ANALYSIS-U.S. debt-cutting lessons from Canada, Belgium

Published: 03 Jun 2009 17:34:12 PST

NEW YORK/WASHINGTON, June 3 - U.S. President Barack Obama will need a lot of political will on his side when the economy recovers and he turns his attention to slashing the country's burgeoning budget deficit.

That's the lesson from Canada and Belgium, two countries that managed to cut huge deficits in the 1990s without sending their public finances into chaos.

But that political support could be hard to come by, even for a popular president.

Getting a handle on the deficit -- which is forecast to rise to the highest level since World War Two in the current fiscal year ending on Sept. 30 -- is vital to the long-term health of the U.S. economy. If investors lose faith in the country's ability to pay its debts, interest rates would jump, making it more expensive to buy a home or start a business.

The problem is growing more pressing as the 70 million-strong Baby Boomer generation approaches retirement and begins to collect Social Security and Medicare.

Obama and his economic team are eager to emphasize that the country cannot and will not live beyond its means forever.

Even as he ramps up spending to fight the recession and deliver on campaign promises, Obama has promised to halve the deficit by January 2013, the end of his first term.

Bringing down a deficit usually means harsh spending cuts and painful tax hikes -- never politically palatable and even less so when mid-term elections are looming in 2010 just as the economic recovery is expected to pick up pace.

"It is tough to do. It would have been impossible without public opinion on our side," Paul Martin, the Canadian finance minister in the 1990s who is credited with eliminating the country's deficit, told Reuters in an interview.

China and other big investors are growing increasingly fretful about the rising debt burden. Federal Reserve Chairman Ben Bernanke warned on Wednesday that rising U.S. debt was contributing to a spike in longer-term interest rates and said now was the time to start working on reining in deficits.

The International Monetary Fund expects the U.S. debt burden to rise to 97.5 percent of gross domestic product by 2010.

LESSONS FROM CANADA, BELGIUM

Canada and Belgium's tasks of garnering political support for cutting debt were helped by a number of external factors.

The Mexican peso crisis, which sent the Canadian dollar tumbling two months before Martin's budget, hammered home the need for a smaller economy to keep the country's fiscal house in order.

For Belgium, where debt peaked at 137 percent of gross domestic product in 1993, it was the prospect of not qualifying for membership in the planned single currency euro zone that helped drum up political will.

The Belgian government cut debt through tough public spending cuts and tax hikes that were key to adopting the euro. Failure to qualify for the euro would have been an embarrassment for Belgium because it had been one of the first countries in the European Union.

Canada also benefited from a global trend during the 1990s toward reducing deficits, Martin said, which helped persuade the public it was the right path to take.

Just as countries around the world have come together to fight the recession, they should turn to cutting deficits at the same time when the recovery takes hold, he said.

"It will be very important that just as the major economies have talked about stimulating at the same time they should cut the deficits at the same time," Martin said.

To Douglas Holtz-Eakin, who was chief economic adviser to Obama's 2008 opponent, Senator John McCain, Obama's promise to cut the deficit in half by the end of his term sounds familiar.

Former President George W. Bush was also elected on a tax-cutting platform and stuck to his pledge even after the 2001 recession and the Sept. 11, 2001, attacks, he noted. But when Bush's presidency ended, he left behind a huge deficit.

"He said, 'We're going to have to run deficits, don't worry about it, I'll cut it in half by the end of my term," said Holtz-Eakin, who is now president of DHE Consulting. "Barack Obama said exactly the same things."

PERSONALLY DIFFICULT

For Obama, who campaigned for president on pledges to provide healthcare to the uninsured and lower taxes for the overwhelming majority of Americans, cutting the deficit will prove to be difficult personally and politically.

Canada's Martin recalls how hard it was to come face-to-face with the human cost of cutbacks. One example in particular sticks in his mind: a woman at a senior citizens residence who took him to task about reducing spending on a program she relied on.

For Obama, paring down popular programs such as Social Security and Medicare would be a political nonstarter due to his campaign promises, although his economic advisers argue that cutting out inefficiencies could contain costs.

In May, Obama said he could wring $17 billion in savings from his budget by cutting waste in areas from weapons systems and education to the cleanup of abandoned mines.

But the cuts in 121 programs amounted to less than one-half of 1 percent of the total budget for 2010 and even the slim list of reductions is likely to face resistance in Congress.

Cutting defense spending would also be tough. The Obama administration has put forward proposals to rein in military spending, but with the United States still fighting wars in Afghanistan and Iraq it is not an area likely to see big cuts.

To be sure, if the economy stages a strong rebound and tax revenues rise, it would take some of the pressure off of public finances. However, the Fed's Bernanke and many other economists think the recovery will be sluggish.

That has led some economists and fund managers to worry that the United States will have to deliberately provoke inflation to cut the value of its debt. Allowing inflation to rise, particularly by letting the value of the dollar fall, eases the pain of repaying debt because money becomes worth less.

But Goldman Sachs economist Jan Hatzius said this fear is overblown, adding that historically, countries that have used inflation as a debt management tool have also been grappling with political instability, often following major wars.