Flaherty's about face

Flaherty's about face

How the finance minister went from $100-million surplus to $34-billion deficit in less than 60 days

By James Bagnall, The Ottawa CitizenJanuary 24, 2009

Finance Minister Jim Flaherty's sudden conversion to deficit financing is pure pragmatism. If the Conservatives spend too little, they could very well lose the next vote in Parliament -- and with it, the government. The change in tack has been made easier by the country's enviable financial strengths.

Jim Flaherty's epiphany came within days, perhaps hours, of his Nov. 27 economic statement. The finance minister had predicted five years of budgetary surpluses on the strength of continuing economic growth.

"The days of chronic deficits are behind us," he told Parliament. He was dead wrong, and by early December, he knew it.

Even as Mr. Flaherty was speaking, Canada's job and housing markets had slipped into reverse, energy exports were plummeting and the auto sector was a wreck.

More than 250,000 Canadians -- 1.5 per cent of the workforce -- are now expected to lose their jobs in 2009, according to economists at the TD Bank.

Which is why, on Tuesday, Mr. Flaherty will publish a budget that just two months ago he could not have imagined writing.

He is expected to show a spending shortfall of $34 billion for the fiscal year ending March 31, 2010, and another $30-billion gap the year after that -- the federal government's biggest deficits since the mid-1990s.

How did Mr. Flaherty and his fellow Conservatives not see the writing on the wall sooner? Hubris, optimism, disbelief? Maybe a little of each. There was also the influence of economists, the majority of whom did not begin forecasting economic recession until December.

Nevertheless, there were plenty of portents that something was profoundly amiss. The stock markets had collapsed in September, and the Bank of Canada had been intervening to support Canada's financial system since Aug. 9, 2007 -- when the closure of three subprime mortgage investment funds managed by BNP Paribas, a French bank, signalled the onset of the credit crunch.

Within hours of BNP's action, Canada had its own credit crisis as $32 billion worth of corporate notes, many of them created by Coventree, failed to find buyers. These and other asset-backed securities were converted to bonds only last week.

In 2007 and much of 2008, the consensus view among central bankers and politicians was that the credit contagion had been confined to the financial sector. But last fall the infection spread to the real economy.

Had the Conservatives moved to stimulate earlier, there's little question they could have helped to soften the downturn that began in the last months of 2008.

Mr. Flaherty is trying to make up for lost time. Up to $15 billion of the projected spending deficit for the current fiscal year reflects lower-than-expected tax revenues, according to calculations by Dale Orr, an economist with IHS Global Insight Inc. The rest represents the costs of Mr. Flaherty's stimulus programs.

The amount earmarked by Mr. Flaherty for extra spending will depend on its use. A massive program to refurbish bridges, highways and other infrastructure will take time to organize and implement, and will likely have to be spread over several years.

If the Tories decide the emphasis should be tax cuts or capital infusions to shore up the country's banks and federal lending institutions --such as the Export Development Corp. and Canada Mortgage and Housing Corp. -- then huge amounts can be allocated almost immediately.

Mr. Flaherty's sudden conversion to deficit financing is pure pragmatism. If the Conservatives spend too little, they could very well lose the next vote in Parliament -- and with it, the government.

The Tories' change in tack has also been made easier by the country's enviable financial strengths.

Until this year, Canada was the only major industrialized country with a government that spent less money than it took in. Not only that, government debt last year was slightly less than 30 per cent of the country's annual economic output -- down from nearly 70 per cent in the mid-1990s. This makes Canada the least indebted of the G-7 nations by a fair margin.

Even if Mr. Flaherty racks up more than $100 billion worth of cumulative deficits over the next five years, as he conceded this week is likely, Canada should readily be able to manage the extra debt load.

Of course, all of this pre-supposes that Canada's economy will grow again in the second half of 2009, as predicted Thursday by the Bank of Canada.

Is this realistic? One of the most unsettling parts of the global credit crisis has been its violent and unpredictable swings. Even now, more than two years after the United States' subprime mortgage lenders began filing for bankruptcy protection, no one

can say with any certainty whether we are most of the way through this mess, or just beginning to sort things through.

Independent economists have been frantically revising their forecasts as new pieces of intelligence emerge, each more depressing than the last.

A Bloomberg survey of 10 economists last October suggested Canada's economy would grow at an annual rate of 0.3 per cent during the fourth quarter of 2008.

Earlier this month, the consensus forecast had shifted dramatically. The same group predicted the economy had contracted 2.1 per cent in the fourth quarter, a performance that would now be followed by at least two more quarters of reduced economic output.

While mainstream economists often miss the turn into a recession, this one has been particularly difficult to chart accurately.

That's because the credit crisis is different. The recessions in the early 1980s and early 1990s were induced by central bankers keen to keep the economy from overheating. The Bank of Canada pushed interest rates so high that eventually consumers and corporations reined in their borrowing, and the economy slipped into reverse for several quarters.

In earlier recessions, re-igniting growth was relatively simple. The central banks cut interest rates, prompting a new round of borrowing by consumers and homeowners.

The Bank of Canada and its counterparts are applying the same fix, but to far lesser effect. That's because, in this case, the financial system itself is broken, and this is much more difficult to fix than the economy.

The root of the problem is that the financial industry created immensely complicated investment products -- securities based on mortgages and other assets -- that no one really understood, and which could not be properly priced.

When the housing markets weakened in 2007, there were few takers for these exotic investments. Since many of the latter were funded with short-term money (notes that matured in months, rather than years), the financial system very quickly froze.

That wasn't the only problem. Many of the finance industry's assets were on the books of a new class of quasi-banks, also known as the shadow banking system. Its members included hedge funds, investment banks, private-equity providers and non-bank mortgage lenders shared two common features. They were aggressive, and they aren't covered by deposit insurance.

At its peak, in 2007, New York investment bank Bear Stearns had $33 in loans for every $1 in bank capital -- three times the ratio maintained by the more conservative Canadian banks.

Once Bear Stearns acknowledged the weakness of its loan portfolio, investors began to doubt the firm's staying power. Bear Stearns was acquired for a pittance last March by Bank of America -- a regular, deposit-taking institution.

The unwinding of the shadow banking system has occurred with astonishing speed in the U.S. But investors, businesses and employees alike are still bracing for ugly surprises in the quarters to come -- all of it related to the ability of corporations to keep solvent.

When employers and lenders are busy preserving capital, they are not creating jobs or stimulating economic growth.

Mr. Flaherty and his advisers have no clear idea how long this dangerous phase of the economic cycle will last.

Should they have acted sooner to head it off?

Certainly there were many who warned that financial calamity was on the way. Robert Shiller, an economics professor at Yale University, warned in 2004 that a housing bubble was forming.

Raghuram Rajan, a professor at the University of Chicago's Booth Graduate School of Business, presented a paper in 2005 that concluded the world's financial systems were developing in a manner that exaggerated risk.

And Nouriel Roubini, an economics professor at New York University's Stern School of Business, has published a well-read blog for more than a decade, warning about the implosion of the financial services industry.

But their analyses failed to offer insight into how or when it might unfold, and indeed, their misgivings continued against the backdrop of ever-rising home prices, which peaked in 2006.

Mr. Roubini and Mr. Shiller were dumbfounded at the equanimity of investors in 2007, when the illiquidity of the shadow banking system first became apparent.

Perhaps it was central bankers' quickness in pumping liquidity into the system, or maybe it had to do with the fact no one really understood the makeup of the complicated securities that lie at the heart of the new financial universe.

"The financial system is so complex, non-linear and chaotic," wrote Niall Ferguson in The Ascent of Money, "it's hugely difficult to forecast the timing of financial crises."

Alan Greenspan, the former chairman of the U.S. Federal Reserve Bank, noted in his recently published biography that great improvements in technology, financial software and banking infrastructure had made it possible for the industry to tolerate significantly more leverage (debt).

"A surge above what newer technology can support, invites crises," he noted, "I am not sure where the tipping point lies."

What shocked Mr. Greenspan in the end was the puzzling refusal of the financial heavyweights to protect themselves against a worst-case outcome. Why didn't they keep enough liquidity on hand to safeguard the institution?

This is where Mr. Rajan could have helped Mr. Greenspan -- who happened to be in the room when the Chicago academic delivered his paper. Mr. Rajan warned the new world of finance was incorporating pay incentives that offered huge benefits to financial services executives in a rising market, but imposed a small penalty for making bad calls. Risks were being discounted, greed celebrated.

The stewards of national economies -- Canada's included -- were also infected by hubris.

The Western World's central bankers had steered the economy through a massive tech bubble, and had avoided a serious recession for nearly a generation. There was a widespread belief -- supported by blind hope -- that everyone would muddle through.

Canada's Conservatives, starting with their Finance Minister Jim Flaherty, now understand that's not the way it's going to be.

E-mail jbagnall@thecitizen.

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