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Canada was in such bad shape in the early 1990s that its dollar was called the “northern peso” and the Wall Street Journal sarcastically called Canada an honorary member of the Third World. Liberal Prime Minister Jean Chrétien took office in 1993 and put Canada on a brutal austerity diet. Big spending cuts and smaller tax increases took the federal budget from a big deficit to a surplus in just four years. And Canada’s economic growth rate accelerated from less than 3 percent in 1993 to more than 4 percent in 1998.
An editorial in the Washington Times last December said the U.S. “ought to follow the example of responsible nations” like Canada. Reuters reported last November that members of Canada’s deficit-slaying team “have since advised countries as far-ranging as Bahrain and Bangladesh.” Canada’s National Post credits Chrétien’s Liberal government with keeping the lid on spending after growth recovered, noting, “Most governments would not have been so restrained.”
But Canada’s impressive achievement is not necessarily a good example for the U.S., where premature austerity is likely to harm growth. Canada benefited from special circumstances that don’t apply south of the border. A report today by economist Neil Dutta of Bank of America Merrill Lynch concludes that “Canada’s experience is more the exception than the rule.”
Key points from Dutta:
• In Canada, austerity helped lower interest rates. Rates are already super-low in the U.S., so there’s no room to improve.
• In Canada, austerity lowered the value of the Canadian dollar, which made Canadian goods more competitive on world markets. The U.S. is a relatively self-sufficient economy, so it would benefit less from a depreciation, even if one occurred.
• Canada benefited from growing demand for its products from the U.S. and China, which compensated for the chilling affect of deficit reduction. No countries today are eager to soak up more imports from the U.S.
• Canada is indeed an exception. An International Monetary Fund study looked at 172 fiscal policy changes in rich countries and found that on average, reducing the budget deficit by 1 percent of GDP reduced output by two-thirds of a percent and boosted the unemployment rate by one-third of a percent.
Bottom line: If an economy is already suffering from a shortfall in demand, as the U.S. is today, cutting demand further through fiscal austerity can make matters worse, not better.
For more on this, check out my Opening Remarks column in the current issue of Bloomberg Businessweek.