Insight: Lessons for U.S. from Canada's 'Basket Case' Moment

Finance officials bit their nails and nervously watched the clock. There were 30 minutes left in a bond auction aimed at funding the deficit and there was not a single bid.

Sounds like today's Italy or Greece?

No, this was Canada in 1994.

Bids eventually came in, but that close call, along with downgrades and the Wall Street Journal calling Canada an honorary member of the Third World, helped the nation's people and politicians understand how scary its budget problem was.

There would have been a day when we would have been the Greece of today, recalled then-Prime Minister Jean Chretien, a Liberal who ended up chopping cherished social programs in one of the most dramatic fiscal turnarounds ever.

I knew we were in a bind and we had to do something, Chretien, 77, told Reuters in a rare interview.

Canada's shift from pariah to fiscal darling provides lessons for Washington as lawmakers find few easy answers to the huge U.S. deficit and debt burden, and for European countries staggering under their own massive budget problems.

Everyone wants to know how we did it, said political economist Brian Lee Crowley, head of the Ottawa-based think tank Macdonald-Laurier Institute, who has examined the lessons of the 1990s.

But to win its budget wars, Canada first had to realize how dire its situation was and then dramatically shrink the size of government rather than just limit the pace of spending growth.

It would eventually oversee the biggest reduction in Canadian government spending since demobilization after World War II. The big cuts, and relatively small tax increases, brought a budget surplus within four years.

Canadian debt shrank to 29 percent of gross domestic product in 2008-09, from a peak of 68 percent in 1995-96, and the budget was in the black for 11 consecutive years until the 2008-09 recession.

For Canada, the vicious debt circle turned into a virtuous cycle which rescued a currency that had been dubbed the northern peso. Canada went from having the second worst fiscal position in the Group of Seven industrialized countries, behind only Italy, to easily the best.

It is far from a coincidence that the recent recession was shorter and shallower here than in the United States. Indeed, by January, Canada had recovered all the jobs lost in the downturn, while the U.S. has hardly been able to dent its high unemployment.

We used to thank God that Italy was there because we were the second worst in the G7, said Scott Clark, associate deputy finance minister in the 1990s.

Canada's experience turned on its head the prevailing wisdom that spending promises were the easiest way to win elections. Politicians of all kinds and at all levels of government learned that austerity could win.

I WILL DO IT

The turnaround began with Chretien's arrival as prime minister in November 1993, when his Liberal Party - in some ways Canada's equivalent of the Democrats in the U.S. - swept to victory with a strong majority. The new government took one look at the dreadful state of the books and decided to act.

I said to myself, I will do it. I might be prime minister for only one term, but I will do it, said Chretien.

A shrewd political strategist, Chretien believed Canadians were on board, after they were shocked and embarrassed a year earlier when Standard & Poor's downgraded Canadian foreign currency debt to AA plus from AAA.

He wanted history to remember him as the man who rescued Canada from financial ruin and humiliation.

Chretien sat his skeptical Cabinet down and laid down the hard truth. He would get rid of the deficit, it would be painful and unpopular and nobody would be spared. There was no choice, no room for negotiation. It had to be done.

The chill in the room was such that newly appointed junior minister for veterans affairs, Lawrence MacAulay, called his wife afterward to say he would soon be out of a job.

He said, 'Darling, I will be back home in the next election. I will be defeated, because the prime minister explained to us this morning what he intended to do,' according to Chretien's recollection.

MacAulay, who represents the Prince Edward Island fishing community of Cardigan, has been re-elected six times and sits in the House of Commons today. He couldn't be immediately reached for comment to recall the conversation.

RAISING THE ALARM

Canada's scrape with disaster had been building for a long time.

Over a decade earlier, top finance department bureaucrats had begun raising the alarm about the problem of rising debt, a hangover from the big government era of the 1970s.

The period before Chretien came to power in Canada is often likened to the situation in the U.S. today. The country was not yet peering over a precipice, but was fast approaching it.

Clark said he and his colleagues sent memos to their bosses in the 1980s explaining the arithmetic: growth was low, interest rates were high and it was only a matter of time before Ottawa would not be able to pay interest on its debt.

But successive governments ignored the warnings and wrote budgets that allowed spending to continue to grow.

It was hugely frustrating, said Clark. Every year we put out forecasts showing the deficit going away. We just based every budget on ridiculous assumptions.

The budget deficit more than doubled between 1980 and 1990, rising to 8 percent of GDP in 1983 and 1984, before shrinking to a still unsustainable 5.6 percent just before Chretien took over, and all the time debt was soaring. The debt-to-GDP ratio shot up to 67 percent in 1993-94 from 29 percent in 1980.

The numbers aren't that different to the U.S. today with its deficit of around 9 percent for 2011, and debt-to-GDP ratio at 74 percent, up from 40 percent at the end of 2008.

Drawing a parallel to Washington, Clark said Canadian leaders before Chretien paid lip service to the debt problem but did nothing.

There are no lights blinking saying you're at the edge of the cliff, he said. The one lesson others can give the U.S. is that the higher that debt-to-GDP ratio goes, the more difficult it's going to be.

Canada already faced a gaping current account deficit, a weakening currency and high interest rates, and more misery was inevitable if the debt crisis wasn't addressed.

The first kick in the teeth from abroad came from the October 1992 S&P downgrade.

Even two decades later, Don Drummond, in charge of the budget at the finance ministry at the time, bristles at the memory, saying that the downgrade should have been completely irrelevant because so little of Canada's debt was in foreign currency. But the damage to public opinion was done.

We were just mobbed by the media. Here's some foreign institution that says Canada is a basket case. If we had had a Canadian agency downgrade us, probably nobody would have shown up, said Drummond.

The politicians had ignored the bureaucrats, but there was no way to sweep international criticism under the rug.

Fear drives people. It drove us, said Clark.

THEY DON'T GET IT

The Liberals thought their first, rushed budget - delivered in February 1994, three months after taking office, was tough.

It reformed unemployment insurance entitlements, and cut defense and foreign aid, as well as closing some business tax loopholes and ending a C$100,000 lifetime capital gains exemption. The savings totaled C$10 billion over two years.

The government said it would review all programs and predicted a deficit of 3 percent of GDP in 1996. But program spending was still budgeted to rise slightly, and the budget was widely seen as a failure.

Pete DeVries, who headed the fiscal policy division, remembers overhearing chatter from economists' and others as he waited for a flight to Toronto just after the budget.

The mood was so depressed on that plane that I thought we're never going to get off the ground and if we did get off the ground we'd crash, because it was just doom and gloom, he said. Everywhere you heard the words, 'They don't get it. They just don't get it.'

Voters certainly didn't get it. People who had canceled vacations or taken a second job to make ends meet in the recession couldn't understand why Ottawa thought it could live beyond its means.

The upstart Reform Party, then the main national opposition party, had campaigned on zero-in-three - balance the budget in three years. We were always trying to go faster, said Reform's leader at the time, Preston Manning.

Three months later, Moody's Investors Service lowered its rating on Canada's foreign currency debt, citing the government's large and growing debt.

In December 1994, Mexico suffered a run on its currency and the following month the Wall Street Journal stung with its Bankrupt Canada editorial, lumping Canada with Mexico as a country that might need an International Monetary Fund bailout.

STIFFENING SPINES, AVOIDING CLIFFS

The Liberals were stung by the criticism and, at first reluctantly but then with gusto, they got out the chain saws.

I think the Moody's and Wall Street Journal stuff reflected what we knew inside, said then-industry minister John Manley.

Cutting government spending programs went against the Liberal grain. Contrary to the Reform Party, the Liberals saw a more important role for government.

Paul Martin now has a lasting reputation as the finance minister who slew Canada's deficit, but the conversion from spender to cutter was painful. His father, also called Paul, had helped create Medicare, Canada's publicly funded health care system, and suddenly here was Paul Jr. contemplating massive cuts.

Clark remembers riding in a taxi with Martin after meetings in New York.

He said, 'I don't want to do this. I don't want to do this.' And I said to him, 'You don't have any choice because if we don't do it that means you won't be able to keep the programs you've already got. We're going to go over the cliff and we'll be cutting like you won't even believe,' Clark said.

We told him you are still a Liberal but you have to be a small 'c' fiscal conservative to be a nice good Liberal.

In the end, Martin famously vowed to tackle the deficit come hell or high water.

Chretien and Martin later parted ways bitterly, but they formed a formidable duo during the budget cutting.

At one 1994 Cabinet meeting, Martin announced a spending freeze. A minister put forward a project that needed funding but Chretien cut him off, reminding him of Martin's freeze.

A second minister raised his hand to ask for funding, and a testy Chretien told the Cabinet that the next minister to ask for new money would see his whole budget cut by 20 percent.

Chretien's scrappiness, which was one result of his upbringing in a working-class family in rural Quebec, had already earned him the nickname of Dr. No when he was finance minister in the 1970s.

The prime minister was the man with the steel rod up his spine. He was inflexible, Manley said.

For ministers it was brutal. Manley lost half his budget as industry minister in the 1994 budget and went from 54 programs down to 11.

Everyone knew they had to face the music, and they did it, Chretien said in the interview in his law offices. They had no choice. There was no great debate. I had made my view very clear.

MORE SPENDING CUTS THAN TAX HIKES

The ratio of spending cuts to tax hikes was seven-to-one. Asked why, Chretien said simply: There was more need on one side than the other.

That contrasts with proposals this year by President Barack Obama and the Democrats to have a much higher proportion of revenue increases in the deficit-tackling mix.

Canadian ministers were told how much they had to cut and then told to come back with a plan on how to do it. Cuts ranged from five percent to 65 percent of departmental budgets and included controversial cuts in transfers that help provinces pay for health and education, decisions that lengthened medical waiting lists for years to come.

Chretien exempted just a few areas from the cuts, including the Department of Indian and Northern Affairs. He also blocked big changes to benefits for the elderly and made sure tax collectors had enough resources.

In the end, program spending (everything except interest payments on the debt) fell by about 12 percent, or C$14 billion, between 1994-95 and 1998-99. The percentage fall was substantially more after adjusting for inflation.

The gloomy Canadian reaction to the 1994 budget changed to applause in 1995. People came up to me to say, 'You guys got it,' DeVries said.

The deficit disappeared by 1997 and the debt-to-GDP ratio began a rapid decline - it is now at about 34 percent.

The entire political class decided to stop treating this as a matter of political contention and started treating it as a matter of national interest, said Crowley, the political economist.

After wrestling the deficit to the ground, Canada enjoyed what Crowley calls the payoff decade, outperforming the rest of the G7 on growth, job creation and inward investment. From 1997 to 2007, it averaged 3.3 percent economic growth. while U.S. growth averaged 2.9 percent.

The Canadian dollar weakened from around C$1.38 to the U.S. dollar at the time of the 1995 budget to almost C$1.62 in 2002, helping make Canada more competitive. But it has since roared back and now stands close to parity with the greenback.

SHEER DUMB LUCK

Canadians are the first to admit that a lot of their success was the result of good timing that cannot be replicated today. The rosy global economy then contrasts with today's turmoil. There was no euro zone crisis to worry about. The United States and China were growing fast, demanding Canadian exports. Nobody else was reining in spending.

Canadian interest rates plummeted by more than 1,000 basis points between 1990 and 1994, generating huge savings on debt payments and encouraging business investment.

Clark says the U.S. dollar's role as the world's reserve currency may be disguising Washington's problems and means the critical period could be a ways away.

There's no market discipline, said Clark. People want to buy U.S. Treasuries and they always know they will get paid.

The parliamentary political system also helped Chretien, since there is no effective division of powers between the executive and legislative branches as in the United States. A prime minister with a majority in the House of Commons can push through whatever he wants.

And politicians were almost all on board. The opposition Reform Party was screaming for even deeper cuts and public opinion was ahead of the politicians in calling for austerity.

SACRED COWS

Some of Canada's lessons are applicable elsewhere and Britain's Liberal Democrats and the Conservatives both cited the Canadian model when peddling their austerity plans to voters in their successful 2010 election campaigns.

Chretien said he had had no qualms in telling Britain's coalition government that it was wrong to exempt areas such as the National Health Service, regarded as sacred by many in Britain, from the drastic spending cuts.

I told them they made a mistake, Chretien said. I remember talking with a very senior person in health who said to me privately, 'I'm not very happy that I'm exempt' ... He needed the same pressure as the others.

The Canadian mantra was to go big, spreading the pain and sparing no one, to prevent rivalries and resentment.

You have to take immediate action and it's got to be primarily on the spending side..., but at the same time everybody has got to come to the market and that really means tax increases as well, Martin told Reuters in August.

CANADIAN LESSONS

Members of the deficit slaying team have since advised countries as far ranging as Bahrain and Bangladesh. Canada has touted its fiscal record to push for coordinated deficit reduction in the Group of 20 most powerful economies.

Some veterans of Canada's successful rebound believe the United States needs a value-added tax similar to the Goods and Services Tax Canada's Conservatives introduced in 1991.

The Liberals say they were pragmatic, not ideological, on taxes. But they could not boost tax revenues much because Canadians' top marginal income tax rate was already uncompetitive at around 55 percent and the unpopular GST was already on the books.

Reform Party's Manning said the U.S. spending-versus-tax debate does not have to be a question of either/or, but he saw a lesson from the way Ottawa cut its own fat before holding out its hand to taxpayers.

So you don't completely rule out tax changes or tax increases in the future, but you make them conditional on achieving a certain degree of financial order now, he said.

Former bureaucrats also say flat, across-the-board spending cuts are a bad idea, even though it's more palatable to staff to shave 5 percent off the top of each program.

Unless whole programs are killed, departments might simply postpone vitally needed capital spending, including such things as maintenance and repair, and have to boost it back to former levels within a few years.

The final lesson is that you can impose painful spending cuts and still win elections. Chretien went on to win two more back-to-back to form majority governments, a rare feat. He argued that a responsible Liberal who believes the state has a role in reducing poverty can only do so by ensuring a financially healthy government.

Drummond, who later moved to the private sector and is now an advisor helping the Ontario provincial government slash its deficit, noted that governments on the right and left in Saskatchewan, Alberta and Ontario won more voter support after their own budget cuts in the 1990s.

Brutal, brutal fiscal restraint, and all won majority governments right afterward, he said.

(Editing by Janet Guttsman and Martin Howell)