It is a piquant irony that, just as Bob Rae is being urged on all sides to admit his past mistakes, everyone else is about to repeat them. Rae nearly bankrupted the province of Ontario in the last decade trying to spend his way out of a recession, a fiasco from which he claims to have drawn the appropriate lesson. Yet it seems he’s the only one who has.
All across the world, leaders are drawing up plans for “fiscal stimulus,” in amounts that astound and terrify. China: $586 billion. Japan: $275 billion. Britain: $180 billion. And topping them all, the United States, where Barack Obama is preparing to add another $600 billion or so in “stimulus” over two years, notwithstanding a deficit that was forecast to exceed $1 trillion as it was—on top of the trillions of dollars the Federal Reserve has already pumped into the system. (A trillion here, a trillion there, pretty soon you’re talking real money.)
Here at home, Stephen Harper has gone from denying any possibility of a deficit during the election, to conceding, post-election, that it was indeed possible, to warning it was probable, to shrugging it off as unavoidable in the circumstances. But all of that was only prologue. Under fire from the opposition, who suggested it was not the economy but his government’s extravagant spending that was to blame, Harper went one step further at last week’s APEC summit in Peru. No longer was the deficit an unpleasant consequence of an economic downturn. Rather it was an “essential” instrument in fighting it. What was once a bug is now a feature.
So, to add to his ever-lengthening list of jaw-dropping about-faces, the former deficit hawk has become a believer in fiscal stimulus. How convenient.
If only it actually worked. Yet neither theory nor evidence gives us much reason to believe it will. However many times it may be invoked these days, and whatever its appeal as an economic cure-all (just add spending and stir!), it remains a fact that deficit spending has never actually worked as advertised. It didn’t work for Rae in 1991. It didn’t work for Marc Lalonde in 1982. It didn’t work for the Japanese in the 1990s, the French in the 1980s, the British in the 1970s, or the Americans in the 1960s. For that matter, it didn’t work for Franklin Roosevelt. (It wasn’t the New Deal that finally ended the Great Depression, but the war.)
The reason it does not work is that an economy is not so simple as the highly restrictive assumptions of Keynesian models would pretend: raising government spending does not, beyond the very shortest of terms, increase aggregate demand, but merely alters its composition, the public sector expanding at the expense of the private. It turns out you can’t get something for nothing, even in macroeconomics: the money the government spends has to be extracted from elsewhere in the economy, a process that rapidly unwinds any transitory gains in output.
Either it is taxed, which obviously cancels out most of the “stimulus,” or it is borrowed, leaving that much less for the private sector to borrow and invest. (What about Keynes’s famous “liquidity trap,” wherein banks refuse to lend no matter how much money is sloshing about? Isn’t that the situation we are in now? Perhaps in other countries: but in Canada, bank lending is up 11 per cent over last year’s pace. And in any event, there are other ways to inject money into the system besides the banks.) Such “crowding out” can be mitigated by borrowing abroad—but since foreigners can only lend us the dollars they gain from trading with us, that means imports have to rise, and exports to fall, far enough to generate the required trade de?cit. Again, this mutes any initial stimulus.
There is one other alternative: governments could order central banks to finance their deficits. But any resort to the printing press must eventually lead to higher inflation, and since markets know this, tends to be reflected almost instantaneously in higher interest rates. Serious buzz killer.
So the results of this latest Harperite conversion, assuming he means it, can be predicted. It will have little or no impact on the economy. It will, however, drive us deeper into debt. To a point, that might seem tolerable: even if the deficit were to hit two per cent of GDP, the debt-to-GDP ratio would soon resume falling under any reasonable growth scenario.
But suppose that “reasonable” scenario does not materialize for some time. Or suppose that, when the economy does at last revive, central banks are too slow to withdraw the liquidity they have been stuffing into the economy, as they always are, and we get a surge in inflation coming out of the recession, and the spike in interest rates that goes with it. Then the debt really starts to compound—just in time for the first wave of the baby boomers to reach retirement age, with all the strain that that will eventually impose on the public finances.
We are at serious risk of repeating the mistakes of the 1970s, ’80s and ’90s, in other words. Only this time we might not be able to avoid hitting the wall we seem so determined to hurl ourselves against.