As the United States, Canada and other countries unleash trillions of dollars of economic stimulus packages on the world’s teetering financial system, it may be helpful to recall that the last time governments tried to “fix” the economy with mountains of borrowed money, it ended up making the problem worse.
Remember stagflation? Economic malaise? They were terms coined to describe the period of soaring inflation and shrinking GDP that characterized much of the 1970s and which we now know was a product of failed government policy.
Throughout the 1950s, the 1960s, right up until the early 1980s, governments regularly forked out “fiscal stimulus” in the belief that a slow economy could be rejuvenated by injecting it with money. Instead, it resulted in, among other things, ballooning public debt that continues to haunt taxpayers a generation later.
Blame it on the followers of John Maynard Keynes, the British economist who popularized the idea that it is the proper role of government to regulate the economy. In the aftermath of the Great Depression, Keynes made the case — radical for the times — that instead of sitting on the sidelines when the economy fell apart, government should apply fiscal stimulus to get the patient functioning properly and boost employment.
Prior to Keynes, the prevailing view was that economic cycles were a part of life and there was not much you could do to change them. Part of Keynes’ appeal was that he provided government with an action plan that could be publicly rolled out in time of need. Governments could be seen to be “doing something.”
His basic theory was that governments could spend money they didn’t have to keep people employed.
“Keynesian economics came out of the 1930s when Keynes was writing about the possibility of market failure,” said Toronto-Dominion Bank economist Craig Alexander. “People needed a way to understand what was going on. Keynes provided the answer.”
It was the wrong answer, according to University of Chicago economist John Cochrane.
“It was based on the idea that if the government borrows a dollar from you and spends it on me, output will go up by one and a half dollars,” said Mr. Cochrane, who calls Keynesian economics “logically incoherent.”
To be fair to Keynes, his prescription was intended for times of market collapse. When the crisis was over and the economy was growing again, governments were supposed to rein in spending. It was the policy wonks and politicians who failed to heed the second part, leading to the excesses of those times.
In the 1960s, serious economists recognized that what had come to be known as “Keynesian economics” did not work because the models it used to predict future outcomes kept spitting out wrong answers, Mr. Cochrane said.
But by then, it was firmly entrenched political orthodoxy in the United States, Canada and much of Europe. Even as developed countries were enjoying the biggest and most sustained economic boom in history, their governments were rolling out ever more ambitious spending programs financed by borrowing.
“Under [Prime Minister Pierre] Trudeau, Canada got into a whole bunch of businesses,” said Jason Clemens, a senior fellow at the Fraser Institute and director of research at the Pacific Research Institute. “There were airports and a slew of transportation projects,” much of which the government has left behind.
There was also the expansion of employment insurance and the Old Age Security program.
It all came at a price. In 1965, the federal government had a budget surplus of $21-million. A decade later, the surplus had turned to a deficit of $6.2-billion, or -3.6% of GDP, and by 1990 it had swelled to $32-billion, or -4.7% of GDP.
The contradictions in Keynesian economics became obvious toward the end of the 1970s as inflation took off while the economy went into a tailspin — a situation the great man never believed possible.
“That’s when the moorings came loose,” said William Robson, chief executive of the C.D. Howe Institute. “That’s when people realized it was a great granddaddy of a failed experiment.”
Central banks responded by jacking up interest rates — painful medicine that caused massive upset for mortgage holders who were suddenly faced with double-digit interest payments.
Meanwhile, taxes had to go up as well so governments could afford to cover their debt.
In the United States, successive governments first tried to tame inflation with wage and price controls, with disastrous consequences.
“We are all Keynesians now,” Richard Nixon said back in 1971, but he was repudiated nine years later when Ronald Reagan was elected president on a promise to cut spending and shrink government, the underpinning of what came to be known as Reaganomics.
“Government is not the solution to our problems; government is the problem,” Reagan famously said in his inaugural address.
The fundamental problem with Keynesians is that “they got inflation wrong,” said Mr. Cochrane. “They failed to realize that increased government spending would lead simply to inflation, not economic growth.”
That basic error was compounded by the escalating debt levels created by all the spending. The heightened government presence in the economy also had the effect of stifling entrepreneurial activity and crowding out private investment.
Perhaps the worst example of Keynesian economics gone awry was Great Britain, where a succession of governments piled on debt and enacted ruinous union-friendly labour laws that left the country with a collapsed economy and spiralling unemployment.
Ironically, the term stagflation was coined in Great Britain in 1965, but it wasn’t until 1979, when Margaret Thatcher came to power, that government officially recognized the catastrophic consequences of years of failed Keynesian policy.
It took decades to pay down the debts racked up by Keynesian policymakers, but now, in the face of the financial crisis, it appears the world is once again looking for answers in a failed idea.