Hell or High Water

by Paul Martin

  We had another problem as well. Canada had the highest debt-to-GDP ratio among the G8 countries, except for one. That was Italy, which on the face of it had dug an even deeper hole than we had. Yet it was not subjected to the same kind of market pressure that we were. Why? Because Italy’s debt was largely held by Italians, while ours was mostly in foreign hands. We didn’t just have a fiscal issue; we had a sovereignty issue, because foreign lenders were much more likely than our own to act on a momentary shift in sentiment and move their money elsewhere, forcing us to jack up interest rates.

  In the years to come, we were able to address this problem by rolling our debt into longer term bonds. We paid higher interest rates when we did this, but it meant that we did not have a ninety-day clock running on our debt, exposing us to a sudden flight in interest rates every time there was an economic shock, either here at home or abroad. But this was 1994, and the ticking of the debt clock was thunderous.

  One stop on my post-budget tour in the spring of 1994 was Japan. I was surprised to see on the schedule that my officials had lined me up to meet the minister responsible for the Japanese post office. When I asked why, I was told that the post office was the largest savings institution in Japan and that it held a lot of Canadian debt. When I arrived for the meeting, I heard someone whisper “Canada” into the minister’s ear. He had a large tabbed binder that obviously contained information on a variety of countries. I could see that most of them had just a few pages of documentation. I could also see that there was a thicker tab on one particular country, which I assumed was some struggling place in the developing world. When our conversation began, of course, I realized as he flipped to it that the oversized tab was for us.

  I had stood up in the House of Commons on budget day in 1994 thinking that I was delivering a pretty sound document. By historical standards, it was. I remember Preston Manning, then leader of the Reform Party, coming to the finance committee one day when I appeared and remarking that I was clearing the bar only because I had set it at three feet high. Jim Peterson slipped me a note commenting that that was pretty good when you were standing in a hole six feet deep.

  The “hole” he was talking about was the fact that the government’s largest single expenditure was servicing the debt: thirty-six cents out of every dollar. Things were so bad we had long since stopped borrowing to build a stronger future; we were borrowing to pay the interest on debt governments had incurred to pay the interest on debt that previous governments had incurred, if you get my drift. While my first budget may have succeeded by the standards of my predecessors, it had not passed what I now believed was the critical test for the markets — that of re-establishing Canada’s fiscal credibility. This was the marker we simply had to hit in my second budget. I believed I had one more shot at it, but that was it. If I could not restore Canada’s credibility in the 1995 budget, there might be no reversing the vicious cycle of rising interest rates and increasing deficits and debt.

  I had no trouble convincing my officials at Finance that this was the case. But they had seen previous finance ministers come to similar conclusions and fail to take the drastic steps necessary to set us right. The markets weren’t the only ones who had experienced serial disappointment.

  As I prepared for the next budget — certainly the most challenging I would ever produce as minister of finance — I knew that success would depend on the team I had working with me. I had been critical of the department, but I also made it clear from the start that my plan was to restore its reputation as the elite of the public service, in terms of intellect and accomplishment. Indeed, the right people were all there; they knew what to do. The problem was that there had not been the political drive to achieve what they knew needed doing. At the top of the department were people such as David Dodge, Scott Clark, Don Drummond, Ian Bennett, Pete de Vries, Paul-Henri Lapointe, and Munir Sheikh who could have been making their mark — and lots more money — elsewhere. They were public servants because they believed in the importance of the department’s work. Some of the other officials who struck me as falling into this category were Kevin Dancey, who had left one of the big accounting firms to come to Finance as head of the tax section, and Len Farber, who seemed to have been weaned on tax policy. When I got into an argument with the department over taxes, I often had my way, but I quickly learned that when Len said no it was time to stop pushing; he was invariably right. Susan Peterson was also part of the core team, working on federal-provincial relations, social policy, and the Canada Pension Plan, as was Barbara Anderson, whose knowledge of the North and Aboriginal affairs was invaluable. Later on we also recruited Jackie Orange to head up our efforts to give new life to Canada Savings Bonds.

  We also recruited an outsider. David Dodge mentioned to me that there was something called the Clifford Clark visiting economist program, which was designed to bring outside scholars into the ministry. This seemed ideally suited for Peter Nicholson. Crucially, as the Clifford Clark scholar, he would not be lodged in my office as an adviser but would operate from within the guts of the department, where he could examine the issues from the inside but with the perspective of an outsider. He contributed significantly in the year to come with the development of the so-called grey and purple books that laid out the macroeconomic context in which we were working and foreshadowed the program of investments in areas such as education and research that we would initiate once the deficit was under control.

  Finally, I was fortunate in the appointment to Finance of two MPs who brought particular skills to the job. Doug Peters, as secretary of state for financial institutions, brought an outside expertise to our debates that balanced the department’s institutional memory. David Walker, my parliamentary secretary, added a Western perspective and passion for the social responsibilities of government.

  It was a tremendous team, though I have to admit with regret that I did not make much progress in making the department less male, white, and anglophone than it had always been.

  Soon after joining us in the department, Peter Nicholson put the challenge of the deficit in particularly startling terms. He asked what the deficit would be in five years if we maintained the status quo. “Would you believe $60 billion?”

  There was a stunned silence.

  “Look,” Peter said, articulating the point I made everywhere I went in the coming years, “this fiscal problem isn’t a matter of ideology; it isn’t something that should separate left from right. It is the arithmetic of compound interest. And if we don’t deal with this, no government is going to be able to achieve the social objectives the public wants it to.”

  It was a powerful argument. It was also clear to me that if we could break out of this vicious circle, there would be an equally dramatic “virtuous circle” of lower interest rates, declining deficits and debt, and a stronger economy. This was what we were going to need to face the growing Asian competition that was no longer simply a speck on a faraway horizon.

  One of the elements in the vicious circle was that governments of all stripes had employed what was called the “hockey stick approach” to the pain required in attacking the deficit — always deferring real cuts to sometime in the future. Repeatedly, finance ministers had laid out plans for expenditure reductions that when illustrated on a graph looked like the blade of a hockey stick resting on the ice for the first couple of years, with the shaft representing the cuts jutting sharply upward only in the third or fourth year. Of course, governments never really got to the shaft of the stick, and therefore very little ever happened. To change this, I insisted on “two-year rolling targets.” That is to say, in each budget we would lay out what we needed to do in the coming two years only and not make faraway promises. That meant our progress could be tracked in close to real time. It also meant that for the moment, we could keep everyone’s eyes fixed on the Red Book promise of getting the deficit down to 3 per cent of GDP, even though I was already determined to eliminate the deficit altogether.

  Another equally import
ant innovation in budget planning had already been adopted in our first budget in the form of a “contingency reserve.” One of the little secrets of economic forecasters is that they design their models on the basis of past experience, then plug in what seem to them reasonable assumptions, and hey, presto! You have a forecast. Ask them what happens if the price of oil doubles, or a war unexpectedly erupts halfway across the globe, or the Asian banking sector collapses, and they say, “Well, that’s outside our assumptions.” The problem is that something unexpected always happens. And although you can have good surprises as well as bad, it was the bad surprises I was worried about. In order to have a truly robust plan for conquering the deficit, we needed to have a “contingency reserve” that would act as a shock absorber against bad economic news. In other words, if catastrophe struck — or even something much less than catastrophe but large enough to throw off our planning — we needed to be able to take the shock without rushing in an emergency budget or, worse still, allowing it to deter us from our path. Governments had included “contingency funds” in their budgets before, but these had been designed to deal with unexpected expenditures. Ours was not for spending but for dealing with unforeseen bad economic news. If the news was good, on the other hand, the money would automatically be used to reduce the deficit and eventually to pay down debt, thus lowering our borrowing costs.

  Just to give us one additional level of assurance, when we calculated our budgetary plans, we used “prudent” assumptions. In other words, if the economists were predicting growth between 2 and 3 per cent, we might make our calculations on the basis of 1.8 per cent growth. This was the opposite of what previous governments had often done, preferring to work with the sunniest possible scenarios, which made their budgets look good on budget day but quickly diverged from economic reality. Sad to say, as I sit here writing in 2008, it is a bad practice that the current government has resurrected.

  These policies really showed their worth after the September 11, 2001, attacks. When the terror struck out of a clear blue sky, not only was there a sudden, unexpected economic shock, affecting both the stock market and the underlying economy, there were also new and entirely unanticipated demands for expenditure. As a result of our belt-and-suspenders budget planning, we were able to absorb $8 billion in new spending over the next few years for border security, intelligence, and the military, including our commitment to Afghanistan. We did all that, and we were able to do it without falling back into deficit.

  As we approached the difficult job of cutting spending, Peter Nicholson developed the concept of what he called the “four pillars”: spending by federal departments, transfers to the provinces, Unemployment Insurance, and Old Age Security. These categories accounted for nine-tenths of the government’s costs (excluding servicing the debt, of course). It was clear to me that we needed to keep two objectives in my mind as we cut. First, we had to make structural changes that would not only yield a reduction in the deficit right away but would ensure that governments did not easily lapse back into their old habits once the short-term crisis had been bridged. And second, we had to make sure that the pain would be evenly spread. I was convinced that individual Canadians would not accept a program of restraint if they believed that they were being hit while others were escaping untouched.

  I had already signalled in my first budget that we were going to conduct a comprehensive review of government programs. I had long believed that the structure of government was out of whack. Our spending was in the wrong areas, and governments had tended to adjust it with incremental cuts to particular programs or, more frequently, incremental increases, without ever re-examining their priorities in a fundamental way. That was the reason for the “program review” I announced in the budget. Originally the idea was to conduct this review over five years. Marcel Massé, the former clerk of the Privy Council under Mulroney, who had run for us in 1993 and been appointed president of the Treasury Board, was to chair the review. Marcel knew the ins and outs of the government in a way that I could never hope to, and he was perfectly suited to the job. The idea was that he would lead a panel of ministers, including some of the left-leaning ones, who would conduct the exercise, in the hope that it would win some buy-in from cabinet.

  What I did not foresee was that I would return from my alarming tour of the capital markets after the 1994 budget convinced that the five-year exercise I had envisaged was going to have to be completed in time for the 1995 budget — less than a year away. When I came back, I asked David Dodge and Don Drummond up to my office on Parliament Hill. They didn’t need persuading from me that the deficit should be a priority; but I was probably the only one there who truly believed we could make it happen politically. I no longer believed that we could simply restrain the growth in government spending and let economic growth — and the increased tax revenues that would bring — look after the rest. “We’re going to have to cut our way out of this mess,” I said. “We’re up against a very tight timeline. When the next U.S. recession comes — and it may come soon — we won’t be able to weather it by cutting interest rates. We need to borrow too much and we have too little credibility with the markets to allow us to do that. We cannot afford to have the 1995 budget fail. We need to come in with a budget that will get us to the Red Book target of a deficit no larger than 3 per cent of GDP. But we also need to open a path to something more dramatic than we had ever discussed in the election campaign: the elimination of the deficit.”

  Talk about preaching to the converted!

  I told them that we were going to start the process of cutting right then and there. Everyone has heard of planning on the “back of an envelope.” Well, that day, I literally took out a large brown envelope, and as David and Don suggested targets for spending cuts, I began writing numbers on the back of it. I knew that we could not get to where we needed to go without cutting transfers to the provinces — something that was going to be enormously difficult politically because the provinces deliver many of the services, such as health, education, and welfare, that most directly affect people. But I also believed that if we were going to ask the provinces to take a substantial hit, as they would inevitably have to do, we had no choice politically but to cut our own expenditures just as deeply or even deeper.

  We started by setting our goal, which was to cut the government’s program spending roughly 20 per cent. We knew that we couldn’t do it all in a year, but we needed to get on track to doing it within two years. Once we had decided on the total number we needed to hit, we worked back through the government’s departments and programs to find the savings we needed. We went through department after department. David and Don might suggest that a 30 per cent cut was feasible in a particular department based on their own in-depth knowledge, and I’d say, “Why not 35 per cent?” Then we wrote it down. The only area we kept sacrosanct from absolute cuts was Indian Affairs, where the rate of spending growth was restrained to a level below population growth.

  At first, some in the Finance Department felt this was just a starting point for discussions with individual departments and that we’d have to go through a lengthy exercise of research, consultation, and negotiation with each one to make sure our percentage targets made sense. But I knew perfectly well we simply couldn’t do it that way. I was accused of using arbitrary numbers and I agreed. I was told I was being unreasonable and I agreed. If I wasn’t arbitrary and unreasonable, we would be nickeled and dimed and delayed to death. Once we got into bargaining with ministers and departments, we’d be ground away. Eventually, we’d be forced to make an across-the-board cut to meet our targets, which would defeat the exercise by failing to set any priorities at all. We had no alternative. Or actually we did: that we would fail.

  When I explained the situation as I saw it to Marcel Massé, he quickly agreed. I gave him and his very able deputy, Wayne Wouters, the list of targets and said, “This is what we have to achieve.” One crucial tool for Marcel to succeed was to have access to the Finance Department’s nu
mbers. Control of the numbers was a key component in Finance’s power within the system. But Marcel needed to be told everything to do the job. It was so contrary to the department’s traditions that Terrie and I had to pressure the department repeatedly to ensure the continued flow of information. It worked because Marcel was convinced from the beginning that our analysis of the problem was right, and he was enthusiastic about his role in the process.

  That did not mean that the program review process would be an easy one. It began with a series of one-on-one meetings with ministers in which I gave them the number that had started life on the back of that brown envelope (although I chose not to mention that fact!). This would nearly provoke a coronary. The minister would invariably start out by arguing that the target was unreasonable, and usually by questioning my sanity for even suggesting it. But I was not prepared to yield. The next step was for the minister to go before the program review committee led by Marcel to outline how they were going to achieve their designated cuts. The committee quickly acquired the wry nickname the “Star Chamber” — after the 16th-century British court that was legendary for its arbitrary power. The program review committee was told they could alter the specific targets for cuts to each department, but it was a zero sum game: if they wanted to lower the target on one department from 20 per cent to 10 per cent, they could; but then they had to cut deeper elsewhere. The members of the committee, led by left-leaning ministers such as Brian Tobin, were stalwarts about their work and kept the pressure on. Most ministers eventually accepted the deep cuts expected of them, even where they were driven to measures that they found personally difficult.

  We knew that for all this to succeed, we needed to make an irrefutable intellectual case to cabinet for what we were doing. We knew we couldn’t win over every single minister, but we needed to get a critical mass of support, including the prime minister. The set-piece opportunity to do this was at a cabinet “retreat” that Jean Chrétien had called for June.