Merkel: Europe should be more like Canada! Is that realistic?

At a reception in Ottawa on Wednesday, German Chancellor Angela Merkel said that the euro zone should look to Canada for inspiration on how to deal with its ongoing debt crisis. According to Bloomberg, she hailed Canada's efforts to trim its deficits and practice fiscal discipline, saying, "This is also the right solution for Europe."

Should Spain and Italy be a little more like this? (Getty Images)

Well, who doesn't love Canada? Yet some economists have argued that Canada's efforts to tame its budget deficits in the 1990s don't necessarily offer good lessons for the euro zone today. The situations are far too dissimilar.

On the surface, its easy to see what Merkel finds appealing about Canada's experience. Back in 1993, the country had the second-highest debt-to-GDP ratio of any G7 country, behind only Italy. So the Canadian government, led by Liberal Prime Minister Jean Chrétien, embarked on a sharp program of fiscal austerity, chopping public budgets and reining in government debt. Budget surpluses were appearing by the late '90s. Canada's economy grew rapidly. U.S. newspapers no longer referred to Canada as a basket case. All was well in the land of Mounties and ice hockey.

Except, as economist Marshall Auerback points out, Canada also had a number of things going for it that don't apply to the euro zone today. Canada was able to boost its exports dramatically in the 1990s by depreciating its currency and taking advantage of strong growth in the United States, a major trading partner. Canada's oil production also started surging during this period. By 2000, exports made up 45 percent of Canada's GDP. What's more, Auerback notes, Canada enjoyed "an expansionary monetary policy which did significantly stimulate consumer spending, and which was sustained until the financial crisis."

Compare that to the troubled members of the euro zone today. Countries like Spain and Italy can't devalue their own currencies the way Canada did, because all they're tethered to the euro. The world economy is also in a slump at the moment, making a trade-based recovery much harder to pull off. No one has discovered massive new oil deposits in Greece or Portugal. Meanwhile, the European Central Bank has remained fairly tightfisted with its monetary policy.

That's why analysts think it's unlikely that austerity in Spain or Italy will lead to the same miraculous results that Canada saw in the 1990s. A study last year by the International Monetary Fund looked at 173 cases of fiscal austerity over the past three decades and found that, on average, reducing the budget deficit by 1 percent of GDP cuts real incomes by 0.6 percent and raises unemployment by 0.5 percent. That's exactly what appears to be happening in Europe, as budget cuts and tax hikes bog down many euro zone economies, making their deficit problems worse, not better.

"Canada's experience is more the exception than the rule," concluded Neil Dutta, a Bank of America analyst, when he looked at the lessons of Canadian fiscal discipline back in March. Sure, austerity can be painless if, like Canada, a country can devalue its currency and take advantage of a voracious trading partner just across the border. For everyone else, it's a tougher slog.

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Dylan Matthews · August 16, 2012