Thursday, 18 December 2008

No Virginia, we’re not all Keynesians now

With the showdown over who will ultimately hold the reins of power in Ottawa in at least temporary abeyance, people are now focusing their attention on what if any action the government should be taking in response to still developing global financial crisis. Almost everyone seems to agree that Canada needs an “economic stimulus package”. What should such a “package” consist of though, and how big should it be?

Given the way politicians and journalists are talking these days, Canadians can be forgiven for assuming that the only way to “stimulate” economic activity is for the government to “inject” money into the marketplace through increased public spending. This is not the only option available to policy-makers though, nor is it even considered by many economists to be the best option.
The subject is not as complicated as one might think.

Fiscal policy refers to how government borrows, taxes, and spends, and is reflected in its budget. Some economists, mainly those who adhere to Keynesian economic theory (named after its chief proponent, British economist John Maynard Keynes), argue that government should stimulate economic growth through its fiscal policy by increasing public spending during times of economic contraction. Most economists today reject that theory however. They believe that monetary policy, i.e. how government controls the supply of money, is a far more effective means of promoting economic growth.

This dispute was more or less settled in the 1980s when governments of the western industrialized countries abandoned Keynesian theory en masse in favour of what became known as monetarism to combat the high unemployment and soaring inflation that was crippling their economies. Not only was the combination of sound monetary policy and fiscal discipline responsible for finally bringing these problems under control, it also helped us come through at least two other serious downturns in the business cycle relatively unscathed.

Given this impressive record it’s a little surprising that there are still those –mostly left-leaning politicians and political activists – who believe in managing the economy through fiscal, as opposed to monetary policy. The reason may be that monetary policy is decided and implemented quietly and discretely, making it difficult to obtain credit for getting it right. In contrast to this, fiscal policy is wide open to public participation and political manipulation. Even then, the opinion that more public spending is the key to reversing the effects of a recession and promoting prosperity is by no means unanimous.

Dissenters within this group, mostly conservative, point out that government subsidies and bailouts are little more than the forced transfer of capital from productive to unproductive sectors of the economy, a practice that impedes the natural development of those productive sectors. They also point out that speeding up public infrastructure projects only reduces unemployment temporarily, and may in fact encourage future unemployment by inducing dependency on a level of public spending that is only intended to be temporary.

Furthermore, increased public spending is nothing more than an illusion since government must pay for it by either taking the money from productive sectors of the economy, i.e. raising taxes, or by borrowing the money, i.e. deferring those tax increases to a later date. A better way to “inject” money into the marketplace through fiscal policy, the dissenters say, is to limit public spending to only those projects and programs that are the core responsibility of government while lowering taxes, thereby reducing the amount of money removed from the economy in the first place.

In reality, neither of these options is particularly effective at stimulating economic growth since both are predicated on the belief that consumers will spend or invest more if they have more disposable income when, in fact, they tend to either save that extra income during difficult economic times, or they use it to reduce debt. Be that as it may, monetarists are inclined to favour a fiscal policy that controls spending and reduces taxes for the simple reason that such a policy compliments a good monetary practice.

Setting aside the purely economic issues, there are other reasons why increasing public spending in response to a recession is a bad idea.

First, as mentioned above, when government borrows money it’s actually raising taxes, but deferring those higher taxes to a later date. What does this mean in practical terms? Consider that the portion of this year’s federal budget allocated to servicing debt was around 14 percent. That means that for every dollar taxpayers paid to the federal government, they received just 86 cents of goods and services in return… not accounting for government overhead costs. Put another way, without that debt, taxes could be cut by 14% across the board without affecting a single government program. It doesn’t take an advanced degree in economics to recognize the positive impact such a tax cut would have on our current economic situation. In a very real way then, the borrowing of the 1960s, 1970s, and 1980s is hurting our ability to effectively respond to contemporary economic difficulties.

Of course, it’s possible that any deficit would be temporary; that would be the intent at least. But – and this is the second reason why it’s bad policy to start running up the credit card – increased public spending inevitably leads to an expansion of both the size and scope of government that is virtually impossible to roll back when the crisis abates.

This is perhaps the greatest flaw in Keynesian economic theory. In fairness to Keynes, what he advocated was increasing and reducing public spending as a way of regulating the cyclical expansion and contraction of the economy, not the never-ending growth in government. Unfortunately he failed to account for how strongly attached some industries and economic sectors would become to the increased public spending, and how fiercely they would oppose its elimination even during good economic times. This was a serious oversight for which he was severely criticized, provoking his famous and somewhat cynical retort that the long-term implications of his system were irrelevant since, in the long run, we’re all dead.

Except our children and grand children that is, who will be left to pay our bills in addition to their own.

None of this is meant to suggest that the government has no role to play in mitigating the worse effects of an economic downturn, and it must be accepted that in playing that role, the likelihood of posting a budget deficit is high. Running a deficit to maintain essential programs and fulfill critical obligations during difficult times is not the same as doing so in a futile attempt to spend our way out of a recession though. Bad fiscal policy now will only prolong a recession and could well deepen it.

That, coupled with the unjust burden it would impose on future generations of taxpayers, makes a big public spending package something to be avoided by the Harper government, even at the risk of precipitating another election.

Now is the time for the self-styled fiscal conservatives in the federal Conservative Party to prove how committed they really are to the core principles they have professed to believe. Will they step up, or will they show themselves to have been nothing more than big-government liberals who talk like conservatives only when it suits their political needs?

Soon we will all have the answer.