The pitfalls of infrastructure spending: Lessons from Canada

Recent experience and debates about spending on infrastructure as being the panacea for Japan, the US, Western Europe, Canada, for job creation in particular, have reminded me of a long, detailed study I wrote about that topic back in 1998 about the miserable Canadian experience. At the root of that experience was the destruction of accountability in the federal government: and it is worth repeating how that happened. Perhaps present decisionmakers in political capital today can learn some lessons.

Here is what happened.

Max Henderson, Canada’s auditor general until 1973 noted that until the early 1960s, Canadian MPs truly understood government budgets. The report of his predecessor, Watson Sellers, was 80 pages long and simple. These days the Auditor General’s report is routinely more than thousands of pages. The Minister of Finance and the President of the Treasury were traditionally the guardians of public money. The erosion of their role began in the 1960s with the rise of public spending on no-matter-what-trained “macro-strology” planners (as I have been calling those trained in the pseudoscience of “macroeconomics” for the last 30 years) to senior policy positions.

A former Deputy Minister, Alan Ross recalled:

The currency of the day, as far as the major bureaucrats were concerned, was ideas and new programs. That’s what you got good marks for … any program was a good program. And it was an exciting time for being a politician because you were building new programs, you were building bridges, you were building monuments …. I’m going to be promoted. I’m going to have more people reporting to me … and the whole idea therefore of accounting for your resources, demonstrating your cost management skills, just seemed redundant. The people who were in power considered those kinds of discussions about program costs to be what they called the bookkeeper mentality and real managers didn’t bother themselves with that kind of nonsense. We were interested in the big picture, the strategic thinking and those kinds of things.

Beginning in the 1960s, government departments made thousands of recommendations and hired armies of management consultants to examine them and prepare reports. The consultants wrote reports department heads wanted to hear: Increase the size of the office, hire more staff — and send the bill to Treasury. In fact, Ross was appointed specifically to bring new, modern management controls to the bureaucracy. The mandate of the Glassco Commission was to find out how to manage this new size. The Commission’s recommendation was that managers should be left alone to manage. Although this “decentralization” looked good on paper, in practice it suffered from an oversight, as Ross admits: The “managers” were not responsible for their programs’ costs.

By the first year of the Trudeau administration in 1969, this spend-more, deficits-are-good philosophy had captured the imaginations of Ottawa, the federal bureaucracy, and most economists — not only in Canada, but throughout the Western world. The economic boom in the United States that followed the Kennedy tax cuts was taken in Canada as a proof that “just-spend-is-good” works. At first though, the “problem” for Pierre Trudeau’s ambitions was that large-scale spending for all the new programs required scrupulous vetting by the parliament before approval. So the House of Commons changed the rules.

Before Trudeau, the House discussed spending estimates; now “there was no time,” so deliberations were moved outside the House to “standing” committees. It was stipulated that if these committees did not vote on spending measures by June 15, they automatically passed. Paul Dick, then Parliament member and later Minister under Brian Mulroney, recalls that once this rule passed, “people started arguing and discussing policy at the standing committees, but they didn’t discuss the finances of a department anymore. And we lost public scrutiny of parliament … Nobody was taking a look at the beans anymore. Nobody was taking a look at what was happening with the dollars and cents.”

This general breakdown of legislative discipline that remains to this day, the change of rules, was accompanied by the circumvention of the office of controller general. Politicians no longer had to follow budgets for which the controller general held responsibility. By the late 1960s, the cabinet gave spending authority to ministers reporting to the Treasury Board. The problem was, and still is, that the Board is headed by another minister of cabinet. Thus, if the cabinet approved spending, the Board was unlikely to deny it.

The auditor general’s office did not fare better. Max Henderson, who occupied that office during the key period 1960-73, when big-spending theory was translated into budgetary reality, attempted to expose the government’s waste and extravagance. In 1970, the Trudeau cabinet’s reaction was to introduce a bill in the House of Commons cutting staff salaries in the Auditor General’s office and freezing its size. There was sufficient uproar across Canada that Trudeau was forced to withdraw the bill late in the year. Following Henderson’s 1973 retirement, though, the measure was pushed through. In a recent interview before his death, Henderson observed: “They curtailed the fellow in that office so he would behave himself. … I hate to brag, but I prophesied what was going to happen. The depreciated dollar, the incredible size of the national debt, the terrifically high taxes that would sap the incentive of our people.”

Though Kenneth Dye, Auditor General during the 1980s, produced reports warning about the accumulation of debt, he had no impact. His reports, revealing the spending waste and demonstrating the compounding costs of these mistakes were eclipsed by the then influential Keynesian activism’s rosy language. The spend-and-borrow revolution was complete, and government accountability was gone.

This was visible when Canadian governments talked about “job creation.” The rosy published employment statistics did not bring increased living standards. The statistics largely reflected continued government guarantees and subsidies to a wide variety of companies. Just as aggregate statistics and employment figures proved meaningless in the former communist countries, so they still are in countries where governments control increasing spending in an economy — especially, as accountability got lost.

Canadian steel analyst Jay Gordon made a detailed analysis of the Canadian industry, and concluded: “In the Canadian experience the companies which have been the greatest beneficiaries of government largesse have been the greatest flops. The most egregious example is Sydney Steel (SYSCO) in Sydney, Nova Scotia. Essentially what SYSCO proves is that you cannot save jobs which don’t have an economic raison d’être. It’s that simple.”

The company was formed in 1967, when turn-of-the-century steel company DOSCO was shut down, having long since become commercially unviable. Ralph Hindson, then federal Director of the Materials Branch, published a study in October of that year confirming previous assessments that the plant was no longer financially viable. But DOSCO was the major employer in the province, with more than 20,000 on its payroll at one point. Despite the federal government’s initial refusal to help, the provincial cabinet decided to keep the plant open.

Hindson recalls that by 1974, seven years later, the company was in deeper trouble because SYSCO’s management persuaded the Nova Scotia government to “invest” an additional $125 million for which, as it turned out, the company could not even pay the interest. That interest was still compounding when, in the early 1990s, the government injected another $200 million. The government approved SYSCO’s sales to countries such as Bangladesh, but the booked sales were sheer fiction. Payment was never really expected. Indeed, under Prime Minister Joe Clark the federal government wrote-off these obligations: So much about relying on governments’ balance sheets and statistics when accountability gets lost.

Nova Scotia was by no means the only government trying to “save” the Canadian steel industry. Quebec, for example, threw hundreds of millions of dollars into Dominion Steel and Coal in Montreal. Fire Lake Iron Ore cost at least $450 million, and was shut down because it did not work. STELCO in Hamilton went ahead with the largest, most modern greenfield mill in North America. Twenty years later, it operated at about 20% of capacity. As industry analysts have pointed out:

If you make a lot of money, you tend to incur income tax liabilities. So steel companies like STELCO figure out that if we pay tens of millions of dollars in corporate income taxes, the government is just going to blow the money on subsidies to some other industry, or on welfare … If, on the other hand, we invest that money and we build a nice new steel mill, we’re going to be able to generate revenues … and hey, we may even create a few jobs.

Then there was the $55 billion cost incurred during 1974-85, when the federal government controlled oil prices, subsidizing wasteful consumption. And if all these mistakes did not impose enough costs on Canada — reflected in the accumulated $600 billion visible federal debt — the government, in nationalistic response to miscalculated private-sector lobbying, granted Canadian-owned oil companies advantages over foreign ones. This set the stage for firms such as Dome to borrow large amounts to buy up the “foreign” assets. What happened? The foreigners took their money out of Canada, and Dome’s stock price went from a high of $25 to almost zero once the price of oil dropped.

In light of Mr. Trump’s election, it is interesting to quote the observation I made in that study 20 years ago: “To be fair, it is not that Canada’s politicians in most cases acted out of ignorance or deliberate venality, but rather, that they were caught in a vicious circle. As taxes rose to pay for well-intentioned (if ultimately wasteful) programs, creeping fiscal disincentives increasingly snuffed out private-sector job creation. In order to soak up unutilized manpower, governments were compelled to expand wasteful enterprise subsidies requiring additional tax revenues, and so on. While tragic, it can at least be said that the proliferation of inefficient “job” programs prevented the total dissolution of some communities. This … may be the benefit Keynes may have had in mind when he wrote that it would be better to pay to dig holes and fill them up rather than to have potential breadwinners sitting at home on the government dole. The people, of course, prefer the kind of productive work that flows from a well-designed entrepreneurial society.” If their political leaders fail in providing such a system, however, people may support a second- or third-best system of being taken care of for a while, before they rebel.

Both the steel industry supports and intervention in the oil business reflected a broader theme in Pierre Trudeau’s “Just Society” vision of the late 1960s. Trudeau believed Canada faced two problems as a country: the language divide and the gap between rich and poor provinces. He confronted both with mistaken policies, including a wide variety of “regional development schemes,” the devastating consequences of which persist today.

Subsequent Prime Ministers did nothing to correct Trudeau’s errors. When in 1983, Prime Minister Brian Mulroney scrapped the Department of Regional Industrial Expansion he replaced it with the Department of Industry for all Canada. This new ministry immediately gave $1.8 billion for the Atlantic Canada Opportunities Agency (ACOA). Three weeks later, to satisfy the West, the government established the Western Economic Diversification (WED) agency with $1.1 billion. Quebec got the FORQUE agency with its $one billion budget. Although these sums were intended for “private sector” development in their respective regions, they ended up going instead toward local “job creation” programs, with bureaucrats supposedly picking industry “winners,” which of course they could not.

That the US did not learn anything form this experience. According to Phillip Lloyd, this is what happened in New Orleans. In October 2001, Scientific American published a report on what was likely to happen if a hurricane would strike the Gulf coast again. After a previous hurricane, the federal government sent $20 billion dollar. But instead of building infrastructure needed to mitigate future damages, the money was misspent. When in 2005, Hurricane Katrina came, the Scientific American’s predictions were on the spot: the $20 billion did not mitigate much, if any, damage, and the 2005 damage was estimated to be between $96 and $125 billion. History may not repeat itself, but it rhymes, as Mark Twain wrote.

Now back to Canada of the 1990s: Ottawa also encouraged exploratory drilling in the Arctic Ocean. According to Wilf Gobert, oil industry analyst at Peters& Co. at the time, “if that money had been invested in Western Canada, instead of the 50 or so wells in the Arctic at, say, $50 million each, you could have drilled 8,000 wells and at today’s prices each well would generate a revenue of about 4 million dollars, so with a hundred percent success rate you would have $32 billion. Royalties average 20%, so the Alberta government would have made 6.5 billion dollars.” Even with a more realistic 50% success rate, there is no comparison. Instead, the government subsidized private companies to sink the money in unproductive holes in the Beaufort Sea, the Melville Peninsula and Labrador Straits. But perhaps one of the most flagrant example of the 1990s misspending was the Karbomont project in Montreal east, which received $38 million in government help for a project that is expected to create 45 jobs. How many jobs were prevented by these spending and the higher taxes to pay for them?”

Not much changed during the last twenty years since I wrote that study. The federal and provincial governments continue to complain about — for me, not surprising — Canada’s lack of successful start ups and the miserable returns on its venture capital (about which the Federal government asked me to testify in 2008). Not much will — if oil and other resource prices go up. Countries with vast natural resources and tiny populations — as Canada is — rents from natural resources when the rest of the world does well, can cover for governments’ misspending. Now countries without natural resources, as Japan and, relatively speaking, the US are have to correct their fiscal blunders faster.

[An updated version of my 2008 testimony on Canada’s Venture Capital, can be found here]