Canada Survived the Downturn By Ignoring Keynes

02/16/2012 05:09 EST | Updated 04/16/2012 05:12 EDT

Since the beginning of the economic crisis in 2007, Keynesianism came back into fashion. One of John Maynard Keynes's central ideas is that when you find yourself in a crisis or a recession, the best solution is to increase government spending. Government spending will sustain overall demand, put everyone back to work, and kick-start the economy. The New Democrats and the Liberals are strong proponents of this theory.

Even if you already have a high level of accumulated debt, it doesn't matter. The solution to too much spending is more spending. The solution to high levels of debt is more debt.

There is something fundamentally wrong with that.

The key question you have to ask is this: Where does the money that governments spend come from? It has to come from somewhere. A government cannot inject resources into the economy unless it has first extracted them from the private sector through taxes; or put us further into debt by borrowing the money.

Every time the government takes an additional dollar in taxes out of someone's pocket, that's a dollar that this person will not be able to spend or invest. Government spending goes up; private spending goes down.

Government borrowing has the same effect. The private lenders who lend money to the government will have less money to spend or invest elsewhere. Or they will have less money to lend to other private business people.

Government borrowing and spending goes up; private borrowing and spending goes down. There is no net effect, no increase in overall demand.

It's like taking a bucket of water in the deep end of a swimming pool and emptying it in the shallow end.

A country that has pursued this type of policy is Japan.

Twenty years ago, Japan also had a speculative bubble in the real estate sector, which finally crashed in 1990. The Japanese government embarked on a series of public spending programs to artificially stimulate the economy. They spent trillions of yen. But the Japanese economy stayed stagnant.

In 1990, Japan's gross public debt was 68 per cent of GDP. Today, it's about 225 per cent, the largest in the world. If we are to believe the Keynesians, Japan should have been the fastest growing country in the world during the last 20 years.

Here are two more examples from history.

Ten years before the Great Depression, in 1920 and 1921, the U.S. economy experienced a very severe recession. The economy went down by 17 per cent. Unemployment went from five to 12 per cent. But almost nobody knows about it, because it did not last very long.

The president at the time, Warren Harding, did not believe that increased government spending was the way to revive the economy. He cut the American government's budget almost by half. It went from $6.3 billion in 1920, the last year of the Wilson administration, to $3.3 billion in 1922. He also cut taxes. By the end of 1921, the economy had rebounded and grew for the rest of the decade. Unemployment went down rapidly, to 2.4 per cent in 1922.

What about the Great Depression itself? Many people believe that President Roosevelt's "New Deal" solved the crisis. But that's not at all that happened. Despite all the new spending and new programs, the Depression went on and on.

In 1939, Roosevelt's secretary of the Treasury, Henry Morgenthau, made a startling admission: "We have tried spending money. We are spending more than we have ever spent before and it does not work...After eight years of this administration we have just as much unemployment as when we started...and an enormous debt to boot!"

It is also often said that the Second World War ended the Depression. Unemployment certainly went down, because millions of men were drafted. But the situation did not improve for ordinary Americans. Most basic products were rationed during the war.

The Depression actually ended after the war. That's when government spending was drastically reduced. Government spending went from 92 billion dollars in 1945 to 29 billion dollars in 1948, a reduction of more than two thirds. That's when the post-war prosperity started.

Again, if we follow Keynesian logic, that is not what should have happened. With these spending cuts, government was reducing overall demand. The economy should have crashed.

But you have to look at it from another perspective: The government released resources that became available to the private sector.

Government spending always competes with private sector spending for scarce resources. When you divert resources from the more productive uses that they can find in the private sector, to less productive uses in the public sector, you will not see growth.

To revive the economy, we need to give entrepreneurs the means to create wealth. This means, first of all, to restrain spending. We also need to reduce taxes. We need free trade. Finally, we need less regulation.

Our country did pretty well since 2007, in part because we had sound public finances before the crisis. And because our stimulus plan was limited and well-targeted, mostly on needed infrastructure.

Our conservative government did not lose control of its spending. We did not create unsustainable deficits. And today, we are on a clear path to a balanced budget.

Sustainable growth cannot be achieved with more government spending, more debt and more taxes. That's the Keynesian solution. It has failed. What we need is a conservative approach, which emphasizes the primary role of the private sector in creating wealth and sustaining economic growth.