Economist Stephen Gordon’s economics blog, Worthwhile Canadian Initiative notes that spending may not be the answer when he writes:

The cutbacks in the Harper government’s economic update were clearly wrong-headed, so it’s a good thing that they didn’t pass. But then again, the arguments in favour of the opposition coalition’s rush to spend on infrastructure aren’t particularly compelling: if there’s one sector of the economy that doesn’t need immediate, massive stimulus, it’s the construction sector – employment there actually increased in November.

I agree. Investment stimulus is not the answer. In fact, I think the Conservatives are doing precisely the right thing and — No — I’m not a Harper fan. Stephen Harper looks to me like some toy company’s ill-conceived cross between a cabbage-patch kid and Ken and his government’s lack of stimulus appears to be complacency rather than astute thinking. Still, he’s right not to spend. On that note, I’m pleased by his proroguing of parliament, as it will delay any forthcoming action by his government (or the next one) to “save” the economy through increased spending.

The truth is, the Conservatives are actually one of the only governments — globally — that is doing the right thing. And why is not spending the right thing?* Because, as I’ll explain below, the only cure for economic misery is more economic misery.

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Over the last few months, I’ve been amazed by the failed attempts of politicians to fix the world’s economic problems. Amazed not because the attempts are failing, but because politicians have failed to understand some basic economic concepts that I learned back in Economics 101 and came to appreciate over my career.

What I learned is that the fastest, most surefire way for us — or any country — to get through the bursting of the bubble is to do nothing. That is because the only thing that can cure a boom is a bust.

This way of thinking belongs to the “Austrian school of economics.” According to the Austrians (and, errr … Wikipedia), the business cycle unfolds in the following way:

Low interest rates tend to stimulate borrowing from the banking system. This expansion of credit causes an expansion of the supply of money, through the money creation process in a fractional reserve banking system. This in turn leads to an unsustainable “monetary boom” during which the “artificially stimulated” borrowing seeks out diminishing investment opportunities. This boom results in widespread malinvestments, causing capital resources to be misallocated into areas that would not attract investment if the money supply remained stable. A correction or “credit crunch” – commonly called a “recession” or “bust” – occurs when credit creation cannot be sustained. Then the money supply suddenly and sharply contracts when markets finally “clear,” causing resources to be reallocated back towards more efficient uses.

What that means in plain English, is that in a period of rising prices, people get greedy and poor investments are made. These investments would not be profitable in a period of “normal” prices. This malinvestment needs to be “unwound” before the economy can move forward.

For example, in a perfect world of continuously rising igloo prices, I wouldn’t hesitate to spend $500,000 on my very own igloo with the certain knowledge that eventually I’ll be able to unload it to somebody else for $600,000. Unfortunately, the world is not perfect and continuously rising igloo prices eventually leads to an increased supply of igloos. Moreover, what with few new buyers and, errr … the hot summer season, I soon learn that my igloo purchase was a bad investment. This is bad news not just for me, but for everybody else who was benefiting from continued investment: lawyers, brokers, bankers and pudgy kids with shovels. The solution to the end of the igloo bubble is not for people to keep buying igloos, but for the igloo industry to adjust to the new paradigm. Until then, how will the economy move forward?

To me, the Austrian school of economics is just common sense. If prices have gone up too much — they then now have to go down. People have lost sight of this simple fact in the face of all the political brouhaha about the need to keep the economy growing. Government bailouts, lower interest rates, saving jobs all sounds good in theory until you realize that they just delay the inevitable.

The problems we are facing today are because of countless bubbles: bubbles in property markets and oil markets and copper markets and potash markets, to name just a few. These bubbles created jobs and perceived higher wealth on the back of rising prices and associated increased expenditure in property, mines, drilling platforms, container ships, and the like. In the face of now lower prices, further investment must be halted — at least until new supply can be absorbed by the system. Moreover, the system needs to prove that it can make money at current prices.

This isn’t easy. Consider zinc, which I wrote about in August:

This article at FP Posted is clickworthy for anybody who needs real-world examples that a bull market in something results in increased supply — which ultimately will end said bull market. At current zinc prices, small zinc miners are in financial trouble. But while prices are down 60% from their peak, they are only back at 2005 levels. Obviously, these companies had established these mines under the premise of high prices. And going forward? Any recovery in prices will ultimately mean the taps get turned back on, putting a drag on price recovery.

If you were in the zinc business, would you invest further in mines? If I was in the industry, I’d be waiting — waiting for blood, waiting for bankruptcies among my competitors, and waiting for signs that new supply is not going to drive down prices further. I’d also want to make damn sure that any future expansion in based on conservative assumptions for prices.

One bubble I am particularly concerned of in respect to Canada is the housing market. I reckon price declines have only just begun. I base that on the simple observation that investment returns (rental yield divided by price) on property ownership are meager — without the assumption of never-ending price rises. I also can’t help but notice how much property prices have risen over the last fifteen years. You can read more about my thoughts on property here and here.

Politicians usually tend to have it wrong when it comes to property prices. They tend to believe that high prices are a good thing. I disagree. Overheated property prices should not be artificially supported.

In my view, the government has made a number of mistakes on this front, particularly in respect of the (now-rescinded) 40-year mortgage. This idiotic product made homes appear “affordable” by allowing people who could not afford homes at current prices to in fact borrow more money. Why couldn’t the politicians understand that what was needed to make property more affordable, was not to cheapen money, but to simply allow home prices to fall? The 40-year mortgage only made the bubble worse. To that extent, I think the government should not get too aggressive on interest rate reduction. These things usually tend to be overshoot on the downside as well as the upside. Better to save its ammunition for when it really needs it.

Barring a miracle in Chinese commodity consumption, I believe Canadian housing prices will see considerable downside. The igloos have started to melt. No longer is there an implicit expectation for prices to always rise. In this current limbo, I’m not going to buy, you’re not going to buy, and developers aren’t going to build. Things will generally suck. They’ll suck for property agents who lose jobs. and mortgage brokers will lose jobs and construction workers who lose jobs. They’ll suck for banks who see loan growth disappear and for investors who see share prices fall. They’ll suck for people who feel poorer and no longer spend and for businesses that depended on their spending.

And when will things stop sucking? Not a moment before they’ve sucked enough.

Japan never understood this simple truth about booms and busts. They tried stimulus plan after stimulus plan as they tried to prop up the share and property markets. And that’s why Japan’s essentially seen no growth for most of the last twenty years. The Nikkei is still down 70% from its 1989 peak. Hong Kong on the other hand did understand this fact, and saw its economy roar post-2003 and its own dramatic 70% property price correction.

The truth is, the solution to our economic malaise is more malaise. We need pain. We need property price declines. We need company closures. We need unemployment. We even need you to lose your savings (sorry). And lastly we need those pudgy kids to put away the shovels and find something else to do. Until then, things will suck. And I’ll continue to rent.

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*Don’t get me wrong. When I say “do nothing,” I am exaggerating. I’ve written before how it’s crucial to keep a banking system functioning. Moreover, there are no doubt some capital expenditure programs that could be brought forward to help the economy — infrastructure that is sorely needed . But what the government should not do is use our capital to prevent the correction that needs to occur in those bubbles that still remain. The government must use its ammunition wisely.