest OECD economies, against the accumulated public debt of these countries as a share of their GDP.(14) The correlation is actually slightly negative.(15) Even countries with accumulated public debts only a fraction as large as Canada's (such as Spain, Australia, Denmark and Sweden) suffered interest rate increases as large or larger than ours.
Similarly, Figure 5 performs the same exercise, except comparing the rise in interest rates to the current public deficit as a share of GDP, rather than the accumulated debt (to test whether the current degree of fiscal discipline of government sends a message to financial markets that is clearer than the level of accumulated debt). The correlation is similarly unconvincing.(16) Once again, countries with deficits smaller than Canada's (including France, Denmark and Australia) also suffered from very painful increases in interest rates. Note that in both Figures 4 and 5, Canada is in the "middle of the pack" as far as debts and deficits are concerned, further undermining the case that our finances are to blame for our high interest rates.
The increase in interest rates this year has been a global phenomenon that has affected virtually all countries.(17) Blaming our debt or political situation for the fact that the rise in Canada's interest rate was marginally higher than the increase suffered in some other countries(18) is folly, and brings to mind the following analogy. A boat sinks in the Caribbean, and all the passengers are eaten by sharks. Some financial analysts, watching from a circling helicopter, start a heated debate about why one passenger was consumed a few moments before the others. They conclude that this passenger was undisciplined, and couldn't swim as fast as the others. Nevertheless, all the passengers were eaten. The financial analysts, of course, lost sight of the main question: why did the boat sink? Unregulated, speculative interest rate increases are sinking the boat of the global economy, and it is time to turn our attention to the main question.
We provide one final, illuminating piece of evidence in support of the contention that high interest rates have caused our debt crisis, and hence that we can have no hope of resolving that crisis unless we reduce interest rates first. First of all, note that the real rate of interest paid on the federal debt between 1950 and 1980 averaged some 3.87%.(19) This is a healthy real return for investors, given the extremely low risk of the investment. Suddenly starting in 1981, this real rate of interest increased dramatically; between 1981 and 1994, the average real interest rate paid on the federal debt has almost exactly doubled, to 7.66%.
We conducted the following thought experiment. What would have happened to the federal deficit and accumulated debt, if this sudden doubling of real interest rates had not occurred? In other words, what would have happened if we had continued paying interest on the federal debt at the same rate--3.87% per year--that we paid from 1950 to 1980?
One way to very conservatively answer this question is to go back and recalculate the federal government's interest payments at the old lower real rate, and then adjust the cumulating debt to reflect the annual savings that were attained. This is an extremely conservative methodology, in that it only considers the direct impact of interest rates on the government's own debt financing costs, but not the equally important indirect impact on other expenses and on revenues due to the impact of interest rates on economic activity. In fact, this counterfactual experiment vastly underestimates the true savings that would have resulted had interest rates not suddenly doubled, because economic growth would in fact have been much stronger through the 1980s and 1990s.
Figure 7 plots the actual and adjusted federal debt as a share of GDP. Once again, instead of needing between $15 and $30 billion of additional cuts to stabilize debt as a share of GDP, this ratio would have already been more or less constant during the past eight years.
This experiment highlights the key lesson underlying Canada's fiscal crisis--a lesson that Finance Minister Martin, by all accounts, has not yet grasped. The dramatic and permanent increase in real interest rates that was engineered at the beginning of the 1980s is clearly the chief culprit behind our growing debt difficulties. It caused our debt by throwing our economy into a permanent, controlled recession. Without any change in government policy whatsoever, this would automatically create vast government deficits, due to the pro-cyclical nature of the government's fiscal balance. And thanks to these very high interest rates, which vastly exceeded any potential rates of real economic growth, that initial deficit escalated into an exponential debt crisis.
The strategy of Ministers Martin and Axworthy now appears to be to try to ram the round peg of what is left of Canada's social programs into the square hole of the permanent, controlled recession. But this is far too little, too late, if they sincerely want to get the debt under control. The only feasible solution is to bring real interest rates back down to a level that can be realistically exceeded by the pace of economic growth. That is the inevitable conclusion of Minister Martin's own deficit arithmetic.
So do not misunderstand the positions that we advance in this submission. We are not "soft" on deficits. To the contrary, we are concerned that this government's stated goal to bring the public debt under control will fail miserably, because it has completely misidentified the true underlying causes of chronic deficits. But if we accept the relationship between the interest rate and the growth rate as given, then even the most radical spending cuts imaginable will not be able to stop the exponential growth of Canada's debt. "A top priority of the government's jobs and growth strategy is therefore to address the factors that are preventing interest rates in Canada from falling to the level warranted by our commitment to low inflation. Specifically, this demands sustained fiscal discipline." A New Framework for Economic Policy, p. 14.
Clearly, the rise in global interest rates has been driven by factors other than the fiscal discipline or political stability of particular industrialized economies. Equally clearly, there is no reason for us to have any faith whatsoever that even the most desperate budget-cutting will bring down interest rates in Canada (at least in light of the current free reign that we provide to financial institutions; more on this below). If we cannot bring down interest rates, then as we demonstrated above, there is no hope that the Finance Minister's strategy can possibly work. The results are dramatic. Figure 6 indicates the actual federal deficit(20) as a share of GPD since 1975, and the estimated adjusted deficit that would have occurred had interest rates remained at their real average during the 1950-80 period. Far from requiring urgent action to bring the deficit down to 3% of GDP, we would already have far exceeded that task.(21)
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