To understand America's economic future, it helps to look at some of our largest trading partners. Will we move towards a smaller state, a more egalitarian economy or both?

During the mid-1990s, Canada faced a fiscal crisis. Rather than shrink from the challenge, the governing Liberal Party embarked on a sweeping review of federal spending, one that aimed to identify spending cuts within the electoral cycle. That is, the government announced that it would make cuts before the next election, and that in doing so it fully expected to be held accountable for its success or failure in securing the country's fiscal future.

And instead of making the cuts behind closed doors, the government actively consulted the public by releasing detailed briefing papers and holding public hearings, an effort that prompted a tremendous response. Think tanks and pressure groups offered their own budgets, which in turn informed the government's efforts.

The Liberals seemed to understand that the government had no monopoly on wisdom regarding which programs worked and which deserved to be scrapped. The end result has been a leaner and more efficient state. Between 1992 and 2008, government spending in Canada declined to 40% of gross domestic product from 53%. Canada's federal debt has halved over an even shorter period of time, falling to 32% in 2008 from over 70% in 1995. Until last year's made-in-the-USA economic downturn, Canada has also enjoyed large budget surpluses. Canada's fiscal responsibility over the last decade and a half will help the country through the wrenching reinvention of Ontario's devastated manufacturing belt.

Over the same period, Germany has also pursued a distinctive course. Whereas the United States has run persistent trade deficits, the Germans have proved to be among the world's most prolific exporters. And while America has gone through a consumption binge, one that has left behind a crippling consumer debt burden that will take a decade or more to unravel, German consumption has remained strikingly low, as have wage increases. Taken together with an extremely heavy tax burden, you can see why Germany suffers from a low birthrate: Starting a family in this environment is difficult, even with generous subsidies.

In stark contrast to the United States, the gap between Germany's rich and poor has remained fairly narrow, yet that has curbed the growth of low-wage services that have enabled middle-class American families to outsource household labor. Solving one perceived social problem—the yawning earnings gap between the most-skilled and the least-skilled workers—has created a new one, namely a brain-drain of some of Germany's most talented people. It's hard to imagine this happening to the United States. But given Canada's shrewd economic strategy, it won't be long before talented Americans start thinking seriously about working in Toronto or Vancouver or Calgary.

In a recent column, economist Ken Rogoff bluntly stated that "within a few years, western governments will have to sharply raise taxes, inflate, partially default, or some combination of all three." Given that a partial default is all but inconceivable and that deliberate inflationary policies are only slightly less so, that leaves us with sharp tax increases. Higher taxes won't turn the United States into an outsized simulacrum of some hellish Brezhnev-era Soviet satellite. The effects will be subtler: more 30-year-olds living with their parents; less frothy consumption; middle-class families might be slightly less inclined to have children. This will be, to the delight of many on the left, a greener economy. It might also be meaner: less expansive and less ambitious, with more tension between social groups fighting for their share of a zero-sum economy.

My sense is that we need higher taxes. The Canadians, for example, embraced a value-added tax to address their long-term budget woes, and this proved both wildly unpopular and very effective. But let's not kid ourselves about the likely social consequences.

Instead of learning from our North American neighbor, one gets the sense that the United States is destined for a larger and more burdensome state. Some of the blame lies with President Obama and the Democrats, who seem far too eager to permanently expand the scope of the federal government. Yet the Democrats rightly respond that the Bush administration's combination of tax cuts and spending increases have left the country in badly weakened fiscal shape, and that the Republican failure to tackle galloping medical expenditures has contributed to sluggish wage growth and private sector employment.

However strongly conservatives reject Democratic prescriptions for revitalizing the American economy, there's no denying that the Bush approach has been found wanting, or at least incomplete. At the moment, the right is learning the power of defending the status quo. Ironically, Republicans are emerging as champions of Medicare in an effort to blunt Democratic reform efforts. In the end, this is a losing game. By not making an affirmative case for a smaller and more cost-effective state, we will slide, slowly and almost imperceptibly, into German-style stagnation.