The financial crisis has created very few winners. Just about every asset class has been torched and almost every sector of the economy is feeling the knock-on effects of a growing global recession. But the one area in which there is a bull market is government intervention.

In good times, governments are often relevant to investors only at the margins. They may affect corporate strategies in regulation (tweaking labour and environmental standards, for example), tax policy, and trade and investment rules. But they typically aren’t at centre stage.

Now, however, with the deepening of the global financial crisis and its spillover into the overall economy, governments are being thrust into the spotlight. Troubled industries are turning to governments for salvation and worried workers are seeking government help. And, as governments respond, their policy choices become increasingly important to investors.

“In recent years, investors could, broadly speaking, ignore the role of the government when thinking about markets,” notes Alex Patelis, an economist with Merrill Lynch & Co. Inc. , in a recent report. “This period is now over. History suggests that big government is often the response to financial crises.”

Indeed, as markets have tumbled and economies have contracted, companies and consumers have turned to governments for solutions. Central banks have done their best to loosen monetary policy, and there may be further to go on that front. But, so far, it hasn’t been enough to soothe market or economic fears.

The widely touted meeting of the G-20 in Washington, D.C., on Nov. 15 didn’t deliver much. Policy-makers from around the world agreed to some broad principles — that financial regulation needs reform, continued monetary stimulus is necessary, fiscal stimulus is required but trade protectionism is not.

Some had hoped that co-ordinated fiscal policy would follow the co-ordinated global rate cuts that were delivered earlier this year. But it appears that fiscal measures remain strictly a national prerogative. Indeed, with the world’s biggest economy, the U.S., mired in that awkward period between an election and the inauguration of a new administration, it is not likely that much will be done right away.

However, as CIBC World Markets Inc. research note observes: “With the outlook for the U.S. economy deteriorating daily, the equities market’s only hope is that another round of fiscal stimulus greases the nation’s economic wheels.”

The report adds that U.S. president-elect Barack Obama has made the delivery of fiscal stimulus a priority for his administration. What remains to be seen is how that stimulus is delivered, how big the booster shot is and how quickly it will take effect.

Already, stimulus packages are being either introduced or crafted in many of the world’s major economies. The biggest blow so far comes from China, which has pledged to spend US$586 billion domestically over the next two years, largely on infrastructure.

According to economists at JPMorgan Chase & Co. Inc., there already is fiscal stimulus in the pipeline — in the form of tax cuts, increased infrastructure spending and measures such as increased training and social welfare programs — in many economies, amounting to about 1% of GDP in most developed markets (with the exception of Spain, whose measures are closer to 3.7% of GDP) and tracking as high as 6% of GDP in certain emerging markets.

There needs to be more where that came from, say many analysts. “A major fiscal stimulus plan is woefully needed before yearend and again when Obama takes office,” urges Bank of Montreal chief economist Sherry Cooper in a research note. The federal government in Canada must implement a stimulus package as soon as possible, she adds.

Canadian taxpayers and investors may have gotten their first look at what the federal government has in mind when federal Finance Minister Jim Flaherty delivered his fall economic update on Nov. 27 (after Investment Executive went to press). However, Flaherty has dampened expectations that any new measures will be unveiled; that will probably have to wait for the next federal budget, which typically comes in February.

According to analysts at Standard & Poor’s Corp., fiscal stimulus from the Canadian federal government may come in the form of support for the auto industry and accelerated infrastructure spending. These two areas are also likely targets for added stimulus in the U.S., although efforts to agree on aid for automakers have so far floundered.

@page_break@Whether or not auto industry aid comes to pass is anybody’s guess. While the optics of more bailouts for failing industries are horrible — rewarding ineffectual management, favouring certain sectors over others and increasing moral hazard, to name just a few — some fear that the consequences of standing on principle would be much worse.

“As much as I thought I was a free-market capitalist,” Cooper writes in her research note, “I have to agree with [those that favour a bailout] that it is too dangerous to allow GM Corp. or any other automaker to file for Chapter 11 bankruptcy protection.”

The note warns that the chain reaction that could be triggered by such a move “would make the Lehman [Brothers Holdings Inc.] bankruptcy and its ensuing fallout look like a good day on Wall Street.”

So, pending the automakers’ bailout, infrastructure looks like a probable avenue for fiscal stimulus in the U.S. As the CIBC World Markets report notes, direct infrastructure investment is emerging as a leading candidate for government support: “Typically, it has a bigger economic impact than tax rebates, and also has a much longer-run impact.”

The effect of these efforts is also likely to be long-lasting on government finances. A report by economists at Morgan Stanley Inc. suggest that added fiscal stimulus in the U.S. could lead to the biggest deficits faced by that country in the past 50 years. In total, the report expects a US$1.5-trillion deficit for fiscal 2009, or about 10% of GDP, composed of bank bailouts, fiscal stimulus and its “core” deficit.

Deficits, it seems, are inevitable as governments grapple with the fallout from the credit crunch. Although the potential for deficits is not just a function of increasing government outlays (through additional spending, tax cuts or bailouts), it is also driven by the financial and economic conditions. For example, Alberta’s government just slashed its surplus forecast, reflecting the recent sharp drop in commodities prices and reduced investment income.

One way or another, it appears that Canada’s recent string of federal budgetary surpluses is certain to come to an end. In the throne speech of Nov. 19, the federal government stressed that long-term “structural” deficits must not be allowed to return, but that it probably can’t avoid a short-term budgetary deficit in order to support the floundering economy: “In an historic global downturn, it would be misguided to commit to a balanced budget … at any cost.”

SACRIFICING CONVICTIONS

Indeed, capitalists and fiscal conservatives everywhere are sacrificing their convictions in the face of the cold, hard reality of a severe economic recession. The realization that big government is the only effective counterweight to a massive market meltdown recalls the theories of Hyman Minsky, a professor of economics at Washington University in St. Louis, Mo., the Merrill Lynch report explains, who believed that capitalism is inherently unstable and prone to such booms and busts.

The countervailing forces to this, Minsky suggested, are central banks that act as a lender of last resort and big government that can serve as a stabilizing force. That means not only boosting spending during a bust but also curbing liquidity during a boom.

It may be some time before the other side of that theory can be put to the test, however. While current efforts to shore up the global financial system with expansionary monetary and fiscal policy will surely bolster economic growth, what’s less clear is what the side effects of these policies will be. That economic salvation could be short-lived, as the effects of the stimulus wane and inflation risks return.

“Congress will probably feel it has spent its bullets, in terms of stimulus, as 2009 comes to a close,” the CIBC World Markets report notes. “Europe could be in the same mood. While job losses might have been replaced by modest rehiring, consumers in the major developed economies, including Canada, could still feel shell-shocked by earlier wealth losses.”

Moreover, credit isn’t likely to become as cheap as it has been in recent years, and consumer spending may well be subdued as a result.

Without continued stimulus, any economic rebound could prove transitory, the report warns: “Absent new action, the economy will lose the rush it will get from the upcoming pump priming. And auto companies, mortgage borrowers and others that might hang on with government help through 2009 could be back on the precipice all over again.” IE