Fiscal Federalism: Hints of a Greek Tragedy to Come?
The Greek crisis has prompted numerous commentators to remark on the dangers of a monetary union which has no common fiscal policy.
From the perspective of euro members, the external value of the euro is threatened by large deficits and growing public debt in the so-called PIIG countries, notably Greece and Portugal.Â There is no effective mechanism in place to enforce the fiscal rules which were part of the euro agreement, and the European central bank has no power to buy government debt.Â In this context, bond spreads have grown dramatically between the euro countries, and especially between Germany and Greece.
From the perspective of Greece and other high deficit/debt euro countries, the euro has become a box. Faced with soaring deficits and debt, soaring interest rates and slumping growth, they do not have the option to devalue. Fiscal austerity is held out as the only solution. (Of course, the radical option to default on at least part of the debt and to leave the euro does exist – which is precisely why credit default swaps on Greek bonds have now risen to almost 4% of the face value.)
Are there lessons in this for Canada? Of course, the fiscal and economic situation is dramatically different. Nonetheless Canada is not totally unlike the euro area. From a provincial perspective, we have a monetary union, rather large differences in fiscal and economic circumstances and, crucially, no common fiscal policy worth speaking about.
Today (extrapolating a bit from the latest TD numbers), total provincial net debt is about 22.5% of GDP, or 38% of the total combined debt of the federal government and the provinces. That is a big number compared to most other federal countries where the federal spending role is much larger.Â Provincial net debt peaked at almost 30% of GDP in the mid 1990s, and is again on an upward trajectory due to recession induced deficits and the shared costing of stimulus measures.
The recent very gloomy prognostications of the Parliamentary Budget Officer built a rather scary long term scenario of the federal fiscal situation on some rather heroic assumptions regarding fiscal federalism. A key assumption was that federal transfers to the provinces would, after current arrangements expire in 2014, grow in line with health care spending, which is now running at close to 7% of GDP and expected to rise quite rapidly (ultimately to 12% of GDP according to the PBO, which sounds rather extreme.) The Canada Health Transfer will be running at about $30 Billion per year when the current deal expires.Â The Canada Social Transfer and equalization payments have also been growing following short-term arrangements made under the Martin and Harper governments. Ultimately, however, equalization and transfers are federal spending programs whose size is determined by the federal government (and the Harper government would prefer to return to the classical federalism model of divided responsibilities.)
The key point is that some provinces have fairly high debts and face much more acute spending pressures than the federal government. Equalization will help, but I for one would not assume that the federal government will necessarily maintain the rate of growth of health and social transfers. Meanwhile, Ontario and Quebec in particular likely face much weaker growth prospects than the rest of Canada, and, of course, have no ability to set interest rates and, with interest rates, the exchange rate. Debt will grow rapidly in provinces with slow growth rates as and when interest rates start to rise. The key dynamic here is thatÂ it will be very difficult for some provinces to return to balance andÂ to avoid a compounding of debt under “normal” circumstances in which nominal interest rates exceed the nominal growth rate.
Little wonder, then, that the provinces are having to borrow at significantly higher cost than the federal government. Bloomberg reports that the average yield gap between federal and provincial bonds is now 54 basis points, rising to 77 basis points for Quebec, and 80 basis points for Ontario.
The austerity being inflicted on Greece today by financial markets is an order of magnitude greater than Harris era austerity in Ontario. ButÂ austerity will beÂ increasingly forced on the weakest provinces and may well assume Harris era dimensions. Unless, of course, interest rates are keptÂ down below the growth rate, and the federal government assumes its proper share of future provincial spending responsibilities.