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.”
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