Can we really spend our way out of this mess?

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”?