March 2009

Which way out of a recession?

The natural reaction during tough economic times is to reduce spending and pay down debt. Unfortunately, that doesn’t help get the economy moving! So what should we do?

Are we the victims of a “paradox of thrift”?

This concept, outlined by John Maynard Keynes in the context of the Great Depression of the 1930s, seems to fit our current situation to a tee. The paradox is this:  when everyone starts saving their money in the face of an economic crisis, there’s a decline in consumption, which results in job losses and lower family income for many people. These people can no longer save, and the country’s overall savings decline. Thus, by hanging onto our money, we end up making the economic slowdown worse – and damaging our overall savings rate.

A consumer-driven economy

In this situation, it’s not surprising that major sections of the latest federal budget – from personal income tax cuts to tax credits for home renovations – are aimed at getting us to pry open our wallets. In Canada, roughly two-thirds of the economy is driven by consumer spending.

The problem is that many people’s wallets are already empty. In 2008, average Canadian household debt reached a record high of $90,700, or 140% of disposable household income. In recent years, our spending and debt levels have risen faster than our incomes. So increased spending is simply not an option for many people, especially those who are worried about their job security. Others who are less vulnerable would be willing to spend a little more – except that the banks have turned off the flow of credit.

A new consumer

The result is a new breed of consumers, more closely focused on their budgets. A recent survey revealed that 62% of Canadian households were planning to cut their spending in 2009. At this point, putting a little more money into taxpayers’ pockets through tax breaks won’t likely be enough. In the 1990s, the United States tried this tack by offering lump-sum tax rebates:  Americans used them mainly to pay down debt.

So how do we break out of this vicious circle and restart the economy? There’s just one answer:  since consumers no longer want to spend, the governments will have to step up instead. Let me explain...

A “good” deficit?

That’s the thinking behind the recovery plans proposed by our governments. The theory, largely inspired by Keynes, is that the government is now the only actor with the means to jump-start the economy. Basically, when you overspend, you go bankrupt; but when a government overspends, it runs a deficit – the weight of which, if properly managed, is shared by millions of individuals over more than a generation. So there is such a thing as a “good” deficit.

According to Keynes, it matters very little exactly how the government spends its money, providing that it gives people jobs and money of their own to spend. This is more or less what the Roosevelt administration did in the 1930s, building roads and national parks, and getting people off the unemployment lines in the process.

Massive action

These days, there is no shortage of places to spend our collective money:  many of our roads, schools, and hospitals, in particular, are more than ready for rejuvenation. If the programs are well managed, they could create jobs in the short term while building infrastructure that will improve our productivity in the long term.

But this approach can also be scary. People who lived through the 1980s and early 1990s will remember the out-of-control deficits of that period. At the time, Canada was sometimes compared to Argentina, a country that experienced a complete meltdown of its public finances.

Unfortunately, Dr. Keynes’s medicine can’t be taken in half doses. The studies and delays typically associated with government spending are strongly contraindicated – which of course adds to the risk that the programs could be abused. Is that a reasonable price to pay? We’ll know in a few years.

In the meantime, for consumers, the standard rules of careful money management apply more than ever:

  • save if you must;
  • spend if you can;
  • and weigh all of the potential risks and rewards of each financial decision!