Yesterday the Ontario Government’s consultant on how to fix the province’s finances, Don Drummond, released his 543-page report. For anyone who thinks our province isn’t spending enough on some programme or other — and let’s concede up front that there are legitimate cases to be made to increase funding on some things — it’s depressing reading.
Yet, for those of us who know the game of leverage is coming to an end — that “growth as we’ve known it” will be hard to come by, and that the ability to run deficits and grow out of them is finished — the proposals put forward are surprisingly tame. Efficiencies? Sounds terribly close to “cutting the gravy” (municipal) or “reducing waste” (federal).
So, while the author of Leverage: How Cheap Money will Destroy the World, Karl Denninger, took heart this morning at Drummond’s appraisal of our situation (I’ll forgive Karl confusing the province and the country), his final statement: “Now let’s see them implement it” is precisely the same one I would make.
GDP = C + I + G + (x – i)
That little formula — “Gross Domestic Product = Consumption + Investment + Government Spending + (exports – imports)” — is the true “devil in the details” we’re going to have to face (and we’re going to have to face it in our city and in the nation at large, not just in Ontario, but let’s deal with the province only today). We’re used to thinking of GDP as being a national statistic, but every jurisdiction has one. Every jurisdiction has a trade balance; every jurisdiction has some form of business community that invests (or not) within its bounds; every jurisdiction has its own spending; and, of course, its consumption (so long as its not a true “paper entity” with no one living there).
Let’s assume (without irony or snickering) that the McGuinty Government is seriously going to implement the Drummond report (and remember, Drummond himself said that the proposals were a package designed to work together, not to be cherry-picked for the more palatable options and ignore the rest — not, of course, that the two Opposition Leaders didn’t react immediately by doing exactly that, nor the usual special interest groups immediately start decrying the “destruction” and suggesting a life of “fire and brimstone” be unleashed at the very thought of their oxen being gored even slightly within minutes of the presentation of the report yesterday). Or, if you like, we could assume that they come up with their own approach, but it achieves the same shift in the spending we do. What happens, thanks to the GDP formula?
- Deficit spending pulls demand forward in time. This gets expressed as C (Consumption) that wouldn’t otherwise have happened. Cutting deficits immediately translates into lower C and a lower GDP. It also is a lower G (Government spending) — so there’s a double-whammy. The good news is that the system does adjust in 2-3 years.
- Cutting programme spending (in deficit or not) that is handed to enterprises to “create jobs” leads to the same effect, but this time with I (Investment) and G. Again, the system adjusts in 3-5 years (it takes longer because private risk investment is used to having government take the risk, and it takes time for the fund managers involved to finally realise they’re going to have to compete for projects and get off the sidelines waiting for a policy change).
- Bailing out the ill (e.g. as in 2008-9 when we poured money into GM and Chrysler to keep them afloat, is often seen as maintaining x (Exports) through the use of G (Government spending). (For large-scale industries one must take the entire supply chain into account to know if it is a good investment: in this case, is (x – i) for the auto industry as a whole positive — if it is negative you are probably pouring money down a rat-hole, and even if it is positive you may be destroying the “x potential” of other players by favouring some.) “Innovation agendas” are often created as well with the hopes of future x in excess of i accruing — yet almost always these fail to do more than allow the player to be built for sale to deeper pockets outside the country (and, as we’ve seen again and again, with the centre of gravity of that firm shifting outside as well, turning it from an x contributor to an i contributor in the locality’s market).
- Meanwhile, of course, much G government spending goes to regulation, supervision, and “rules to play by” in the jurisdiction. I am not going to argue that these are a bad thing (although some are — it is inevitable given the sheer number of regulations now in effect [a statistical universe conclusion without reference to individual items]) but they do often have an effect on I (jurisdictions compete for investment decisions except where the investment decision must be local, either because the situation is confined at present to this locality or because it must be made here to be made at all, and therefore there is a long-term conditioning of (x – i) as a result of the regulations in effect.
- Finally, government also delivers (or operates) services directly, which is part of G, and, wherever G spending involves employment on the public payroll in this or any of the above, those incomes and programme distributions in turn lead to a flow of C in the economy.
- … and one more point: some portion of G goes to paying interest on debt previously accumulated, which does little to nothing for the GDP but does affect how much G there can be for any combination of taxation (revenue) + this year’s deficit (i.e. new debt issued) + (if you are a jurisdiction that can do this) direct money creation (i.e. “printing”).
Cutting G, therefore, will cut C (2-3 years), I (3-5 years) and G‘s contribution to GDP. It is a sudden contraction. (In other words, to stop overspending on G is to trigger what we normally call a depression — and to fail to do so is to put it off until the day that new debt cannot be raised.) That’s why it’s such a trauma to rein the spending in, why the problem multiplies (not just adds) over time, and why politcians shy away from the really hard course.
In the case of Ontario, the last time we actually chopped into G (1995-99) we needed to do about 1/4 of what we need to do today. That’s been the price-tag of all the proligacy since, coupled with failing to use reformed public finances to pay down the accumulated debt to that point (which is now a multiple of what it was then).
Yes, that’s the reality: if you’re going to cut, you need to go beyond Drummond’s recommendations — you actually need to run a surplus, and a substantial one. This is because:
- Cutting G contracts C and I. This reduces economic activity, causing private-sector retrenchment. Support programmes for the unemployed, etc. start to require additional funds to meet commitments to a now-larger client base. Individuals also make shifts in their consumption patterns: last year’s private school tuition becomes this year’s “student in a public classroom”, for instance. So you need to cut G deeply enough to leave room for these increases in G that will occur during the transition.
- Drummond noted that tax increases would be a problem, and that’s because increasing governmental revenues during a reduction of G (remember, that’s spending, not revenue) must come out of funds available for C and I, making those contract further. (There’s also the fact that there’s only one taxpayer, that the other jurisdictions are facing similar issues and may be increasing their take simultaneously, and that taxes on enterprises simply get paid in product prices in any event, so simply raising corporate taxes or value-added taxes simply falls through onto C [spending more dollars to get less consumption]). I’ll also note (Ontario can’t easily “print”, but the Federal level certainly could) that planned monetary inflation reduces the value of money and has the same effect (one of the reasons the official statistics are constantly being reconfigured to make it look as though price increases that are showing up through an effective exchange rate devaluation on i, or via increased circulation of money against the same pool of goods which shows up against C that people pay get excluded from the jiggered numbers) that C can easily be reduced by monetary means.
- Finally, G must be below the rate of revenue for Government in order to start chewing down prior debt, freeing the interest paid segment of G (which does no “work” in the GDP) to become part of the GDP in future. Otherwise, you remain “stuck” in this position for years to come.
- If you want to try and improve (x – i), there’s also a need to consider carefully what mix of changes would make it possible for what Jane Jacobs called import replacement to take place, which at the very least can reduce i and improve local GDP, and at best have the positive improvement of increasing x as well, which is the only true measure of “growth” that is sustaining. Some other G may need to be assigned to make the jurisdiction “work better” (e.g. transportation and communications, energy supply and distribution, etc.) — in which case it’s got to come from the diminished G above.
The media in the weeks ahead will be happy to report the bleatings of interest groups, the whinges of opposition politicians, and to celebrate the quarter- and half-steps of the Government. Don’t be fooled — the acid test for change is not “how we want the world to be” but “how do we fix this”? If you have an investment decision or a programme spending (on operations or staffing) issue to push, it’s incumbent on you to also put forward what we won’t do, what we would cut, how we would make the overall picture better.
Otherwise, this will just get worse even through whatever portion of the recommendations do get put into effect, because the real underlying problem won’t be tackled.