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Don Drummond on testing times ahead


 

This week’s issue of Maclean’s features a story about how the aftermath of the recession is likely to play out in a federal election—whenever the campaign comes. A key figure in the story is Don Drummond, the former federal Finance official whose insider knowledge of Ottawa has made him an indispensable commentator since he joined TD Bank Financial Group as chief economist in 2000.

In the story, Drummond talks recession and recovery. He explains why stimulus spending had little to do with making the downturn hurt less than the worst projections; low interest rates and other monetary policy measures, he says, did the heavy lifting. And he predicts that beating back the federal deficit, which both Tories and Liberals vow to do without raising taxes, will be enormously difficult because so much government spending is viewed as uncuttable.

But he had even more interesting analysis to offer than could fit in the magazine piece. In this additional edited portion of our conversation, Drummond discusses why, even if the recession didn’t hit as hard as many feared, the climb back is likely to be an unusually long, tough slog.

Q. How did the recession we’ve just weathered size up historically?

A. Well, with most countries about to record growth, and France and Germany having already recorded growth, it’s ended up being a garden-variety deep recession, a little lighter than the early Eighties and a bit deeper than the early Nineties, but not terribly different.

Q. Yet Liberal Leader Michael Ignatieff says the economic challenges we face coming out of the recession have changed fundamentally. Have they?

A. All of the challenges in the global economy that were there before the recession are still there, and almost all of them have been exacerbated, either by the nature of the recession or by the policy response.

Let’s take the United States. They had a 40 per cent debt-to-GDP ratio going into this and they will probably touch 100 per cent coming out of this in two to three years time.

All that’s happened in the U.S. is some shifting around. The private sector was accumulating the debt, and now the private sector savings rate went up a little bit. They just shifted the debt to the public sector. Meanwhile, the surplus savings in the Asian countries got dented for a while, but they are racing back again. Nothing got solved.

Q. So what is the implication of that exacerbated imbalance—U.S. indebtedness and Asian savings—for Canada?

A. The U.S. will have a huge fiscal headache. They might succeed in addressing it, and success will mean that they’ll have to constrain their rate of growth in expenditures for a long time, and in turn constrain the growth rate of their economy.

Or, more likely, they will fail at it, and they will see a trend of depreciating their currency, which will mean a trend of appreciation of the Canadian dollar. And they will probably pay a substantial premium on their bonds, and history shows when they pay a premium on their bonds, ours tend to go up as well.

All three cases—low growth rate, weaker U.S. dollar, higher bond rates—translate badly for Canada.

Q. So we need to hope the U.S. government somehow comes to terms with its debt…

A. But that’s not the end of the challenges. Certainly in the U.S. and possibly in Canada, my bet is we’ll also end up with a semi-permanent higher household savings rate. It’s another feature that will constrain growth rates in the short term.

And the process of deleveraging and recapitalization of financial institutions around the world, though not in Canada, is going to proceed for a very long period of time and, again, constrain the economic growth rate.

Q. So you see governments, banks and individuals all constrained for years to come. I’m almost afraid to ask what sort of outlook that leaves us with.

A. With the fiscal challenges, the financial sector challenges, the possible change in the spending behavior of households, I think unlike other recessions, this recovery is not going to be a wonder of a couple of years—you go down, you come back, you go on as before.

I think as late as 2015, even beyond that, we’ll still be talking about the repercussions of this episode—and none of it to the benefit of Canada.

Q. What must Ottawa do to make the best of a testing time?

A. The government should now be planning for a much lower rate of growth in program spending. That should be the focal point. You can’t control the deficit. You can’t control the debt. You can, with some degree of accuracy, control your rate of growth of spending.

Q. Why is government spending so worrying to you?

A. Since we balanced the budget in 1997-98, the rate of spending growth has been six per cent, and of course has soared way above that in the last couple of years. It’s going to be very difficult to ramp that down.

Q. Why? I mean, cutting is one thing, but just refraining from increasing spending in a big way doesn’t sound as hard.

A. Let’s go through where we spend our money. After Brian Mulroney’s attempt and Paul Martin’s, you think anybody is going to touch Old Age Security and Guaranteed Income Supplement? Not a chance.

Prime Minister Harper has said he would never touch cash transfers to the provinces. And I’ll bet they won’t touch Defence as long as we’re in Afghanistan.

So we’ve just eliminated 50 per cent of federal spending. And that 50 per cent will naturally increase, combined, at a 5 per cent annual pace.

Now, I think overall program spending growth has got to be held at no higher than two per cent. If 50 per cent is going to grow roughly at five per cent a year, then by definition the remaining 50 per cent has got to decline by one per cent.

Q. You were an official in the finance department for 23 years before you moved to the private sector. Can you give a sense of what trying to cut half of government program spending by one per cent a year might be like?

A. I went through a lot of expenditure-reduction exercises, and trust me, it’s not easy to get spending going down. Nobody’s done this for a long time. The provinces and the federal government have run through an era of pretty rapid growth in program spending.

Q. Isn’t there a chance that a growing economy will spin off higher tax revenues fast enough to clean up the federal balance sheet without difficult cuts?

A. If program spending is growing by six per cent, there’s no way in this world that revenue is going to grow faster on a sustained basis. If you can ramp spending growth down to two per cent, then in about five years, maybe four, you could get back close to a balanced budget.


 

Don Drummond on testing times ahead

  1. Great interview.

    the points about bond premiums and the effectiveness of the spending we went in debt for are highly relevant. All the more reason to be pudent about being at the debt trough while the elephants (US, UK etc) drink their fill.

    Maybe the US will come to the same conclusion about the efficacy of spending as simulus. The immeadiate problem was a solvency and monetary problem that threatened to wash into large scale unemployment due to restriction of credit flows. That problem has abated, but not completely disappeared.

    Put the plan in place to pay off debt, it doesnt matter if it is over 3 years or 6 years, it just needs to be credible and real.

  2. Yes, very good interview. The bit where Drummond explains why growth in government spending is built into our whole conception of what the federal government is supposed to be is something all Canadians should read. What he doesn't say is that cutting spending growth on programs down to 2 percent would mean political suicide for any party stupid enough to actually try it.

    In other words, it looks like the fuse we lit way back in the 1970s is about to reach the bomb.

  3. Yes, very good interview. The bit where Drummond explains why growth in government spending is built into our whole conception of what the federal government is supposed to be is something all Canadians should read. what d he doesn't say is that cutting spending growth on programs down to 2 percent would mean political suicide for any party stupid enough to actually try it.

    In other words, it looks like the fuse we lit way back in the 1970s is about to reach the bomb.

  4. I agree that spending needs to be contained. In addition, we should be reducing our debt burden further before the boomer crunch really hits in the late 2010s. That means raising revenue to create a structural surplus (or at least get us out of the structural deficit so that spending containment can increase the surplus over time). And that is probably best accomplished by raising the GST or introducing a carbon tax. One thing I agree on, though, is that low corporate taxes are important. It’s one part of the CPC platform I have always supported (as have the LPC).

    If we can keep our debt under control, it will make it much easier for us to run circles around other developed countries, as they will be forced to tax capital at such a rate that it will force investment elsewhere. I can see Canada developing high-value-added manufacturing, finance and other industries through a favourable corporate income tax environment.

  5. Yes, very good interview. The bit where Drummond explains why growth in government spending is built into our whole conception of what the federal government is supposed to be is something all Canadians should read. What he doesn't say is that cutting spending growth on programs down to 2 percent by cutting non-transfer spending would mean political suicide for any party stupid enough to actually try it.

    In other words, it looks like the fuse we lit way back in the 1970s is about to reach the bomb.

    • I actually think Mike Harris and Jean Chretien both proved that controlling spending when we are in a deficit position is rewarded by voters. I continue to believe that voters are more likely to reward good fiscal management than pork spending.

      • Oh that's true as far as it goes. And my compliments to you for having the courage to pick positive examples from both sides of the aisle. But, as Drummond points out above, it isn't pork driving increases in government spending it's things such as transfers to individuals and provinces that will continue to increase at 6 percent. And note that they will increase at this rate even if the government does absolutely nothing to add to them. The increase is built into the system.

        That means controlling spending will require actual cuts not just refraining from pork.

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