Mr. Flaherty was in New York a few weeks ago bragging about Canada’s fiscal situation, and warning the U.S. that it needs to act promptly to get its fiscal House in order. Mr. Flaherty’s trip to New York and his lecturing the U.S. government was clearly meant for Canadian consumption, since the U.S. Treasury Secretary could hardly care less about what Mr. Flaherty thinks. Perhaps Mr. Flaherty’s next stop will be Athens, Lisbon, or Rome.

Nevertheless, Mr. Flaherty has a point. The U.S. and Europe are making a mess of things and the world economy will suffer as a result. The U.S. and Europe have two things in common right now. First, the U.S, and a number of the Euro countries have serious debt problems; and second, the U.S, and many of the Euro countries have dysfunctional governments and government institutions, incapable of credible decision-making.  In the U.S., politicians are playing high stakes political poker over the approaching deadline for raising the debt ceiling. Few people in Washington are confident that a compromise will be reached that will include any kind of credible strategy to deal with the growing U.S. debt problem in the next decade. This on top of an economy already characterized by faltering economic growth, high unemployment, widening income disparities and a depreciating infrastructure.

In the EURO countries, everyone is focused on Greece, and rightly so. But Greece is simply a manifestation of far deeper structural problems in the EURO countries. No one in Frankfurt or Brussels is surprised by what is happening in Greece. First, Greece should never have been allowed into the Euro in the first place. Second, Greek debt should never have been guaranteed and third, Greece should never have been allowed to borrow at roughly the same interest rate as the German government. The reality is that the sovereign debt of all EURO countries is not riskless, as the authorities would like to believe. Nor is there a will among many EURO countries to finance on-going policy failures of other EURO countries. The reality is the EURO needs a major re-think about its underlying operating assumptions and conditions for membership. Mr. Trichet, the outgoing head of the ECB, understood this very well when he suggested a EU Ministry of Finance, knowing full well this would not happen.

The debt situations in the U.S. and Europe could have important implications for the world economy. The European banking system is fragile and the risk of contagion is very high. The U.S. economy could falter under rising debt and declining confidence. One thing is certain, international risks are increasing and this inevitably means higher interest rates.

What should Mr. Flaherty be doing about these international risks?  He should be developing a fiscal strategy, which would mitigate the negative impact of adverse international developments on the government’s finances and the economy. The 2011 budgets (March and June) are inadequate and we don’t have the luxury of waiting until March for the 2012 budget.

Good budget planning would include an adequate amount of “insurance” or “prudence” to guard against unforeseen events and inevitable forecasting errors. The purpose of the “insurance” is to protect the fiscal targets as much as possible and to give confidence to financial markets and stakeholders that the targets might actually be achieved. This enhances the credibility of the fiscal plan.

Mr. Flaherty understands that the budget needs to include “insurance”. In the 2011 budgets he adjusted downward the private sector forecast for nominal GDP for budget planning purposes by $10 billion in each year of the forecast. This adjustment for risk represents a downward adjustment of $1.5 billion in fiscal revenues in each year of the forecast.

But this amount of “insurance” is not nearly enough to deal with consequences of emerging international debt problems.

It amounts to only about one-quarter of the “insurance” included in the budget by the previous government during a period when the economy was much smaller. The 2005 budget, for example, included insurance increasing to $7 billion in the fifth year of the forecast, equivalent to 4 per cent of total government revenues.

The Minister of Finance has expressed his concern about the debt crisis in Europe and the serious fiscal imbalance in the U.S. Despite the evidence that economic growth is slowing in the U.S., and that interest rates will not only rise in coming years but also be more volatile, he has a built a budget framework that offers very little protection against adverse international developments.

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