POLICY OPTIONS: Mr. Flaherty, thanks for doing this.

JIM FLAHERTY: A pleasure.

PO: First of all, on the budget, the deficit, you seem to have made a strong case for your argument that it’s cyclical and not structural, bringing it down over a five-year period from $54 billion in the fiscal year ending March 31st to $1.8 bil- lion in 2015, from about 3 percent of GDP to one-tenth of 1 percent of pro- jected GDP five years out. Why would- n’t you just have gone straight to zero?

JIM FLAHERTY: Well, that’s not where the arithmetic took us, and we did have that discussion about why didn’t we do some other restraint item that would get us to the magic balance of zero.

PO: Because it’s a rounding error in those terms.

JIM FLAHERTY: Well, it is, and I thought we ought not to artificially try to create a zero balance. I thought, Let’s just do the numbers the way they are.

We didn’t do small things; we did big things, and with DND [Department of National Defence], with the foreign aid envelope and with the public service, three large moves, and those moves work out to that deficit of about $1.8 bil- lion, which is a small deficit in 2014/15.

PO: And no tax increases? Read my lips: no new taxes, right?

JIM FLAHERTY: That’s right.

PO: And your assertion is that you can balance the books, in essence, on restraining spending growth to 3 per- cent of GDP per year, which is half of the average of this government, histori- cally, and it seems that you caught a bit of a break in terms of forecasting when the fourth-quarter GDP growth was 5 percent. That’s a big number. Is it pos- sible that these numbers, the consensus forecast that you have on reducing the deficit, are even too conservative?

JIM FLAHERTY: It’s possible, and several of the bank economists have said that since the budget, and when I met with them at the beginning of February their prognostications were on the upside, which is just the oppo- site of later in 2008 where the numbers they were giving were weighted to the downside. So the numbers may be bet- ter over time; we’ll see.

PO: Is it important that the projec- tions for growth are consensus fore- casts by outside consultants and financial institutions rather than in- house forecasting by the Department of Finance?

JIM FLAHERTY: That’s right, and the Department of Finance has followed that procedure since 1994. We used this year 15 outside economists, including all of the big-bank economists, which is important because you get independent economists, one here, one there, who will have very different numbers and use different assumptions and then say, ”œWell, you, the government, are way off in your assumptions and your numbers are wrong.” Well, actually not our num- bers. They’re the average of this year 15 outside private sector economists. Some are from academia, and some are from the banking sector.

PO: So when some in the media say, ”œFlaherty’s assumptions could be proven wrong,” they don’t get it.

JIM FLAHERTY: Well, they’re not familiar with the process, which sur- prises me. This year we went through the trouble of listing them all in the budget.

PO: And bringing them in for a photo op and meeting with them.

JIM FLAHERTY: And saying to the economists " my assistant deputy minister was very clear with them. I was in the room, and he said, ”œWill you stand by this 2.6 percent real GDP growth average for the next fiscal year?” and the consensus was ”œYes.”

PO: Still with the deficit, and the US deficit, $1.6 trillion is 11 percent of GDP, and their debt-to-GDP ratio is reaching 67 percent. It’s getting to be the kind of number where the IFIs [International Financial Institutions] show up and ask for the keys to the car. When do you think the Americans are going to be as concerned about their deficit and debt as the rest of the world is on their behalf? Have you talked to [US Treasury Secretary] Tim Geithner about this?

JIM FLAHERTY: Yes, and in fact I talked to him very recently about this and to [Fed Chairman Ben] Bernanke, and [Bank of Canada Governor] Mark Carney and I have been talking about it as well, and I was at a meeting recently with several of the US senators and with Phil Gramm, who used to head the Senate Banking Committee, and there’s a lot of concern in the United States among people like the ones I just men- tioned about that, the level of the deficit. We’re talking about trillions of dollars.

PO: We’re talking about a current deficit of $1.6 trillion, the equivalent of the annual output of Canada, and we are a G7 nation.

JIM FLAHERTY: Right. American politics are complicated. They’re hav- ing a lot of difficulty with both Houses. Their midterm elections are coming up in November. This is not a good situation in the United States. I know that Tim Geithner wants to move towards a more realistic debt-to- GDP ratio. And I hope that he lays out a plan sooner rather than later.

PO: What’s your sense of the kind of shape Canada is in coming out of this recession, thanks to the virtuous cycle we had going into it and pru- dence in our financial institutions?

JIM FLAHERTY: Well, in the first three years of our government we paid down about $38 billion worth of debt. Thank goodness we did that, because we went into the recession in a much stronger position than any other Western developed economy, and we’re coming out stronger than any of the others. There really isn’t much room to move in some of the economies like the United Kingdom and the United States.

PO: Or Japan.

JIM FLAHERTY: Or Japan or Italy, and then there are the worrisome countries, not just Greece but some others in the EU that have very sub- stantial sovereign debt problems, and this is a lesson to sovereign nations not to get themselves in a position where they are going to have to take drastic steps to stay afloat.

PO: So there’s certain sovereignty issues around that, aren’t there?

JIM FLAHERTY: There are, and through the United States and China; China holds a great deal of American paper.

PO: Over a trillion dollars.

JIM FLAHERTY: The United States has the consumer power to buy a lot of Chinese manufactured goods, which is important, but consumer demand in the United States is weak.

PO: Just to finish with the deficit, your position is that about nearly half of it is in stimulus that is ending after the next fiscal year, and the rest of it can be obtained through these kinds of efficien- cies as in the expenditure review that [Treasury Board President Stockwell] Day’s going to be conducting as well as normal economic growth, right?

JIM FLAHERTY: Yes, and of course the spending restraint we brought in with respect to those three big items, DND, the foreign aid envelope and the public service.

PO: Now, we’re experiencing a housing boom in this country, and you’ve addressed some prudence around that in urging financial insti- tutions to raise mortgage thresholds from 5 percent to 10 percent down payments. Is there a point where we leave the housing boom and move to the cusp of a housing bubble that you’re concerned about? Do you have any US-style con- cerns here?

JIM FLAHERTY: Certainly nothing of the magnitude of what the United States went through.

We have to make sure that the mort- gages that are out there that are insured are of good quality. We know that they are of substantial quantity. So far they are of adequate quality, but we’re watching, and I work closely with Julie Dickson, the Superintendent of Financial Institutions, watching not only household mortgage credit but also household credit in a broader sense, credit card credit, the degree to which people are extending them- selves, and there are some concerns there that we’re seeing some tenden- cies to extend credit.

PO: So, too much household debt.

JIM FLAHERTY: Yes, but as I say, it’s not a bubble. There’s no evidence that we have a housing bubble, because you’d have to have low quality in terms of the mortgage securities, which we do not have, but we all know that interest rates have nowhere to go but up, and regrettably, some people seem to act as if that is not an inevitability.

PO: Well, part of this housing boom is obviously due to cheap liq- uidity that you guys pumped into the system in the fall of 2008 and subse- quently in the budget of 2009, Carney on the monetary side and you on the fiscal side. But as you just said, some of these liquidity issues aren’t going to continue going forward, and Mr. Carney’s embargo on interest rates is fast approaching on the 30th of June.

JIM FLAHERTY: Yes, and there are some other developments that’ll hap- pen this year, including the introduc- tion of the HST in Ontario and British Columbia on July 1, which will have some market effects. We also hope to see some moderation in the housing market as a result of the few steps that we took recently.

PO: Looking ahead to the G8 and G20, which Canada is hosting this year and obviously you’re playing a leading role there, what do you think we’ve learned from the meltdown of the fall of 2008 and the deepest reces- sion in our lifetime? Have the banks learned in Europe and America, do you think? What’s your sense of that?

JIM FLAHERTY: Well, unbridled greed is a dangerous thing. You know, lax lending standards are dangerous.

PO: And things like derivatives and the commodification of financial instruments?

JIM FLAHERTY: Yeah. High lever- age is dangerous. Irresponsible bor- rowers are dangerous, and I see dangers always in a systemic sense that the system is fully capable of collaps- ing. The history of Lehman Brothers is very instructive, and at the end of the day in Lehman Brothers, there was no buyer, and the United States did not have a choice at the time. I had discus- sions with [then US Treasury Secretary] Hank Paulson at the time, and despite frantic efforts they had to let Lehman Brothers go under. The Europeans then took great issue with the Americans, and I was in the meeting when that happened, about letting Lehman Brothers go and displaying a chart from the European banks showing that credit spreads had gone wild after the demise of Lehman Brothers. As I pointed out to the German minister at that meet- ing, he had banks levered at three to one and four to one in Germany, and here he was pointing his finger at Lehman Brothers and the American administration. So the lesson to me from all of that is that financial insti- tutions, when they see other financial institutions making relatively easy money, albeit taking on dangerous risk, will take on dangerous risk and will try to make that easy money, and that means that government has an important role to play here, that when we regulate we have to not just have regulations; we have to have effective regulations and enforce them. And I made those points recently at a bank- ing reform conference in the United States, and it was very well received, because the big institutions that failed in the United States, Lehman Brothers, Bear Stearns and so on " well, Bear Stearns was bought, basically; it was going to fail " were regulated. These weren’t unregulated institutions, but they were poorly regulated.

PO: So where does moral hazard meet moral suasion in all of this? Is there a way of putting this into a G8- G20 communiqu�

JIM FLAHERTY: Yeah, I think so. I think we’re making progress. I hope that we will end up with some sort of contingent capital fund for financial institutions globally. Everyone has to dance on this, and if everyone’s not on the dance floor, that means that capital will just go to the place where it is not regulated, as it will be in the other places. So Canada will do its part. We’re against a capital tax. We’re against a tax on capital transac- tions. We disagree with [British Prime Minister] Gordon Brown on that. I’m not quite sure where the Obama administration is on that. Tim Geithner was against it when we had a G20 finance ministers’ meeting in November in St. Andrews, and so was I. We both said so publicly. I’m not sure whether the Obama administra- tion may be rethinking that position, but we are in agreement, and we all agreed at Iqaluit, which I said pub- licly, that as a matter of principle, if financial institutions contribute to a crisis in the financial system to the extent that they do, they should bear the cost of that, and not taxpayers, and it’s a question of how one does that.

PO: I want to come back to fiscal frameworks, and particularly fiscal fed- eralism, because there may be a couple of big trains coming down the track. One is the renewal of the $41-billion health care agreement in 2014, and the other is the question of the sustainabil- ity of equalization payments going for- ward. I know you’ve promised the provinces to maintain them at 3 per- cent growth rates, but looking down the line, what kind of debate do you see there in federal-provincial relations?

JIM FLAHERTY: Well, the health spending is going up at 6 percent per year, as agreed; the Canada Social Transfer at 3 percent a year, as agreed, Equalization at the rate of growth of the economy.

PO: Do you see any red lights flashing there?

JIM FLAHERTY: Well, I see it on health care. I mean, health care costs at the provincial level are growing at 7 percent or 8 percent per year, depend- ing on which province one looks at, and I think the provinces are going to have to look at how they make their systems more affordable.

PO: And we have the largest cohort in world history approaching retirement age.

JIM FLAHERTY: Yeah, but probably the healthiest, which is an interesting thing because it cuts both ways: live longer but live healthier, with fewer demands on the system, although we all know that the greatest demands on the system are in the last six months of life. So yeah, I think the provinces will have to look at that. I tried to deal with it in Ontario when I was finance minister there, and it’s a tremendous challenge, because regardless of the degree of eco- nomic growth, health care costs will march along growing at 6 percent, 7 per- cent, 8 percent, 9 percent per year in the absence of any rational containment of health care costs, and it would be not good for the federation, for the provinces to just try to dump excess health care costs on the federal government, because the federal government doesn’t have the tools to control health care costs because it’s not our direct jurisdiction.

PO: Nor for you to download on them, on the provinces, as Paul Martin did in 1995.

JIM FLAHERTY: Yeah, that’s right. You know, it’s an important decision in this budget this year. We had to make a big 35,000-foot decision. We went through the usual way of doing budgets, of look- ing at individual items, all the trees, and at the end then we looked at the forest and went up at 35,000 feet, looked at the forest, and I did not like what I saw, because it would have been a lot more spending and it would have been very difficult to get to balance in the medium term. So we had to resolve that we would do a different kind of budget, have the least amount of new money spending in more than 10 years in Canada, do a few large things to control the rate of growth of spend- ing going forward and then be resolved that we would do it with modest economic growth expecta- tions, which is how we ended up with the budget that we did.

PO: On competitiveness and inno- vation issues, which is a major themat- ic of the budget, obviously, where do you see some of the challenges for Canada in terms of how you can tweak the system with budgetary measures and some of our comparative advan- tages, notably on corporate taxes and new investment and taxes on the investments?

JIM FLAHERTY: Well, we’re starting to have tax advantages. We already do, and there will be even more. I mean the Americans, when I describe our system to them, are just in awe, quite frankly, of where we’re going on cor- porate taxes and that we can afford to do it, because they’re in no position to do it. President Obama faces serious challenges in terms of the revenue he’s going to need to find.

PO: There’s one of your hot charts in the budget papers that’s quite strik- ing on comparative Canada-US and G7 taxes on new investments. You have the US at 34 percent and Canada having reduced from 32 percent when you took office to 16 percent when fully implemented in 2012. That’s a major source of comparative advan- tage, is it not?

JIM FLAHERTY: It is, and our person- al income taxes have been coming down. And a lot of poorer people or lower-income people are off the tax rolls altogether, so all of that is good. We can still run the government and substantial programs. Then you continue to build the military and rebuild the military. So we’re still able to do a lot with a fairly strong tax base in Canada.

PO: We put out an issue of Policy Options last month on Canadians and their pensions and whether they’re going to be available going forward, whether there will be some funding issues. Clearly there’s a lot of anxiety out there about Canadians wondering whether their pensions, both public and private, are going to be there when we need them. Is this a coming nation- al conversation that we need to have?

JIM FLAHERTY: It’s a current national conversation. Ted Menzies, my parliamentary secretary, did some consultations last year, and we made some regulatory reforms last year, but that was more directed toward the cri- sis we had had with some of the defined benefit pension plans, where they could not pony up and meet their capital obligations because of declines in the stock market. Now Air Canada would have folded had we not inter- vened last year and the same with another Canadian entity, which I won’t mention. So we made those reforms now in cooperation with the unions, and now we have the broader problem. We’ve had discussions feder- ally, provincially on this. There are basically three areas. There’s the ques- tion of whether we would expand the CPP mandatory system, or expand the CPP to take on a voluntary system, or use the private sector with a voluntary system, or do some combination of those three, or do none of the above. That’s basically what we’re looking at. British Columbia’s quite interested. Quebec has been quite interested too, following along, conscious of the needs that’ll be expected from the Quebec Pension Plan, and Ontario’s involved as well. So we have a lot of the governments in Canada that are going to participate in the public con- sultations we’re going to do in the next two months, and then the finance ministers are meeting again toward the end of May, and I hope by that time we’ll be able to look at the options quite closely and start narrow- ing the options.

PO: Is it fair to say that the CPP/QPP’s in better shape, though, than social security in the US going forward?

JIM FLAHERTY: Vastly better shape. I mean our Canada Pension Plan is one of the most solid, stable in the world, and actuarially stable going on at least 70 years.

PO: Even Kevin Page would settle for that.

JIM FLAHERTY: Yes. Yes. Dear Kevin.

PO: And in terms of defined bene- fits, the private pensions, the feds, as I understand it, regulate only about 7 percent of the equity, right?

JIM FLAHERTY: Right.

PO: So you’re not the major player in this space?

JIM FLAHERTY: We’re not, but the provinces and territories tend to look to the federal government to lead on pension reform. We’re working close- ly together, as I say, with most of the provinces on this issue. I don’t see any tendency in any of the provinces to want to be a renegade on this. I think we all realize the mobility of pension plans in Canada is essential for eco- nomic growth.

PO: A big part of the rescue of GM, in fact, was Ontario putting up the money for the pension plan, right?

JIM FLAHERTY: Yes.

PO: And what would you tell a Nortel pensioner who had spent his whole 35 years, 40 years of his life working out here in Kanata or someplace else in the sys- tem and ends up at the end of the day facing retirement shortchanged? Who does he see about that? I mean other than saying, ”œI feel your pain,” what can be done for them?

JIM FLAHERTY: Well, I have to state the obvious, that they’re a provincially regulated pension plan, not federally regulated, but I think you need to look at alternatives there, and we are.

PO: This is your fifth budget. Are you still a happy warrior?

JIM FLAHERTY: This one was more tiresome.

PO: More demanding?

JIM FLAHERTY: More wearying than any of the others. As the Prime Minister said, we had to say no a lot, and it’s my job to be the naysayer, so some of my colleagues are not thrilled with not getting anything, because we had to make that deci- sion, as I say, after looking at it from 35,000 feet to say no to almost everything.

PO: Right, and finally, the ques- tion on the minds of all Canadians: Where did Flaherty get that pom- padour?

JIM FLAHERTY: One of my col- leagues, who’s a woman cabinet minis- ter, said to me in the House today, ”œNow you know what it’s like, Jim, about women and their hair.”