Strategy

Economic recession: Battle royale

Two great minds of the 20th century on the best way to manoeuvre out of the world’s current economic situation.

The federal finance minister, Jim Flaherty, recently committed Canada to recurring deficits. U.S. President Barack Obama’s plan to revitalize America’s economy is so costly that few nations could afford it — and some fear the U.S. may not be among them.

At the root of all this lies the belief that a nation can buy its economy out of recession. Can it really? That just might be the most important question facing the global economy. But this is not the first time it has been asked.

Before the Great Depression, many economists subscribed to laissez-faire thinking. One popular belief was that savings and investment automatically balanced themselves. If the economy went into recession and consumption fell, people would save more of their incomes. A savings glut would push down interest rates, which in turn would encourage businesses to invest. Governments should not intervene, the reasoning went, but rather support free markets and private ownership of property, low taxes and minimal regulation. The public pocketbook should be balanced even in crises — by raising taxes if necessary.

The Depression thwarted this thinking. Interest rates fell, yet no recovery was forthcoming. Between 1929 and 1933, prices plunged in a destructive deflationary spiral. Businesses failed. Canadian unemployment reached 27%. Economists were at a loss to explain it.

That was, until the arrival of British economist John Maynard Keynes. A dazzling polymath, Keynes was at once a daring commodity and currency trader, mathematician, public intellectual and theatre operator. He was also startlingly elitist and anti-Semitic. In the 1930s, he turned his attention to explaining the Depression — and what to do about it.

In 1936, Keynes published The General Theory of Employment, Interest and Money. Its dismaying premise: the economy was not self-correcting. Rather, circumstances could arise where businesses wouldn’t automatically invest in response to falling interest rates. The ultimate aim of investment is profit; if businesses believed falling consumption would persist, they would not buy new equipment or expand facilities. Keynes also pointed out that incomes collapsed during a recession, so savings dried up. Indeed, by 1932 Americans saved nothing.

Keynes’s remedy was nothing short of heresy. When businesses and citizens hoarded money, governments must stimulate the economy by lowering interest rates, reducing taxes and increasing spending on public projects.

Keynes didn’t invent fiscal stimulus. He merely provided a theoretical framework justifying it. His ideas had become orthodox by his death in 1946, and remained so for decades. In 1971, the folowing quote was famously attributed to President Richard Nixon: “We are all Keynesians now.”

That phrase actually originated in 1965, from a man whose ideas eventually supplanted Keynes’s. Originally a Keynesian himself, Milton Friedman meandered successfully between academic and government service. He came to believe the Depression resulted not from a failure of laissez-faire policies, but precisely the opposite. The Federal Reserve’s monetary policy was so inept, he argued, it turned what could have been a manageable contraction into a disaster.

Governments should not micromanage the economy or manipulate the unemployment rate, Friedman argued, because the public would realize what was happening and would tend to act against it. And central banks should be prohibited from fiddling with interest rates.

Economists blamed Keynesian policies for the massive inflation of the 1970s. By the 1980s, Friedman’s hour had arrived.

Friedman died in 2006, near the summit of popularity. Some interpreted the subsequent financial crisis, however, as a stinging rebuke to his ideas. His faith in minimal regulation, in particular, took a beating; leading banks are now widely believed to have behaved recklessly in an unsupervised environment.

Just as there are said to be few atheists in a foxhole, it seems Keynesian ideas gain currency during recessions. Prime Minister Stephen Harper, heretofore primarily concerned with keeping the public books balanced, now seeks to cast Keynesian policies as “conservative.” And the public largely supports it. One recent poll found that a clear majority of Canadians thought unemployment was the most important issue facing Canada, while virtually none deemed deficit spending a prime concern.

It seems we’re all Keynesians, once again. But we won’t likely remain so forever.