The phrase “paradigm shift” was coined by the historian Thomas Kuhn to describe the process by which an old belief system, long entrenched and widely shared, is suddenly overthrown by a new one. But how to describe the sudden revival of an old belief system to replace the new?
How, in particular, to explain the remarkable re-embrace of deficit spending (“fiscal stimulus,” in the phrase of the moment) across much of the developed world—not only by the political class, for whom its appeal is obvious, but by much of the economics profession? How, when so little fresh evidence has been offered of its effectiveness, and so much of the original critique that first discredited it remains intact? And how, in Canada of all places, which suffered more than most from a previous generation’s experimentation with deficit finance, and where the case for Doing Something would seem less pressing than elsewhere?
Yet here we are, with a Conservative government preparing to run a string of “stimulative” deficits the likes of which we haven’t seen since the early 1990s—as high as $40 billion, according to one report—urged on by the Canadian Council of Chief Executives, the Conference Board of Canada, and the editorial board of the Globe and Mail. Dissent, at least in public, has been confined to free-market think tanks, the Canadian Taxpayers Federation, and the odd crankish columnist.
It isn’t as if its new-found adherents show any great enthusiasm for the cause. It seems more resignation: we might as well try this. Or rather: people expect us to try this. Or perhaps: we will be punished if we don’t try this. For to the left of the Conservatives are four other parties, all of whom may be relied upon to criticize the government for not going far enough.
What we are witnessing is a kind of policy panic, a herdlike rush every bit as mindless as the financial panic that preceded it. If we have not gone as far as the Americans—at 2.5 per cent of GDP, even a $40-billion deficit would be dwarfed by the $2-trillion, 10-per-cent-of-GDP monster the incoming Obama administration is preparing—we have done so with even less justification. There, at least, the economic situation is such as to justify a little panic: the worst recession in at least 25 years, and possibly 70. Here, we have not as yet even met the technical definition of a recession.
I don’t doubt we will, though how deep and how long it will be is anybody’s guess: the worst-case scenarios currently forecast a peak unemployment rate of eight per cent, which would have been cause for celebration not so long ago. But the recourse to “fiscal stimulus” is a non-solution to a non-problem, or at best the wrong solution to the wrong problem.
Most recessions, indeed virtually all of those in living memory, are policy-induced. If not quite deliberate, they are at any rate the consequence of a tightening of monetary policy, generally in response to an earlier, too-loose policy.
This one’s different. This isn’t a policy recession. It’s what’s called a “balance-sheet” recession, driven first by the credit crisis—the collapse of financial markets, and the associated unwillingness of financial institutions to lend, either to the public or each other—and then by the efforts of businesses and households to retrench in its wake. Banks lend less. Households save more. Everybody hoards cash.
While the credit crisis has been most acute in the United States, its effects will inevitably be felt in Canada: with roughly 40 per cent of our economy devoted to exports, and 75 per cent of these delivered to the U.S., a one per cent decline in spending south of the border will tend to reduce the demand for Canadian products by about three-tenths of one per cent.
But to get a really severe, U.S.-style recession in Canada you’d have to have a really severe, U.S.-style credit crisis here. So far we haven’t seen that. And if we did, deficit spending would no more recommend itself as the solution here than in the U.S.
What is required, rather, are measures to address the problem at its roots: the disease, not just the symptoms. The first priority for policy makers, here as in the U.S., should be to fix the credit crisis; the second, to ensure that it does not recur. And, while there is room for some shoring up of aggregate demand while the patient recuperates, it is far from clear that fiscal policy is the right instrument for this.
How to get out of this mess? Best to ask how we got into it. The collapse of financial markets last fall fed a lot of instant analysis of the “capitalism is dead” variety. The fiasco was variously blamed on greed, the inherent instability of financial markets or the idiocies of investment bankers. The crisis, it was said, was the bitter fruit of years of free-market ideology, of a “frenzy of deregulation” that had allowed markets to run amok. The conclusion followed: if another Great Depression beckoned, Depression-era remedies were called for—loads of new regulations, and masses of public spending.
No one’s here to defend the actions of those who issued mortgages to people who couldn’t afford them, or who repackaged and sold these loans without regard to the likelihood of their repayment, or who bought these complex financial instruments and their derivatives without understanding what was in them, or who loaded up with too much debt themselves. But any attempt to pin the blame on “the free market” has to reckon with the pervasive influence of the state at every stage of the process. In brief, the government’s fingers are all over this thing.
Start first with the housing bubble, the doubling of U.S. housing prices in the space of a decade, whose subsequent collapse set off the crisis. And what inflated the bubble? The state: not by a failure to regulate, but more or less as a deliberate act of regulation.
This is true in at least three ways. First, there was the overly loose monetary policy pursued by the Federal Reserve in the wake of the 2001 recession. From 2001 through 2006, the Fed kept interest rates significantly below the rate consistent with non-inflationary growth, as indicated by the famous Taylor Rule, devised by Stanford University economist John Taylor. The result: rising inflation, and runaway housing prices.
Second, there were the various regulatory schemes, under both Democratic and Republican administrations, aimed at pressuring banks and other financial institutions to provide more and easier mortgages, especially for low-income borrowers: the Carter-era Community Reinvestment Act, in particular, originally intended to combat discrimination against low-income neighbourhoods in the writing of mortgages, in the 1990s became more or less an explicit quota system. As Peter Wallison writes in a study for the American Enterprise Institute, “it was now necessary for banks to show that they had actually made the requisite loans, not just that they were trying to find qualified borrowers.” To this end, banks were enjoined to use “innovative or flexible” lending practices, i.e., lower their standards.
Inevitably, Wallison writes, this relaxation of standards infiltrated the broader market: “Bank regulators, who were in charge of enforcing CRA standards, could hardly disapprove of similar loans made to better qualified borrowers.” This was reinforced by the actions of the two government-sponsored mortgage giants, Fannie Mae and Freddie Mac, whose original mission of promoting middle-class home ownership underwent a similar politically inspired transformation. With Congress’s blessing, the two went on a mortgage-buying spree, eventually accounting for nearly 50 per cent of all U.S. mortgages. The only proviso was that a certain percentage of these be for low-income housing: 30 per cent at first, rising to 55 per cent by 2007. To make these targets, they were required to take on the riskiest sort of loans, the so-called subprime mortgages. The rest is history.
A third broad contributor to the bubble is worth mentioning: the influx of savings from abroad, notably China. It isn’t that there was a savings “glut,” as is sometimes alleged: foreign savings simply made up for the decline in domestic savings. But whereas domestic investors could invest in any asset, China was prohibited by law, as Laurence Booth of the University of Toronto’s Rotman School of Management writes in a recent study, from investing surplus U.S. dollar reserves in real assets or buying U.S. companies. Instead, it was obliged to invest in “U.S. government and agency debt, mainly the mortgage debt issued by Fannie and Freddie.”
Of course, the housing bubble is only one side of the mess. The other was what was done with those mortgages after they were issued, as they were combined and recombined into packages of assets of dizzying complexity. That many financial institutions made reckless bets on these investments, without fully understanding what was in them, is well known. The interesting question is why. They employed a faulty risk management system that that did not properly account for the possibility of a once-in-a-lifetime, generalized market meltdown. Why was that? Compensation schemes emphasized short-term returns to the exclusion of any concern with the long-term health of the company. Again, why? Why should so many financial institutions have seemed so hell-bent on self-destruction?
Could at least part of financial institutions’ refusal to consider the worst-case scenario be explained by the fact that, at repeated intervals in the past, they had been spared the worst? The present crisis, after all, was preceded by the long-term capital management crisis of the late 1990s, and before that the savings and loan crisis of the early 1990s, both of which ended in bailouts. As the economist Tyler Cowen of George Mason University has written: “creditors came to believe that their loans to unsound financial institutions would be made good by the Fed—as long as the collapse of those institutions would threaten the global credit system. Bolstered by this sense of security, bad loans mushroomed.”
That’s not to say that some sort of regulatory reform will not be part of the solution. The days in which large investment banks could take on unlimited amounts of leverage are clearly over (as, indeed, are most of the investment banks themselves). But if there were gaps in the regulatory framework, it is also clear that a certain amount of misregulation was at work. The securitization craze, for example, was in part an attempt by U.S. banks to break out of the limits imposed by their geographic isolation, a legacy of Depression-era prohibitions on interstate banking. Internationally agreed banking standards, known as the Basel accords, are now seen to encourage too much lending in good times, too little in bad times, since the value of the capital that banks are required to set against loans will rise and fall with the business cycle.
But that’s for another day. The immediate problem is the freezing up of credit, particularly in the interbank market—the loans between financial institutions on which all other lending depends. So long as there remains an unquantified inventory of bad loans, hidden inside complex debt instruments and buried deep in balance sheets, a degree of generalized mistrust will prevail—a phenomenon Taylor calls the “Queen of Spades problem.” As in the game of Hearts, where every player seeks to avoid being the one left holding the Queen of Spades, so every bank wishes to avoid getting stuck with the “toxic” assets. In short, if banks were too blithe about risk in the past, they are neurotically risk-averse today.
Governments got us into this mess, and governments will have to get us out of it. But how? As much as you may have heard it repeated, our situation is indeed different from that of the U.S. We did not undergo anything like the same housing boom that the Americans did, nor has our bust been anywhere near as deep. Subprime mortgages, while not unknown here, did not take a remotely comparable share of the market. Our banks are relatively well-capitalized and broadly diversified. The credit crisis is not nearly as severe here as there, nor has our economy—so far—taken the same nosedive.
So it is hard to see the emergency that justifies a sudden lurch into $40-billion deficits, for starters. Add to this the practical problems. It’s all very well to spend money on infrastructure. Indeed, there’s an argument for bringing forward projects that were already in the works: in a recession, with all that surplus labour at hand, these are likely to be cheaper. But is it as simple as that? Is there all that much in the pipeline, waiting and ready to go? If not, how soon, realistically, can new projects get under way from a standing start? How likely are these to pass basic cost-benefit tests, if they are dreamed up on the fly? And is there all that much surplus labour hanging about? As things stand, Canada is still experiencing labour shortages, especially for skilled tradesmen.
The more fundamental objection is that fiscal stimulus does not stimulate much of anything. Journalists talk about government spending being “injected” into the economy, apparently oblivious to the fact that the money has to come from somewhere. Either it is borrowed, or it is taxed: in either case, whatever initial stimulative impact there might be (see construction delays, above) is very quickly unwound.
Standard Keynesian models showing large “multiplier” effects from deficit spending typically assume economies are closed to trade (else much of the spending “leaks” out to imports), and expectations of the future are blind, i.e., consumers and investors do not worry about the long-run consequences for debt, taxes and ultimately for inflation of running large deficits. They tend also to minimize the importance of government borrowing “crowding out” private borrowers. Relax these highly restrictive assumptions, and much of the case for deficit spending disappears.
Indeed, latter-day proponents are notably short of examples of it actually working as advertised. Take Japan in the 1990s, the textbook balance-sheet recession. The Japanese government ran huge budget deficits, poured money into infrastructure projects, year after year after year. Japan’s debt to GDP ratio rocketed from 14 per cent in 1992 to more than 85 per cent in 2005. The recession ground on regardless.
Before then there was the French experiment of the 1980s—François Mitterrand’s famous “dash for growth.” It lasted little more than a year, before he was forced into a humiliating U-turn. And before that there was Britain. At a Labour Party conference in 1976, a rueful prime minister James Callaghan told delegates: “We used to think that you could spend your way out of a recession and boost employment by cutting taxes and boosting government spending. I tell you in all candour that that option no longer exists.” Doesn’t anyone remember?
As for the Great Depression itself, perhaps I should quote Barack Obama’s new chief economic adviser Christina Romer, who it turns out is something of an authority on the subject. In a 1991 paper for the National Bureau of Economic Research (“What Ended the Great Depression?”), she attributes the economic recovery to an expansion of the money supply (something to do with massive inflows of gold). “Fiscal policy,” she writes, “contributed almost nothing to the recovery before 1942.”
One last point about fiscal stimulus: we can’t afford it. No, a deficit of 2.5 per cent of GDP, even a string of them, is not going to bankrupt us—on its own. But we are not starting from zero, and the longer-term fiscal forecast is bleak. The C.D. Howe Institute has just released another paper on the fiscal impact of Canada’s aging population, with the first of the baby boomers reaching retirement age next year. The study estimates the increase in costs associated with the rising numbers of elderly, especially for health care (net of lower costs for education, as the numbers of children decline), at $1.5 trillion, enough to raise the tax burden for the main “demographically driven” programs from 14 per cent of GDP to nearly 20 per cent. This is not the time to be plunging headlong into deficits.
To repeat: this is a problem of credit markets. Much of what needed to be done to get them working again has been done. For example, Ottawa’s $75-billion purchase of mortgages from bank portfolios, or the offer of temporary federal insurance on interbank loans.
But so far as broader macroeconomic support is required, the necessary and sufficient mechanism is the Bank of Canada. Understand what this does and does not mean. Much commentary on the economy seems to assume that, in the wake of the biggest financial bust in history, no one has to feel any pain. Policy makers are urged to reflate housing prices, boost consumer spending, force banks to lend, almost as if the intent were to repeat the whole sorry history of the last decade. This cannot be. A certain amount of “taking our medicine” is inevitable: banks need to repair their balance sheets, consumers need to save more, and no amount of easy money can avoid that.
Still, if it’s stimulus you want, monetary policy is the best, quickest and most effective instrument. It works fast, it is less prone to politicization, and it more nearly targets the problem at its source: in the workings of financial markets.
Much nonsense has been printed to the effect that the bank has “run out of ammunition,” that with interest rates at historic lows fiscal policy is the “only game in town,” that the refusal of banks to lend means monetary policy is “pushing on a string” (in Keynesian terms, a liquidity trap). None of this is true. Again: Canada is not the United States. Interest rates have further room to fall here. It’s not clear that banks are refusing to lend. And as the Federal Reserve has shown, central banks have many more tricks available to them than simply twiddling the interest rate dials. In recent months, the Fed has been effectively bypassing the banks, buying up mortgage-backed securities on the open market, buying commercial paper, even announcing it will buy government bonds— anything to get money into the public’s hands, in whatever amounts the public wishes to hold. And while fears of deflation have been raised in the U.S., the Bank of Canada has an additional advantage: our generally successful experience with inflation targets means the public can have confidence that, come what may, the bank will see to it that prices do not drop.
But this approach comes with its own risk: with all this liquidity sloshing around, there is potential for a serious outbreak of inflation, once the crisis has passed. Central banks will have to be as quick to withdraw liquidity from the economy as they were to provide it. That has not always proved to be the case in the past.
The combination of massive monetary easing and large deficits is particularly worrisome. All it would take to turn a manageable $40-billion deficit into an out-of-control $100-billion deficit would be a sustained spike in interest rates. Then the magic of compound interest takes over, and it’s the 1980s all over again.
But look. We all know the budget is going to be about stimulus. You know it, I know it, and God knows the interest groups know it. “Stimulus” has become the catch-all for every special pleader and crackpot schemer looking for a handout. Very well: two can play at that game. There’s much the government could be doing that would be beneficial for the economy in the long run, even if it had little to do with the present crisis: tax cuts, sales tax harmonization, a national securities regulator, health care reform, the works. Couldn’t we all just agree to call this “stimulus”?