The financial crisis that broke last fall and triggered the recent deep slump is without doubt a major historic event. Businesspeople, investors and economists, along with psychologists, satirists and polemicists, have compared it with the tulip craze, the South Sea Bubble, the great banking panics of one and two centuries ago – and, of course, the financial failures and Depression of the 1930s.
Even if, as we hope, the parallel with the 1930s does not hold, an economic setback of this scale will leave major marks on the economy and on society. But what kind? The immediate focus is naturally nurturing the green shoots of recovery that have sprouted since the spring. Further out, one possible impact looms large: a steep increase in the power and cost of government that shrinks the freedom and resources of citizens.
Canadians who prefer free association and action by individuals to state coercion must confront this threat. Economic and political crises often provoke statist reactions. Frustratingly, avoiding these reactions or, better yet, enhancing openness and personal opportunity in Canada, is largely hostage to events elsewhere – notably in the United States. Yet Canadians who see government as citizens’ servant rather than their master have plenty of scope for action at home.
Our response will affect not just the speed and durability of Canada’s recovery, but also shape the economic environment for the expansion to follow. Equally important, the most compelling stories about what happened and why will shape the philosophical environment for that expansion and beyond. In both areas, advocates of a free, open and dynamic Canada have much, and rewarding, work to do.
Three Key Takes on What Happened
The scale of the crisis, with 21st century human capital and communications, has already given us a voluminous literature on what happened. Three themes deserve special note here.
One is the disruptions critical in every bubble and mania since the invention of money and credit centuries ago. Faster growth in less developed parts of the world created both more goods and services for consumers in developed countries to buy, and more savings to borrow to finance them. Financial innovations, especially new securities backed by assets such as mortgages, consumer loans and leasing receivables, brought lenders and borrowers together more readily. Like past disruptions such as ocean-going ships, railways, and the internet, these ultimately benign innovations provoked outsized responses – too many people pouring in more resources than the nascent opportunity merited.
That spawned another element in the story: entrepreneurs, speculators and outright crooks whose energy, enthusiasm and shenanigans inflated the bubble. The disruptions and consequent enthusiasm spawned new business models. Many were legit, but created poorly understood risks, either within the business or to its counterparties. Some compensated their owners or staff in ways that discouraged prudence. A few – because of overreach or outright criminality – were no better than Ponzi games and cheque-kiting schemes. Financial buccaneers who, sometimes willfully, ignored the dangers of extreme, opaque leverage are a second key theme in the collapse.
The third is policy failures. Regulators charged with keeping financial institutions and systems safe and sound sometimes misunderstood the new securities and models, or failed to act on what they understood. A focus on the capitalization and liquidity of individual institutions left systemic risks unaddressed. Measures that might have been reliable in a static world were misleading when rising asset prices made everybody look good. Sometimes mandates left gaps: responsibility for key institutions or markets was unclear or missing.
At least as vital as passive mistakes, moreover, were purposeful actions. It mattered that earlier this decade the US Federal Reserve, under former Chairman Alan Greenspan, held interest rates too low too long. So – and central to this third theme – did US policymakers’ promotion of homeownership for even minimally creditworthy people, through subsidies, tax breaks, and political pressure on financial intermediaries with formal or implicit government guarantees.
All these elements – benign, careless and malign – seemed tolerable in the go-go bubble years of cheap borrowing, underpriced risk, rampant spending and rising asset prices. The latter two – rogue bankers and policymakers – are key to the pop, and the tactical and strategic challenges advocates of limited government now face.
Smart Tactics to Mitigate the Slump
Granted that events abroad can deflect the best laid plans at home, what tactics can speed Canada’s recovery and set the stage for a free-market-friendly expansion? Four main areas jump out: monetary, fiscal, international, and regulatory.
Central banks, as lenders of last resort and arbiters of the availability of money and credit, have been first responders to the crisis. Happily, we in Canada needed this support less than others, and got what we did need in a timely and well calibrated way. And not by accident: for a reason advocates of limits on state power should applaud, since governmental abuse of power over money has been a constant threat throughout history. The Bank of Canada, with Parliament’s explicit support, has targeted the domestic price level for almost two decades, and since the end of 1995 has kept CPI inflation close to 2 percent annually. Mounting evidence here and in other inflation-targeting countries – not the least of which is the durability of these regimes – suggests that such price-level mandates are the best bulwark against inflationary abuses yet devised.
These targets gave the Bank a first-class map for steering through the slump. They also made its steering easier, since confidence in money’s future value makes fears of inflation or deflation less likely to provoke surges or dips in interest rates and spending. The Bank of Canada was able to provide lots of support – and credibly promise more – when Canadian banks and insurers were struggling and spending was collapsing. The targets also provide the strategic and political bases for withdrawing that support as the economy recovers.
Less happy conditions elsewhere emphasize our achievement. Consider the United States, whose central bank has no formal price-level mandate. Having fueled the crisis with overly-easy money, the Fed then had to extend itself much further than the Bank of Canada in reacting to it. The US central bank is now a major lender to governments, businesses and consumers. The risk that inflation will follow is already worrying investors.
For Canada, less responsible monetary policy abroad creates risks and opportunities. It creates risks because actual inflation hurts confidence and distorts decisions, and because fears of inflation may destabilize interest and exchange rates. Yet less responsible policy abroad creates opportunities, because a country that mandates its central bank to maintain its currency’s value will stand out for the soundness of its money and its banks.
Sound Fiscal Policy
Fiscal policy also fought the slump as governments tried to prop up demand and restore private-sector confidence and activity. Here too, Canadians benefitted from victories by smaller-government advocates in recent decades. Public debt and taxes are far lower than they were 15 years ago, and balanced budgets and lower taxes are key fiscal planks in the platforms of both major federal political parties.
This fiscal discipline gave Canada more capacity to stimulate without a surge of public debt that would undercut confidence more than stimulus can help it. Again, the contrast elsewhere is striking. Our bailouts, pork-barreling and borrowing are trivial next to those abroad – with the United States again foremost in the rogues’ gallery.
That the world, especially our southern neighbour and major trading partner, faces a future of low saving, high public debts and high taxes, will hamper Canada’s pursuit of prosperity. And the temptation to spend more even before initial efforts have kicked in is dangerous. Yet relative fiscal virtue means both more effective short-term stimulus and a long-term Canadian advantage of sustainable public programs and competitive taxes.
In the second half of the twentieth century, major triumphs over arbitrary state power occurred on the daunting battlefield of national borders. Tariffs, quotas, regulations, currency controls – myriad obstacles to goods and services, investment, and people moving between countries – shrank or vanished.
Canada led that liberalizing effort and, in principle, open borders still have bipartisan support here. Granted, practice falls short of the ideal. Parliament’s support for border barriers to support our milk, poultry and egg cartels is embarrassing. The pain of the slump tempts people to shut out foreigners; worse, bailouts and stimulus spending give more scope and tools for doing so. Even now, however, Canada is cutting tariffs on investment goods, has liberalized its taxation and regulation of cross-border investment, and is seeking new free-trade agreements.
Our situation and performance stand out positively, amid a crisis that is further thickening a US border already complicated by national security concerns, protectionism, and a heavy-handed and hopeless “war” on drugs. By avoiding tit-for-tat border restrictions, Canadians can ease the slump – permitting foreign materials in, say, a new bridge greatly helps getting it built in time – and make Canada a stronger magnet for people and businesses who value openness to the world in the years ahead.
To round out what could be a much longer survey, consider regulatory policies. No less than government budgets and border barriers, regulation is a battleground where genuine public interest blurs into a struggle by pressure groups for state-mandated advantage. Efforts to shrink this battlefield and limit the weapons deployed have diminished state supervision of some economic sectors and aspects of personal life, but, in general, the late 20th century saw massive increases in regulation of employment, product standards, and business and personal behaviour.
As it has at national borders, the crisis is fostering more internal state control in many countries. The US government is dictating management changes at car companies and regulating bankers’ pay. Here too, Canadians can set themselves apart. Fewer dysfunctions going into a milder crisis mean less temptation for expanded state control here. And less state control over key sectors such as financial services will give Canadians a more dynamic, innovative economy. So our scope for emerging as a freer, more open society is greater – and, with the right tactical and intellectual guidance from backers of free association and action, can grow over time.
Interpreting the Crisis and Shaping the Future
For Canada to recover with a dedication to limited government – and, we hope, distinguish itself for freedom and entrepreneurial energy in the next expansion – it needs good tactics in these and other areas. Skill substitutes for power in any craft: a smart, small government can do more good than a clumsy, large one. Tactical success and realizing the strategic vision, however, depend on carrying the message. Canadians need to hear, early and often, the compelling story of how enhanced opportunity and spontaneous cooperation were and are the surest route to a successful society.
The Faulty “Failure of Capitalism” Thesis
The crisis – widely seen as a failure of capitalism warranting larger government – has complicated that task. For many, the second theme dominates the story: rapacious bankers who, with willful ignorance if not malign intent, borrowed from and lent to misguided and overextended people. Therefore, the prescription: further state oversight of individuals, institutions, and systems to stop negligence and malfeasance leading to more of the same. To facilitate successful tactics – the responses that will, over time, vindicate themselves – and win the larger war, classical liberals need to stress the other two themes.
First, the disruption: yes, we had a bubble – another speculative mania, followed by a panic. But the world survived the South Sea and other bubbles in the 1700s, the great railway bankruptcies of the 1800s, the tech wreck of 2000, and many other bumps on the road to greater prosperity.
As for how the state should respond, the third theme – both inadvertent and willful malfeasance by policymakers – is critical. Far from snoozing at their desks in the run-up to the crisis, regulators were making new national and international rules. Even with the best will in the world, however, they did not understand institutions, instruments and markets well enough to prevent the crisis – and negligence, turf wars, and conflicting priorities meant the will often fell well short of the best.
Policy’s Central Role in the Crisis
Indeed, key roots of the crisis lie in active policy – nowhere more than in the United States, where efforts to get houses into the hands of people who cannot afford them, and a resulting cycle of booms and busts, goes back decades. Like its predecessors – the “Own Your Own Home” campaign of the 1920s, the Home Owners’ Loan Corporation of the 1930s, the Federal Housing Administration’s urban-loan program of the late 1960s and 1970s, and the S&L crisis of the 1980s – the sub-prime collapse of 2007-08 followed years of promotion of low-quality mortgage lending by US elected leaders and officials.
One difference this time, aside from the disaster’s scale, is the rapid, wide documentation of the ties between pressure groups seeking easier home ownership, government officials who channeled that pressure, and financial executives who leapt at the chance for influence and profit. Consider Countrywide, the biggest subprime lender of all, whose former CEO Angelo Mozilo now faces charges of fraud: the first bank to sign an easier lending agreement with the US Department of Housing and Urban Development in the early 1990s, the biggest spender in $370 million of industry lobbying over the decade to 2008, the provider of below-market-rate loans to congressmen and administration officials identified as “Friends of Angelo” in company documents. Or government-backed mortgage insurers Freddie Mac and Fannie Mae – the latter headed for 13 years by CEOs who then or later took concessional Countrywide loans, and which bankrolled, through its employees and their political action committee, key legislators, notably Democrat Banking Committee Chairman Christopher Dodd, and then-senator Barak Obama.
This story – every bit as dramatic and compelling as that of rogue bankers – leads to utterly different prescriptions. The hats on the cavalry the statists want riding to the rescue are not white. They never were. The demands for greater transparency, oversight and accountability now being made of the financial industry apply with greater force to the public sector. Governments shape the environment in which borrowers borrow, lenders lend, and in which rogue bankers thrive, or not. Citizens are entitled to prevent ideology or personal interest subverting the public interest. A key way to protect the public interest is to limit the monetary, fiscal and regulatory tools governments can use to subvert it.
The Task for Canadian Advocates of a Free Society
Success breeds success. Canadians who fear the crisis has crippled the cause of free individuals and free markets should consider how well past successes prepared them for this challenge. Their compatriots, including many who are agnostic about or even hostile to classical liberal principals, have taken pride in Canada’s resilience in the face of the collapse, and the contribution of sound money and fiscal positions to that resilience is widely acknowledged.
Without descending into nativism and anti-Americanism, advocates of market-friendly policies can point to less wise policies and less happy outcomes abroad, most notably in the United States. Indeed, they must do so. Following the US on auto sector bailouts opened Canadian doors to hand-out seekers as well, and the gusher of spending announcements since then recalls Tammany Hall more than John Maynard Keynes. The need to revert to our wiser course is a compelling story: superior Canadian performance before and during the crisis as prelude to superior Canadian performance after it.
For Canadians who prefer government as a servant than as a master, then, the crisis and slump are – as the old cliché has it – not just threats, but opportunities. The balance between free association and action on one side, and authoritarian coercion on the other, shifted in a less statist direction in Canada in recent years. That shift contributed to Canada’s current relative success. Building on that success with adept tactics, and insisting that the freedom, openness and dynamism that helped Canada through the slump provides a strong platform for the future, is a mission Canadians should undertake with relish.
 William Robson is President and CEO of the C.D. Howe Institute. The views expressed here are personal, and do not necessarily reflect those of the Institute, its supporters, or its Board of Directors.
 For a recent instructive comparison with past bubbles, see John P. Calverley, When Bubbles Burst: Surviving the Financial Fallout (London: Nicholas Brealey Publishing, 2009).
 For a comparison with previous monetary regimes, see William Robson, To the Next Level: From Gold Standard to Inflation Targets – to Price Stability? C.D. Howe Institute Commentary 285 March 2009.
 An excellent account of this long-standing US policy preoccupation is Steven Malanga, “Obsessive Housing Disorder,” City Journal 19:2, Spring 2009. See also Stan Liebowitz, “The Real Scandal: How Feds Invited the Mortgage Mess,” New York Post, 5 February 2008.
 Daniel Golden, “Countrywide’s Many ‘Friends’,” Condé Nast Portfolio, 12 June 2008.
 Lindsay Renick Mayer. “Update: Fannie Mae and Freddie Mac Invest in Lawmakers” Center for Responsive Politics. September 11, 2008.