Canada is still on shaky ground

With the United States credit rating being recently downgraded and some European countries tittering on the verge of debt crisis, Canadians can rightly be proud of our AAA credit rating.

However, the recent market volatility combined with declining commodity prices should not make us too complacent.

There are serious external risks facing the Canadian economy which bolsters the need for a strong and credible plan to deal with deficits and debt problems at home.

If our government does not heed the warning signs, it risks not learning from past mistakes.

In June, the federal government tabled a plan to balance the budget in five years. To get there, the Conservatives forecasted revenues to grow at a robust average rate of 5.6% over the next five years while planning to hold program spending increases to an average rate of 2%.

The problem with this plan is that, while the federal government directly controls the amount it decides to spend – though Canadians should exercise healthy skepticism as the Conservatives’ track record on spending suggests it will be unable to hold the line at 2% – the government is exposed to revenue shocks that are beyond its control.

A balanced budget plan that relies on strong revenue growth is one with significant downside risk and little to no upside potential.

Lower than forecasted revenue growth will mean larger deficits for a much longer time period and significantly more government debt.

The same approach did not work in the 1980s and early 1990s as successive federal governments failed to balance the budget by trying to slow the growth in spending while hoping for higher revenues.

Like the incumbent Conservatives, the Progressive Conservative government in the late 1980s and early 1990s was at least notionally predisposed to lower levels of government spending and balanced budgets. But failure to eliminate the deficit came from the Progressive Conservative’s inability to constrain spending growth coupled with lower than expected revenues.

That ultimately resulted in ongoing deficits, mounting debt, and a downgrade in Canada’s credit rating in 1994.

And now, just two months after the 2011 budget was tabled, the current government’s fiscal plan is facing similar risks with signs of a slowing U.S. economy and the possibility of a double-dip recession increasing.

Given that Canada’s economy is heavily tied to the U.S., any material slowdown in the U.S. will likely have a negative impact on the Canadian economy, federal revenues, and the Conservatives’ deficit-reduction plan.

To reduce the frailty of the current fiscal plan and to set Canada apart from the rest of the world, the federal government must quickly balance its budget.

Finance Minister Jim Flaherty can use the government’s fall economic and fiscal update to do just that – balance the books in two years, not five.

To get there, Flaherty should ensure that program spending is returned to pre-stimulus levels. This can be achieved by greatly expanding the government’s Strategic and Operating Review, currently a one-year review of program spending – excluding transfers to individuals and governments – which proposes to find a mere 2% in savings from the $352.5 billion in departmental spending planned from 2012-13 to 2014-15.

The expanded Strategic and Operating Review ought to prioritize spending so that important areas are spared deep cuts while lower priority areas carry a greater burden of the spending reductions.

A good starting point is to significantly reduce, or better yet eliminate, corporate subsidies which have grown substantially under the Conservative regime.

A two-year balanced budget plan would reduce the risks associated with a revenue shock like a slowing U.S. economy.

With the U.S. economy is looking ever more fragile, sovereign debt concerns growing in Europe, and commodity prices softening, Canadians should feel increasingly uneasy about the government’s fiscal plan.

The newly minted Conservative government should use its majority to implement the type of balanced budget plan the Prime Minister and his colleagues once championed as members of the opposition.

Niels Veldhuis and Charles Lammam

The Fraser Institute