Small Business Blog from Atlantic Canada

“The current crisis is unprecedented!” “Governments globally are reducing interest rates to historic lows in response to this crisis.” “Government is urging banks to lend.” “TSX is down another 100 points …”

Not a day goes by these days without us hearing the words of economic gloom and doom. Deficit’s seem to be the new economic mantra. It seems to be the magic wand that will seemingly fix our economic woes. And perhaps it will. But I am not sure that getting into a deficit to fund infrastructure spending is the key to our economic recovery. A deficit may be effective depending on how we get into deficit.

The economy would receive greater stimulus if we get into a deficit by lowering taxes (personal and corporate) rather than just infrastructure spending. I remember reading in the last day or two about a politician wanting to put “shovel to the ground” quickly. Gone are the days when hordes of people went to work on a bridge, a highway, or an airport. Machines do most of the work and if the government wants to channel money into CAT, John Deere, etc., I am sure they won’t mind it. (I’ll consider buying their stock!) Also, given the level of government productivity, infrastructure spending is the last place I would pledge my dollars to.

With the excesses the world has seen in the last decade, it is no surprise that we are seeing the current correction. Will it be painful? Yes! How long will it last? At least until confidence returns in the economy. We need long term solution instead of short term band-aid fixes. What I mean is whatever response the government chooses to adopt, it needs to be sustainable.

The only sustainable way of getting out of this correction is to enable people to spend. That much the government agrees. But if I am mired in debt then I am not going to spend. For example, the past holiday season was awesome for anyone wanting to buy household goods – TV, home theatre, furniture – you name it. It was not sufficient for me to go out and buy the things I wanted, because they are exactly that; “wants”. I’d rather pay down my line of credit or my mortgage than take on new debt. Also, I think the people who carry balances on store credit cards or high interest credit cards need to get their head examined. But I digress.

So it makes sense to suggest that the government must implement policies that will enable people lower their debt levels. Let’s explore what will happen in this scenario. As people pay off their debts, (especially credit cards and such high interest debt) the asset side of banks’ balance sheet will decrease and so will the “provision for loss” item on their balance sheet. [a loan is an asset in a bank's balance sheet]. Hence, they will need to (A) borrow less to finance this asset or (B) increase lending.

The initial reaction by banks to people paying off their debts could be choice A. That way their cost of capital will reduce - since now the demand for money will decrease. As more people reduce their debt levels, “provision for loss” would reduce. This would increase the banks’ confidence in lending. When this happens we would see the economy move up the cycle from the trough.

In order for this scenario to come to pass, people need to have money to pay down their debt. In order to do that they either need to increase their revenue or reduce costs. We can’t control how much they gross or how they choose to spend their money. But we can give them a bit more in their take-home cheque by reducing taxes. If they choose to pay down their debt we will be achieving our objective. If they choose to spend, then – hey is that not what the government wanted in the first place?

Lowering interest rates is another tool to put money into people’s pockets. Anyone with a variable rate mortgage that was negotiated before August/September 2008 are now paying one of the lowest mortgage rates. With the prime rate currently at 3% soon some variable rate mortgage owners will be paying around 2% to 2.5%. I am sure the money saved is going to pay down other high interest the debt.

In conclusion, I think cutting taxes should be high on the government’s list of stimulants. If the government creates a deficit due to this then I would not mind a government deficit. Call me a “Supply side economist”, but if the deficit money goes to fund a few corporations for their greed, stupidity and mismanagement, and it does not trickle down to the common man (me), it is useless.

The discussion on how we are going to fund that deficit is for another day.

Update: March 7, 2008
Here is an article by Fabrice Taylor at the Globe and Mail on why the current stimulus package is bound to fail.