Montreal, November 15, 2008 • No 261




Harry Valentine is a
free-marketeer living in Eastern Ontario.




by Harry Valentine


          Within less than a month of Washington approving a US$700-billion bailout package to stimulate the troubled US economy, China's government announced an economic stimulus package valued at US$600-billion. The US Federal Reserve has lowered interest rates down to the historic low levels that gave rise to the recent American housing boom. British interest rates were recently lowered to 3%, allegedly to stimulate the economy. Canada's new government is buying home mortgages to free up capital that banks could then lend out at low rates.


          The cause of all the economic stimulation and loosening of credit can probably be found in a treatise entitled Free to Choose by Milton and Rose Friedman. Friedman claimed the Federal Reserve's tight monetary policy that followed the stock market crash of 1929 was one of the causal factors of the Great Depression. The present chairman of the US Federal Reserve has acknowledged Milton Friedman's influence on his thinking and advised that the Federal Reserve would respond very differently should the stock market crash again.

Subverting Market Signals

          Many central bankers around the world have observed the American bailout package and the US Federal Reserve's reduction of interest rates, and are introducing stimulus packages of their own. However, a stimulus package in the form of below-market level interest rates led to the high-tech boom that was followed by the high-tech malinvestment boom and the high-tech meltdown of the 1990s. The same scenario was followed after 2000 when ultra-low interest rates led to the housing and malinvestment booms that culminated in the recent housing crunch and mortgage meltdown.

          Artificially low interest rates have resulted in large amounts of malinvestment in the American economy and in the economies of America's major trading partners, which include China and Canada. Many companies in both countries sell products to the US market, and they depend on reliable signals from that market. They may instead have planned their long-term production strategies based on misleading signals they received from the American market, but they had no way of discerning genuine market signals from the misleading signals caused by the low American interest rates.

          A large proportion of the stimulus packages being formulated in China and Canada are aimed at providing liquidity primarily to companies that planned their production based on misleading American market signals. This latest round of ultra-low American interest rates, along with the US$700-billion rescue package, runs the risk of generating a new round of misleading market signals. Many Canadian companies that export into American markets are likely to respond to those signals with new production. Some of those signals suggest a possible market for small, fuel-efficient automobiles during a period of falling oil prices.

"A stimulus package in the form of below-market level interest rates led to the high-tech boom that was followed by the high-tech malinvestment boom and the high-tech meltdown of the 1990s."


Governments Mandate Innovation

          There are areas of the American economy that appear to show promise. The signals from the electrical power market indicate that more electrical power will be needed in many regions including New York City and California. Government regulation of the power markets impeded earlier construction of generation capacity. Government programs in Canada provide funding for the development of renewable energy technology that is intended to produce innovative clean energy technologies with export potential. However, prior experience in the American economy indicates that technologies that are subject to state-sponsored research and development have limited market acceptance.

          The Stirling-cycle engine was a proven, efficient, low-powered, externally-heated piston engine that operated on air and that could use a very wide variety of fuels. Beginning in the 1960s and lasting over 30 years, NASA provided a massive amount of funding for research to improve the efficiency of that engine. The high expectations for an imminent breakthrough in efficiency literally stopped commercial production of the Stirling engine as potential customers waited for more efficient versions to appear. After 30 years, the efficiency of the Stirling engine remained essentially unchanged despite the vast amount of research funding that had been allocated to its improvement.

          The Canadian technology development program has resulted in different entrepreneurs in different regions developing almost identical pieces of clean energy technology, some of which are now being offered to a reluctant market. The scenarios of the Stirling engine and the thermo-acoustic engine will likely be repeated in Canada and will involve other market-ready renewable energy technologies competing with almost identical technologies that are being developed with state funding. Potential customers will likely wait for more efficient versions of the newer technology to appear on the market.

          Projected power shortages in regions such as California, Ontario and New York State are the result of earlier regulation of the power industry in those regions as well as several other locations. During the economic downturn, governments in those regions are likely to increase generation capacity by using public capital or by involving willing private sector players. There is a high risk of malinvestment in regions where the power sector is highly regulated and where politics will dictate the choice of technology.

          The power industry is one of several economic areas where political involvement will likely prevail. The interstate highway system is literally crumbling in many parts of America while highway repair work is also needed in parts of Canada. Municipal sewer systems in most major centers throughout the US and Canada are also in need of upgrading after many years of neglect. Governments in both countries seem quite willing to allocate massive amounts of capital to infrastructure projects. Unfortunately, such massive capital allocation will neither correct the massive malinvestment of the previous decade nor strengthen the economy.