Montreal, January 15, 2009 No 263

 

Martin Masse
is publisher of QL.

 

 

OPINION

SPENDING CUTS ARE THE KEY TO RECOVERY*

 

by Martin Masse

 

          Two of the country's think-tanks have recently offered budget recommendations to Finance Minister Jim Flaherty that deviate from the Keynesian consensus. The C.D. Howe Institute proposes very little new spending and argues instead for important tax cuts, especially for businesses and to stimulate investment rather than consumer demand. There should, however, be deficits totalling $40-billion over the next four years to cover the shortfall. The Fraser Institute called for both tax and spending cuts and for a balanced budget.

 

          Why is the Fraser solution the only one that makes good economic sense? The answer is to be found in the distinction between money and real resources, which the C.D. Howe analysts are ignoring.

          Finding money is not a big problem for governments. They can borrow or print gigantic amounts of it and throw it on the economy to boost this or that sector. That's what they did during the latest boom that we went through beginning in 2001.

          It gave the illusion that we had unparalleled prosperity when in fact we mostly got speculation and unsustainable bubbles in some areas, record levels of indebtedness and a depletion of capital that should have been used in sectors where there was a real and solvent demand.

          Now that a crash has predictably happened, these malinvestments have to be purged and the economy has to readjust to a sounder production process before it can start growing again. Real resources―we're talking here about manpower, machines, commodities, etc.―have to move from sectors that were artificially inflated during the boom to sectors where profitable opportunities existed but that had difficulty obtaining them.

          This takes time. During that phase, until they find a better use, resources can temporarily remain idle. This inevitably means higher levels of unemployment, closed plants and low-priced commodities that don't find buyers.

          As Austrian School economists have taught however, the wrong was created during the boom when inflationary policies created all the malinvestments. The recession is the difficult but inevitable adjustment process that will put the economy on a surer footing.

          Governments should do nothing to prevent it, despite how politically unpopular that may be. When governments launch massive spending programs, they simply grab more of the factors of production that businesses need, which keeps the economy down. The best governments can do is to get out of the way and give the private sector the means to navigate these troubled waters.

          Now, the C.D. Howe proposal seems to offer the best of both worlds. The tax cuts and incentives to invest will help companies restructure and adjust to the new market conditions.

          At the same time, by keeping public spending at current levels, the government will presumably continue employing resources that would otherwise remain idle, thus sustaining demand and the overall economy. This temporary support will be paid for by borrowed money that can be reimbursed in a few years when growth has resumed.
 

"The problem is that although money can divert real economic resources, it cannot create more. Borrowing money during a recession will no more create resources than printing money did during the boom."


          The problem is that although money can divert real economic resources, it cannot create more. Borrowing money during a recession will no more create resources than printing money did during the boom. While the government can cut taxes and put more money in the pockets of taxpayers and the coffers of businesses, what's needed is not just a transfer of money but of real resources.

          By cutting taxes while not cutting the equivalent government spending, the C.D. Howe solution would simply set businesses and government against each other as competitors in the same market for the same resources, thus bidding up their price. Who will get the real resources that correspond to the billions of dollars that the private economy gets in tax cuts but that the government is still spending with borrowed funds?

          It's not at all obvious that the private sector will come out the winner. Because they are not bound by the necessity of ensuring their profitability, government agencies can usually offer higher prices or higher salaries than the private sector.

          What is more, the government will issue treasury bonds to finance its deficit. A portion of these tax cuts will find their way into government debt instead of private investments. In the end, politicians and bureaucrats still get their hands on the real resources, the only difference being that they will pay for them with borrowed money instead of tax revenues.

          The C.D. Howe proposal is not as bad as Keynesian pump-priming. The latter implies that businesses get even fewer resources, as government appropriates more of them. This can only torpedo the economic recovery, as happened during the Great Depression or in Japan over the past 20 years.

          But it still doesn't go far enough. And it is still partly based on the Keynesian fallacy that aggregate demand has to be maximally boosted in the short run to avoid a recession, when the crucial issue is instead the proper reallocation of rare resources and a curtailment of government dead weight.

          The American economy rebounded only after the Second World War, 15 years after the Depression started, when government outlays were cut by about two thirds between 1945 and 1948. The only effective way to put more real resources into the hands of businesses and investors is to cut not just taxes but both taxes and government spending, as the Fraser Institute is proposing.

          Since Jim Flaherty is not likely to follow this advice, it will have to be repeated until a more enlightened and less opportunist government is willing to make this unpopular decision. How long will it take this time before this lesson sinks in?

 

* This article was first published in the National Post on January 16, 2009.

 

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