Canadian fiscal and monetary policy and macroeconomic performance 1984-1993: The Mulroney years

Journal of Canadian Studies, Spring 1997 by Curtis, Douglas

Two consecutive majority governments in Canada, from 1984 to 1993 focussed federal government budgetary and fiscal policy on deficit reduction and debt control. From 1984 to 1988 this policy was successful as the economy grew with the support of monetary policy and deficits declined. After 1988 monetary policy shifted to pursue a target of zero inflation, interest rates increased, economic growth declined and budget deficits and debt increased, despite continued improvement in the government's operating budget surplus.

This experience demonstrated the importance of the policy mix to the success of past and future deficit and debt control plans. The Mulroney years, 1984-1993, provide an interesting study in economic policy and performance. While this was a period of two consecutive majority governments, economic policy during all but the last two years was the responsibility of the same minister of finance. Inflation rates were stable in the mid-single-digit range both domestically and internationally, and commodity and energy prices were stable to declining. While there were dramatic political developments in Eastern Europe and the Soviet Union, a short but sharp financial crisis in 1987 and the Gulf War in 1991, these do not appear to have had significant impact on the domestic economic policy agenda. Nor did domestic political turmoil surrounding two rounds of constitutional negotiations seem to have much effect. In general it was a period in which the government could define and pursue its economic policy agenda with a minimum of disruption from internal or external economic events, at least in comparison to the experience of the preceding decade. The newly elected government set out, in 1984, a clear fiscal policy agenda, and would pursue that agenda for the entire two terms of its mandate. Deficit reduction and debt control were the primary fiscal objectives, expenditure control and revenue enhancement the broad means to achieving those objectives. Even the much more wide-ranging initiatives on privatization, free trade with the United States, and tax reform were nested in the larger framework of revenue enhancement through economic growth, driven by private sector responses to improved economic opportunities. Annual budgets and budget papers routinely reported on progress towards deficit and debt control, advances and setbacks in the pursuit of the goal, new policy initiatives consistent with deficit reduction, and new forecasts of the progress to be made in the succeeding three years. The thrust of budgetary and fiscal policy was consistent over the entire 10 years that the Mulroney government was in power. The Mulroney government's record on monetary policy, however, provides an interesting contrast to the observed consistency in fiscal policy. In its first term (1984-88) monetary policy was in the hands of Bank of Canada Governor George Bouey. Bouey continued to identify inflation control as a key objective for monetary policy, but oversaw monetary conditions that accommodated economic expansion. The Bank forsook its previous commitment to controlling the money supply through set targets in favour of a policy supportive of a non-inflationary recovery from the recession of 1982. From 1988 onwards Bouey's successor John Crow defined monetary policy objectives more narrowly. Governor Crow defined price stability such that zero inflation became the goal for monetary policy, a goal he pursued with increasing vigour and success, establishing and meeting formal targets for reduced rates of inflation from 1991 onwards. Thus the thrust of monetary policy shifted from an expansionary or accommodative approach in the government's first term to an anti-inflationary or restrictive one in its second term. This shift was of particular importance because the government's fiscal plans, by contrast, were founded on revenue growth driven by moderate inflation and private sector economic growth. Policy analysts and critics expressed concerns about such a fiscal and monetary policy mix, in particular about the implications of the Bank's restrictive monetary policy. Their concerns arose primarily from a recognition of the potency of monetary policy in a small open economy, and its importance to the economy's adjustment to fiscal restraint and the broader initiatives of free trade. Wilson and McGregor (1985 and 1986) and Wilson and Dungan (1993), in their analyses of the impacts of changes in federal budgets, highlighted the importance of monetary policy, and the policy mix, to the outcomes of fiscal restraint. Fortin (1991 and 1993) argued strongly for a shift in the mix of policy to fiscal restraint with monetary ease. Courchene (1991 and 1992) raised concerns about the effects of restrictive monetary policy on exchange rates (and the adjustment to free trade with the United States). Lucas (1989) and Johnson (1990) identified inconsistencies between restrictive monetary policy and inflation targets and their impacts on government revenue growth plans and forecasts. The broad concern was that the shift to strongly anti-inflationary monetary policy, even though endorsed by the minister of finance, might result in financial conditions and economic growth rates that would undermine the plans to reduce deficits and control debt. This paper provides a retrospective examination of the broad fiscal and monetary policy programmes of the Mulroney government. A brief comparison of Canadian economic performance in the 1984-93 period with performance in earlier periods, and with performance in other G7 countries, provides a background to the study. The fiscal plans and fiscal policy initiatives of the government are then compared with measures of budgetary results and fiscal impacts. A similar treatment of monetary policy compares observed changes in monetary conditions and indicators of monetary policy with the announced policy objectives. Finally, these comparisons of stated plans and objectives with observed actions and outcomes are considered in terms of the impacts the policies had on economic activity and growth rates. Two major observations emerge. First, despite 10 years of consistent plans and actions to control government deficits and debt, the economy had as large a deficit and a larger debt problem in 1993 than it had in 1984. Second, the failure of the government's persistent fiscal initiatives to solve these problems confirmed the predictions of policy critics that the shift in monetary policy after 1988 was inconsistent with the government's fiscal plans and objectives. These observations have particular relevance as the current Liberal government of Jean Chretien, under Finance Minister Paul Martin, sets out once more to bring stability to the country's finances. Macroeconomic Performance 1984-1993 TABLE 1 presents the economic record for the Canadian economy in historical and comparative perspectives. It first compares Canadian performance during the Mulroney years with performance in the two preceding 10-year periods. Then it offers a comparison with the performance of other G7 countries during the 1983-92 period. Finally, it gives a breakdown of the 1983-92 period into two sub-periods that correspond roughly to the first and second political mandates of the government, and more importantly to the announced shifts in monetary policy in 1983 and late 1988. The objective is to provide a background for the subsequent discussion of economic policy and the analysis of policy impacts. From the historical perspective offered by the first three rows of TABLE I, the Canadian economy did not perform as strongly during the Mulroney era as it had in the two preceding decades. The 1983-92 period, however, was one of generally lower growth in most industrialized countries. As a result the Canadian record looks better in the cross-sectional comparison in the lower part of the table. From 1983 to 1992 the economy exceeded the output and employment growth rates of the other major industrial countries. This 10-year average is misleading, and a breakdown of the period into two shorter sub-periods (in the last two rows of TABLE 1) provides a rather different picture. From 1983 to 1988, roughly the period of the first political mandate of the Mulroney government and the last part of Gerald Bouey's second term as governor of the Bank of Canada, Canadian economic growth was much stronger than that in other G7 countries. By contrast, economic growth and employment growth from 1989 to 1992 were very weak. Substantial gains were made in lowering the rate of inflation by the end of this period, but the recession in growth was much deeper in Canada than in other countries, and it pushed the unemployment rate up sharply. It should be noted that this 1989-92 period was roughly the time of the second mandate of the Mulroney government, and the later part of John Crow's term as governor of the Bank of Canada. The different economic growth rates observed in these two periods of the government's mandate are important background for an examination of the macroeconomic policy during the Mulroney years. The next sections of this paper consider the broad policy objectives and programmes established by the government and the impacts of those programmes on economic activity. Of interest as well is the way in which policy co-ordination and conflict impacted on economic growth and inflation and, in turn, affected the government's success in meeting its policy objectives. Budgetary Plans, Experience and Fiscal Policy The Mulroney government's budgetary plans and objectives were set out clearly at the beginning of its mandate and pursued consistently for the two terms it held power. The Minister of Finance, Michael Wilson, established the initial position in A New Direction for Canada: An Agenda for Economic Renewal in November 1984, just two months after the election. This document identified the primary challenge facing the government, in fiscal terms, as the need to reduce the budgetary deficit and reverse the rise in the public debt. Subsequent Fiscal Plans and Budget Papers issued approximately annually from 1985 to 1993 reaffirmed the budgetary objective and provided forecasts of expected progress towards deficit and debt control. The government's approach to solving the deficit and debt challenges was straightforward. The initial attack came through expenditure reduction and control. This was followed by revenue enhancement, based initially on the revenue growth resulting from economic growth opportunities for the private sector. Later, particularly from 1988 onwards, the government pursued a more active programme of revenue enhancement through tax increases and tax reform, and through broader initiatives intended to provide further growth opportunities and incentives, such as Canada-US free trade. The details of these expenditure and revenue plans are beyond the scope of this study. Wilson and Dungan (1993) and Perry (1993) provide extensive description and analysis of expenditure and revenue measures contained in annual budgets. The objective here is a broader evaluation of the government's success in establishing targets and forecasts for its budgetary policy and in meeting those targets. A second objective is to evaluate the effects of the government's budget policies on aggregate expenditure and economic performance. TABLE 2 summarizes the budgetary problem and the government's attack on it in terms of predicted and actual budget deficits. Data on deficit predictions and actual deficits come from the annual budget materials and budget papers, as noted in the first column of the table. Unfortunately, the deficit forecasts that the government provided with different budgets were sometimes made on a public accounts or budgetary basis and at other times on a national accounts basis. The table reports the latter, when possible, for consistency with later discussions of fiscal effects. Predictions on a public accounts basis are recorded, however, and marked with an asterisk for some years. Actual budget deficits are given in the last rows of the table on both national accounts and budgetary bases for purposes of comparing predictions with results. The data illustrate the initial success and subsequent failure of the government's deficit reduction and control strategy. In 1984, annual deficit forecasts (running forward to 1990-91) of $35 billion to $37 billion defined the problem. Fiscal plans implemented through successive budgets from 1985 to 1988 lowered actual deficits, in line with forecasts from $33.2 billion to $19.2 billion. After the 198889 fiscal year, fiscal plans continued to forecast further deficit reductions, with some upward revisions at the start of the forecast, but the results did not materialize. The budget deficit rose from less than $20 billion back into the mid-$30 billion range. Despite the consistent efforts illustrated by fiscal plans and actual budgets, deficit reduction and control was an elusive target in the government's second mandate. FIGURE 1 provides some detail on the expenditure, revenue and budget balance effects of changes in government budget policy after 1984. Budgetary revenue and programme expenditure relative to GDP are plotted over time. Programme expenditures exclude interest payments on the public debt. The difference between the budgetary revenues and programme expenditures is the government's operating or primary budget balance. In FIGURE I it is seen that the government's expenditure control programme, together with the recovery of the economy, consistently lowered the expenditure to GDP ratio in the 1984-89 period. At the same time, strong increases in revenues, sufficient to raise the revenue to GDP ratio even as GDP grew, moved the operating budget into a surplus position in 1987 and subsequent years. Budgetary data confirm that action was taken -- action that eliminated the operating deficit and reduced the overall budget deficit, as noted in TABLE 2. Indeed, these deficit reductions were sufficient to stabilize the debt to GDP ratio for one fiscal year at least 1988-89. How budgetary policy initiatives affected GDP growth and in turn were overshadowed by other events, is a different matter about which FIGURE 2 provides further insight. FIGURE 2 illustrates two measures of the federal government budget position over the 1980-1993 period. First the actual budget balance, as reported in TABLE 2, records the results of government budgetary policy together with the effects of all other conditions in the economy which might affect government revenues or expenditures. The actual budget balance (ABB) can be roughly defined as follows: ABB = Revenue - Programme Expenditure - Interest paid on the Public Debt, or ABB = t*GDP - E - i*D where t is the average tax rate, E is programme expenditure and i is the interest rate on outstanding government bonds (D). The government's fiscal programme sets t and E. Those policy choices together with actual GDP and public debt servicing costs generate the actual budget position. Second, the cyclically adjusted primary budget balance (CAPBB) measures only the budget results of government expenditure and revenue programmes and changes in those programmes. It can be roughly defined as: CAPBB = Revenue at trend GDP - Programme Expenditure at trend GDP or CAPBB = t*GDP* - E* where GDP* is the trend value of GDP and E* is programme expenditure at the trend value of GDP. The effects of short term variations in GDP growth, unemployment, interest rates and other events that are not part of the budget plan have been removed. Changes in the cyclically adjusted primary deficit thus measure only changes in budget balance caused by the changes in the government's fiscal programme, namely t and E. Changes in this budget balance are directly controlled by government. As a result the direction of change in the cyclically adjusted primary balance from year to year provides an indicator of the stimulative or restrictive thrust of fiscal policy (see Wilson and Dungan, 1993, chap. 2). Changes in the cyclically adjusted primary balance, as published by the Department of Finance (1993) and illustrated in FIGURE 2 were consistent with the fiscal plans and predictions discussed above. The expenditure control and revenue enhancement illustrated in FIGURE 1 are reflected in this budget balance. Initiatives to reduce the deficit contained in the 1984 and 1985 budgets reversed the earlier increases in the budget deficits, with particular impact from 1986 to 1988. From then on the budgetary policy delivered consistent improvements in the cyclically adjusted primary balance. As indicators of fiscal policy, these changes mean that discretionary budget changes were persistently restrictive over the 1985-1992 period. Budgetary policy was unambiguously aimed at deficit reduction. On the other hand, the changes in the actual budget balance in FIGURE 2 indicate how economic conditions changed over the period and gradually frustrated the government's deficit reduction strategy. From 1982 to 1986 the recovery in economic activity coincided with falling interest rates and rising employment to complement the government's budgetary policy. The actual deficit was reduced as the cyclically adjusted primary balance improved. Actual deficits fell from $33.2 billion or about 6.5 per cent of GDP in 1984-85 to $19.2 billion or 3.2 per cent of GDP in 1988-89. But after 1988 changes in economic conditions caused changes in government revenues and expenditures that outweighed the deficit-reduction measures in the government's fiscal programme. The total deficit began to rise as economic growth declined and unemployment and interest rates increased. The government's failure with deficit control (observed in TABLE 2) was not a result of a shift in budget policy; in fact, successive budgets moved the cyclically adjusted primary budget balance into the rising surpluses that deficit reduction and debt ratio stabilization required. In hindsight, while policy could have been more restrictive, it was the broader play of economic events that reduced actual revenues and increased expenditures sufficiently to generate a rise in actual deficits starting in 1989. One very important dimension of the change in economic conditions starting in 1989 was the change in monetary policy. In 1988 the Bank of Canada defined a target of zero inflation as the goal for monetary policy. The next section examines some indicators of the direction, timing and magnitude of this policy shift. Monetary Policy Monetary policy during the Mulroney years had two distinct phases. In 1982, following the effects of a sharp close of anti-inflationary monetarism that precipitated the 1981-82 recession, the governor of the Bank signalled a change in the Bank's approach to policy (Bouey, 1982). Rather than concentrating on controlling the rate of growth of a money supply measure, such as M1, as a means to control inflation, the Bank would monitor a wider range of possible policy indicators. The intent was apparently to implement a policy consistent with non-inflationary recovery from the recession (Bouey, 1985: 24). Then in 1988, following a period in which sustained growth with stable inflation in the four per cent range had moved the economy back toward high employment, the new Governor of the Bank, John Crow, declared price stability, or zero inflation, to be the target for the Bank's monetary policy (Crow, 1988). This was an important shift in monetary policy, not just for economic conditions in Canada, but more importantly for the success of the government's budgetary policy initiatives. The nature, timing and magnitude of the shift in monetary policy are illustrated by the data in TABLE 3, using money supply growth, real interest rates and exchange rates, the traditional and now widely used indicators. Of particular interest is the extent to which monetary policy did change in 1982 and again in 1988, the resultant changes in monetary conditions and the impacts of these changes on economic growth as well as on inflation. Money supply growth rate data, interest rates and exchange rates provide a clear indication of the timing of the shifts in monetary policy. Anti-inflationary policy in 1981 and 1982 reduced growth in M1 to negative values, while the accompanying rise in interest rates induced a shift into broader forms of money supply measured as M2 balances. This was tight money in Canada, although perhaps not as tight as in the United States, and the Canadian dollar depreciated relative to the American dollar. A reversal from an anti-inflationary policy to an accommodative or expansionary one was marked by the sharp growth in M1 in 1983, the growth in M2 and the continued depreciation of the Canadian dollar. The sharp acceleration in money supply growth in 1987 and the drop in the dollar mark the financial crisis in the autumn of that year. A second deceleration in the growth of M1 in 1989 and an absolute drop in 1990 followed the announcement of a zero inflation target by the Bank of Canada in 1988. Again M2 growth accelerated with the onset of tight money. More importantly, the Canadian dollar, which had already moved above the lows of 1985-86, appreciated strongly against the American dollar, indicating that there was in effect a monetary policy in Canada more restrictive than that in the United States. This evidence confirms that the announced changes in monetary policy were accompanied by action and particularly after 1988, by policy action that was initiated in Canada rather than imported from outside. Variations in money supply growth rates, together with real interest rates provide clear evidence of changes in monetary conditions over the 1984-93 period, but they do not necessarily indicate how these changes might have affected economic activity. One measure of impact is provided by the exchange rate movements already described. In a small open economy such as Canada's, the exchange rate is one of the most powerful channels for transmitting changes in monetary conditions to real economic activity. Using this as a measure it is clear that monetary policy and conditions were expansionary from 1980 to 1986-87, contractionary from 1987 to 1991 and marked by a return to stimulative policy after 1991. FIGURES 3 and 4 provide two further indicators of the impact of monetary policy on real economic activity used by Laidler and Robson (1993) in their recent study of Canadian monetary policy. FIGURE 3 presents the "M1 Gap," defined as the difference between the rate of growth of money supply MI and the rate of growth of nominal GDP. The M1 Gap measures, in effect, the extent to which money supply growth exceeded growth in the demand for money, thereby providing stimulus to and accommodation for continued expansion. Accepting Laidler and Robson's (1993: 60-63) suggestion that demand for M1 grows at a slower rate than the growth in nominal GDP, a small negative "Gap" could be regarded as neutral monetary policy. Interpreted in this way FIGURE 3 illustrates the shift to expansionary policy in 1982, offset briefly in 1984 by the surge in GDP growth, followed by the shift to restrictive policy from 1988 to 1990. The four-year moving average for the M1 Gap in the same figure provides some recognition of both lags and persistence in the effects of monetary change on economic activity and the subsequent feedback to monetary conditions. These observations confirm that the changes in money supply growth observed in TABLE 3 did indeed mean a buildup of monetary stimulus from 1982 to 1988 followed by sharp restraint starting in 1989 and persisting to 1991. FIGURE 4 provides further confirmation of the effect of monetary changes. Laidler and Robson (1993: 77-79) report a close relationship between the slope of the yield curve or the yield spread -- defined as the difference between the yield on government bonds with over 10 years to maturity and the yield on three-month treasury bills -- and the rate of growth in the economy. Monetary policy actions which raise the T-bill rate relative to the long rate reduce economic growth and vice versa. As FIGURE 4 illustrates, by this measure monetary policy enhanced the rate of economic growth from 1982 to 1987, but subsequently moved sharply in the other direction. It would appear that policy was almost as restrictive in 1989 as in 1981 and that this latter restriction was longer lasting. In summary, there is good evidence that monetary conditions changed in ways that had a strong impact on the growth in real GDP. The strong GDP growth in the first term of the Mulroney government (from 1984-88) was produced by monetary stimulus, despite strong fiscal restraint. The collapse of growth and the enduring recession of the second term (1989-93) was caused by the shift in monetary policy to a price stability target. The importance of this conclusion, as the next section explores, is the critical role economic growth had to play in the government's broader economic agenda for deficit reduction and debt control. Policy Co-ordination and Conflict The preceding observations on economic performance and policy provide an important illustration of interdependencies in the economy. The early success of the government's attempts at deficit reduction and debt control coincided with a period of expansionary monetary policy and accelerating growth, while renewed difficulties with deficit control and government debt coincided with declining growth and restrictive monetary policy. This section considers three key relationships that underlie that experience, namely the relationship between growth in GDP and the endogenous changes in the government's budget balance, the relationship between monetary and fiscal policy and real GDP growth and the relationships that determine the change in the ratio of government debt to GDP. FIGURE 5 illustrates the first of these relationships. It compares annual rates of growth in real GDP with the induced change in the federal government budget balance. The latter is measured as a per cent of the average deficit for the 1980-92 period. The induced change in the balance is derived by taking the difference between the observed change in the total budget balance and the change in the cyclically adjusted primary budget balance. Because the cyclically adjusted primary balance is based on programme expenditures and revenues at constant rates of growth and unemployment, and excludes the interest payments on the public debt, it changes only as a result of changes in expenditure and tax programmes. Changes in the budget balance that differ from this change in the cyclically adjusted primary balance reflect changes in GDP growth rates, unemployment rates, interest rates and other factors that affect government revenues and expenditures. In other words, these are changes in the budget balance caused by changes in economic conditions, not by changes in budgetary policy. Rates of growth of real GDP had a powerful effect on the government's budget. The recession of 1982 reduced annual real GDP growth to -3.2 per cent and caused a 20 per cent decline in the budget balance. The subsequent recovery in real GDP growth to rates in excess of three per cent per year from 1983 to 1988 caused strong increases in the budget position, which contributed importantly to the reductions in the deficit from 1984 to 1988. When the economy grows faster than about three per cent per year, unemployment rates decline and capacity utilization rates rise, generating strong increases in personal and business incomes, which in turn feed the growth in government tax revenues. By contrast, after 1988 declining growth, rising unemployment rates and rising interest rates combined to cause large consecutive increases in the budget deficit. These observations clearly illustrate the importance of economic growth to deficit control. Five consecutive years of strong economic growth (1984-88) reinforced the government's attack on the deficit and deficits declined during this period. The collapse in economic growth after 1988 induced declines in the budget balance that undermined the government's continued attack on the deficit. Increases in tax rates and cuts in expenditure were not sufficient to offset the revenue losses and expenditure increases caused by declining growth in output and employment and by rising interest rates. If economic growth played such an important role in the government's success or failure with deficit control, the question arises: why did economic growth collapse from 1989 onward? Data presented earlier in TABLE I suggest that part of the decline in growth was external to the Canadian economy, as growth rates in all G7 countries were lower in the 1989-92 period than they had been from 1983 to 1988. But even in that context, the decline in Canadian growth was much larger than in other countries. Domestic policy may have contributed to that difference; FIGURE 6 offers some evidence for this. In FIGURE 6 two indicators of domestic macroeconomic policy are compared to the rate of growth in real GDP. The fiscal restraint indicator is the annual change in the cyclically adjusted primary budget balance, measured as a per cent of nominal GDP. A positive value for this indicator reflects discretionary cuts in government expenditure or increases in tax rates, or both combined, which would tend to reduce aggregate expenditure and GDP growth. The monetary policy indicator is the four-year moving average on the M1 Gap. A rising value for this measure indicates growth in the money supply M1 that is faster than the growth in nominal GDP, and thus monetary policy that provides accommodation and stimulus to real GDP growth. By these indicators, fiscal policy was sharply restrictive from 1984 to 1986, and persistently but moderately restrictive after 1987. Monetary policy was accommodative and expansionary from 1982 to 1988, then increasingly restrictive from 1989 to 1991, before easing in 1992. The relationship between policy and growth illustrated in FIGURE 6 corresponds to predictions in the case of a small open economy with flexible exchange rates. In the first part of the period, 1984 to 1988, restrictive fiscal policy did seem to lower GDP growth rates somewhat, but expansionary monetary policy dominated. The economy grew and the deficit declined. From 1988 to 1991, the shift to restrictive monetary policy led to sharp and persistent reductions in GDP growth rates, despite some easing in fiscal restraint. The economy went into recession and the deficit grew. These observations support the arguments about the importance of the monetary-fiscal policy mix offered by Wilson and Dungan (1993) and Fortin (1993). The appropriate mix of monetary and fiscal policy for deficit reduction when exchange rates are flexible is monetary ease and fiscal restraint. From 1983 to 1988 monetary ease supported growth, enhanced revenues and induced expenditure reductions, while fiscal restraint contained expenditures and increased tax rates. The government's deficit strategy worked. After 1988 the policy shift to a combination of monetary restraint (which meant high interest rates and a rising exchange rate) and fiscal restraint produced a persistent recession. This mix did not work. The deficit rose persistently despite continued attempts at deficit control. Even if lower inflation was a worthy objective, the timing of the initiative was inappropriate in terms of the deficit-control objective. Rising deficits renewed earlier concerns about the government's debt position and the size of the debt/GDP ratio. The short-lived success with deficit reduction had stabilized the debt/GDP ratio at about 54 per cent from 1986 to 1989. Even though the government operating budget remained in surplus from 1987 onwards, that surplus was not sufficient to offset the effects of higher interest rates and low growth rates on the total deficit and the growth of the debt. Indeed, the gap between interest rates and nominal GDP growth that opened in this period -- in the order of six to eight per cent -- was larger than additional budgetary restraint alone could offset in any short period. By 1992 the debt ratio had increased to 63 per cent and the upward trend was strong. The shift in the fiscal and monetary policy mix that undermined the attempts at deficit control, not surprisingly, also undermined attempts to stabilize the debt ratio. Concluding Observations The experience of the Mulroney government with macroeconomic policy leads to a number of observations about the policy problems facing the country and about approaches to them. Perhaps the most important of these is the key contribution of policy co-ordination and consistency to the success of policy programmes. When policy is co-ordinated, happily it appears that substantial adjustments in the government's deficit position can be made without large sacrifices in GDP growth and employment. On the other hand, the real interest rates resulting from the success of anti-inflationary monetary policy have made the current budget adjustment problem more difficult. The 1984-92 experience validates the concerns expressed by a number analysts at the time. The mix of monetary and fiscal policy, particularly in this small open economy, was critical to the success and failure of fiscal policy designed to control deficits and the public debt. Monetary policy played a dominant role in determining the rate of growth of nominal and real GDP. Growth in nominal and real GDP, in turn, impacted strongly on both the revenue and expenditure sides of the government's budget. When monetary policy supported growth in nominal and real GDP, the government was able to make substantial improvements in its budget position -- by more than four per cent of GDP -- and to stabilize the debt ratio. When monetary policy was changed to eliminate inflation, permanently reducing the rate of growth of nominal GDP and reducing real GDP growth in the process, the government's budget deficit grew despite continued efforts to control expenditure and enhance revenues. The goal of lower or zero inflation may be defensible, but the timing of the policy initiative was inconsistent with the continued pursuit of deficit control. The record of success with deficit and debt control during the first mandate of the government does provide some hope that future adjustment may be less painful than many predict. From 1984 to 1991 the government shifted its operating budget balance from a deficit of 3.7 per cent of GDP to a surplus of 1.8 per cent of GDP, a 5.3 per cent adjustment. Most of this adjustment occurred between 1984 and 1988. During this period real GDP growth, with the support of monetary policy, averaged more than four per cent a year and unemployment fell from 11.2 per cent to 7.8 per cent. During that period it was possible to make a significant budget adjustment without reducing growth to the extent that unemployment persisted. To put it another way, fiscal policy multipliers were apparently quite small; indeed, some argue that substantially more budget adjustment was possible. Thus it may be that the larger budget adjustments now facing the economy can be made with continued growth supported by monetary policy. This note of optimism is important given the change in economic circumstances affecting budget deficits and debt control. One persistent result of the Bank's success with inflation control is high real interest rates. In the last years of the government, the gap between interest rates and GDP growth was the major contributor to the growth in the debt ratio. GDP growth has now recovered, in 1994, to more than three per cent annually with little or no inflation as measured by the consumer price index. But international monetary developments have pushed Canadian nominal interest rates and real interest rates into the six to eight per cent range. The persistence of real interest rates in excess of growth rates increases the size of the budget adjustment required for debt ratio stability. This cost of reducing inflation persists even though the unemployment and growth rate costs are passing. Co-ordination of monetary support for growth with fiscal restraint is even more important to the solution of the deficit and debt problem today than it was in 1984. NOTES I acknowledge with thanks support provided by the Trent University Committee on Research (SSHRCC), and helpful comments from colleagues. especially Jacqueline Muldoon and two anonymous referees. REFERENCES Canada. Bank of Canada. Bank of Canada Review. Spring 1994. Canada. Department of Finance. A New Direction for Canada: An Agenda for Economic Renewal. November 1984. The Fiscal Plan. May 1985, February 1986, February 1988, April 1989. The Agenda for Economic Renewal: Principles and Progress. February 1987. The Budget. February 1990, February 1991, February 1992, February 1993. Economic and Fiscal Reference Tables. August 1993. Bouey, G. "Monetary policy -- Finding a Place to Stand." Bank of Canada Review September, 1982. Statement prepared for the appearance of Gerald K. Bouey Governor of the Bank of Canada before the House of Commons Standing Committee on Finance, Trade and Economic Affairs." Reprinted in The Bank of Canada Review May 1985. Courchene, T.J. "One Flew Over the Crows Nest." PEAP Policy Study 91-9. Institute for Policy Analysis, University of Toronto, 1991. Mon pays, c'est l'hiver: reflections of a market populist," Canadian Journal of Economics XXV.4 (1992): 759-91. Crow, J. "The Work of Canadian Monetary Policy," Eric J. Hanson Memorial Lecture delivered at the University of Alberta, Edmonton, 8 January 1988. Reprinted in the Bank of Canada Review February 1988. Fortin, P. "Innis Lecture -- The Phillips Curve, Macroeconomic Policy and the Welfare of Canadians." Canadian Journal of Economics (1991): 24. Let's Turn the Macroeconomic Policy Mix Upside Down!" Policy Options 14.6 (1993): 15-19. Johnson, D. "An Evaluation of the Bank of Canada Zero Inflation Target: Do Michael Wilson and John Crow Agree?" Canadian Public Policy -- Analyse de Politiques XVI.3 (1990): 308-25. Laidler, D.E.W. and W.B.P. Robson, The Great Canadian Disinflation. Policy Study 19 (Toronto: C.D. Howe Institute, 1993). Lucas, R. "The Bank of Canada and Zero Inflation: A New Cross of Gold?" Canadian Public Policy -- Analyse de Politiques XV.1 (1989): 84-93. Perry, J.H. A Fiscal History of Canada -- The Post War Years (Toronto: Canadian Tax Foundation, 1993). Wilson, T. and P. Dungan, "Altering the Fiscal-Monetary Policy Mix: Credible Policies to Reduce the Federal Deficit," Canadian Tax Journal 33 (1985): 309-18. Fiscal Policy in Canada: An Appraisal. Toronto: Canadian Tax Foundation, 1993. Wilson, T. and M. McGregor, "The 1985 Federal Budget: Macro and Fiscal Effects." Canadian Public Policy -- Analyse de Politiques XI (1985): 602-16. The Macroeconomic Effects of the 1986 Budget." Canadian Tax Journal 34 (1986): 563-87. TABLE 1: Canadian Economic Performance 1984-93 Compared to Recent Historical Experience and to Performance in Other G7 Countries Growth In Growth In Change In Period Real GDP % Employment % URate % CPI % 1964-73 Mean 5.4 2.8 5.0 4.1 Std Dev 1.6 1.1 1.0 1.5 1974-83 Mean 3.0 2.0 8.1 9.4 Std Dev 2.4 2.1 1.8 1.9 1984-93 Mean 2.8 1.6 9.4 4.2 Std Dev 2.5 1.7 1.4 1.1 1983-92 Canada 2.8 1.7 9.7 4.4 Other G7 2.7 0.8 7.8 4.2 1983-88 Canada 4.5 2.4 9.9 4.5 Other G7 3.2 1.0 8.2 4.1 1989-92 Canada 0.3 0.3 9.3 4.2 Other G7 2.0 0.5 7.1 4.4 Source: Canada, Department of Finance, Economic and Fiscal Reference Tables (Ottawa, 1993). Note: The other G7 countries are the United States, Japan, West Germany, France, the United Kingdom and Italy. TABLE 2: Federal Government Budget Deficits: Forecasts and Experience 1984-1993 billions of dollars on a budgetary(f.*) or national accounts basis) Legend for Chart: A - FORECAST YEAR B - FISCAL YEARS: 1984-85 C - FISCAL YEARS: 1985-86 D - FISCAL YEARS: 1986-87 E - FISCAL YEARS: 1987-88 F - FISCAL YEARS: 1988-89 G - FISCAL YEARS: 1989-90 H - FISCAL YEARS: 1990-91 I - FISCAL YEARS: 1991-92 J - FISCAL YEARS: 1992 A B C D E F G H I J 1984 STATUS QUO 34.5(f.*) 37.1(f.*) 34.3(f.*) 35.1(f.*) 36.4(f.*) 37.7(f.*) 37.3(f.*) -- -- 1985 FISCAL PLAN 31.1 27.5 25.5 -- -- -- -- -- -- 1986 FISCAL PLA -- 26.4 23.2 19.5 -- -- -- -- -- 1987 REPORT -- -- 32.0(f.*) 29.3(f.*) -- -- -- -- -- 1988 FISCAL PLAN -- -- -- 23.3 22.0 20.2 -- -- -- 1989 FISCAL PLAN -- -- -- -- 22.0 23.2 18.9 -- -- 1990 BUDGET -- -- -- -- -- 22.6 19.0 16.2 -- 1991 BUDGET -- -- -- -- -- -- 30.5(f.*) 30.5(f.*) 24.0(f.*) 1992 BUDGET -- -- -- -- -- -- -- 31.4(f.*) 27.5(f.*) 1993 BUDGET -- -- -- -- -- -- -- -- 35.5(f.*) ACTUAL -- -- -- -- -- -- -- -- -- NAT ACCTS 33.2 28.0 25.6 21.9 19.2 21.2 25.5 29.9 -- BUDGETARY(f.*) 38.2 34.4 30.7 28.2 29.0 29.0 30.6 34.6 40.5 Sources: Canada, Department of Finance, A New Direction for Canada: An Agenda for Economic Renewal (November 1984). Canada, Department of Finance, The Fiscal Plan (1985, 1986, 1988, 1989). Canada, Department of Finance, The Budget (1990, 1991, 1992, 1993). TABLE 3: Money Supply Growth, Real Interest Rates and Exchange Rates, 1980-1993. GROWTH GROWTH REAL REAL EXCHANGE RATE YEAR M1 % M2 % T-BILL % 10 YR % C$/US$ 1980 6.2 18.7 2.6 2.3 1.169 1981 3.2 15.3 5.3 2.8 1.199 1982 -0.1 8.9 2.8 3.4 1.234 1983 10.9 6.2 3.6 6.1 1.232 1984 3.7 5.3 6.7 8.4 1.295 1985 4.9 9.8 5.5 7.1 1.366 1986 6.5 9.9 4.8 5.3 1.389 1987 14.0 11.3 3.7 5.5 1.326 1988 5.6 8.4 5.5 6.2 1.231 1989 3.9 13.6 7.1 4.9 1.184 1990 -1.0 10.9 8.0 6.1 1.167 1991 4.3 6.9 3.1 4.2 1.146 1992 5.5 3.7 5.1 7.3 1.208 1993 10.4 3.2 3.1 6.1 1.290 SOURCE: Bank of Canada, Bank of Canada Review (Spring 1994), TABLE A1. Real interest rates are nominal interest rates minus the average rate of inflation as measured by the consumer price index in each year.