Can we really spend our way out of this mess?

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?