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WEALTH OF NATIONS
An Economy In Free Fall
Economists have now come around to the view that a second big fiscal stimulus is required, and soon. The main question is just how big.
The Bush administration has already committed enormous sums of public money to stabilizing the financial system and staving off economic collapse, but it looks like more -- much more -- is going to be needed. Economists have come around to the view that a second big fiscal stimulus is required, and soon. The main question is just how big.
The crisis until recently has had an air of phony war about it. The financial industry has been devastated and governments have stepped forward with interventions that would have been difficult to imagine even months ago.
Yet for most people in the rest of the economy, things seemed to be carrying on much as before. The nonfinancial economy was muddling along. This did not feel like much of a recession, still less like the onset of a new Great Depression. Suddenly, however, the implications of the financial meltdown are feeding through.
Most important, the stunning fall in stock markets at home and abroad, and the continuing volatility and uncertainty, are at last affecting consumers' spending plans. It takes a lot to discourage consumers in this country. (Having an income that falls persistently short of expenditures is not enough to do it, for instance -- which helps explain how we got into this mess in the first place.) The financial mayhem of recent months has finally made an impression.
This week, we learned that consumer confidence crashed in October to its lowest level since records began more than 40 years ago. This is far more worrying than a run of bad days on Wall Street. So severe a collapse in confidence -- forecasters had expected a big drop, but not this big -- is invariably the leading edge of a major recession, and unless governments act promptly and wisely, maybe a very prolonged one as well.
In the present emergency, orthodox monetary policy is more or less exhausted, and a new fiscal stimulus is all we have left.
Several interacting forces are pressing the economy down. First, the credit system is broken. Good corporate borrowers cannot get financing to make new investments, or in some cases even to cover their payrolls and stay in business. Households are finding it harder to get loans as well, which is holding back recovery in the housing market. The government's $700 billion bailout was intended to preserve the flow of loans. Without it, things would be even worse, but the situation is still anything but normal. The Treasury Department is telling banks that they must lend, lend, lend; but they are weak, and a process of sudden "deleveraging" -- a collectively self-defeating effort to avoid risk by curbing credit -- cannot be easily switched off.
Second, households are adding up their net worth. Their homes are valued at much less than they were a year ago, and prices are still dropping. Their 401(k)s have fallen by a third or more. Jobs that might have looked safe even a month or two ago no longer do. People suddenly feel much more vulnerable. To repair some of the savings shortfall, they are spending less, causing sharply lower sales of inessential goods. This, of course, is putting many companies under extra pressure. As firms cut their profit forecasts -- which they are now doing en masse -- and start to lay off workers, consumers become even more worried, and try even harder to cut back. And so it goes.
On top of all this is the fog of uncertainty about where the economy is heading. Until recently, many consumers had been telling themselves that the economy and the stock market would bounce back. They seem to have changed their minds. The parallels with the 1930s that the Bush administration drew to win support for the bailout were hardly reassuring. And lately, economists have been striving to outdo each other in the gravity of their assessments. In the end, all of this alarm seeps through.
A depression like that of the 1930s seems, even now, so unlikely as to be almost impossible -- but in itself this is not very reassuring. Unemployment reached 25 percent in 1933. With government spending now much higher as a share of national income than it was back then, and with Congress, the administration, and the Federal Reserve Board all set on acting promptly and at sufficient scale, it is hard to see how a similarly massive and sustained contraction could happen again.
But unemployment in double digits -- say half of what it was in the 1930s -- is by no means unimaginable. Even if we are not headed for another Great Depression, we could easily be heading for the worst recession that most Americans have ever experienced. In fact, we most likely are.
What can be done? The Federal Reserve Board is almost out of ammunition. This week it cut its benchmark fed funds interest rates another half-point to 1 percent. That leaves another 1 percent to go: Interest rates cannot go negative. Even at a zero interest rate, the Fed is not entirely out of options: It can continue to expand bank reserves, and thus attempt to pump up the money supply. But neither lower interest rates nor a bigger monetary base can do much to expand demand under present conditions. The credit crunch and consumers' efforts to save are the really big constraints, and the Fed cannot do much about either one.
In normal circumstances, Fed action is the best way to avoid downturns, and countercyclical fiscal policy with all its delays and uncertainties is best avoided. In the present emergency, however, orthodox monetary policy is more or less exhausted, and a new fiscal stimulus is all we have left. Choosing his words carefully, Fed Chairman Ben Bernanke said as much in congressional testimony on October 20.
The first stimulus, enacted in the spring, delivered a little over $150 billion in tax rebates. Its effects were positive but unspectacular. The next package, most economists agree, will need to be bigger. A somewhat smaller majority of economists -- but still a majority, I would say -- also want the stimulus to take the form of spending increases rather than tax cuts for households. The thinking is that with consumer confidence in such a slump, people would save rather than spend their tax cuts, which would limit the boost to demand.
If new government spending can be brought on stream promptly, the argument goes, that would be more effective. With a lot of infrastructure projects on hold because state treasuries are short of revenues, federal support for state budgets could get spending on fixing roads and bridges and other useful things going quickly. This, it is argued, should be the focus.
The government has to fill the space that terrified consumers are now vacating, and it is a very big space.
How big a boost? One leading policy economist -- also a noted scholar of the Depression and a level-headed man not given to exaggeration -- is Barry Eichengreen of the University of California (Berkeley). He has called for a further stimulus of 5 percent of national income: in other words, another $700 billion. "This means that the [budget] deficit may be closer to $2 trillion than $1 trillion next year," he points out. A $700 billion stimulus is at the high end of the numbers currently being suggested. Among economists, packages of $300 billion to $500 billion are more the norm, and proposals circulating on Capitol Hill are at the lower end of that range. A year ago, even these smaller sums would have been regarded as staggering.
I agree with Eichengreen. The economy is no longer on the edge of the precipice but tipping over into free fall. A second stimulus package of $500 billion or more -- to include spending on infrastructure and unemployment assistance as well as tax cuts -- is necessary. If you are going to do this, there is no point in half-measures. The government has to fill the space that terrified consumers are now vacating, and it is a very big space.
There is no danger in the short to medium term that this fiscal expansion will fuel inflation. The danger, indeed, is that without such action prices will start to fall -- a nightmare scenario, as Japan discovered in the 1990s, because that would increase the value of the dollar and thus the real burden of debt, giving the economy a further shove toward an even deeper and more prolonged recession.
Are there risks? I'll say. Massive budget deficits might scare foreign investors and turn the recent dollar rally into a rout. That could unleash yet another round of financial panic with a multitude of unforeseen consequences. This danger cannot be eliminated, but two things can be done to reduce it. First, and most important, the next fiscal stimulus must be internationally coordinated. If European governments and other countries introduce big fiscal plans of their own (as they should, in their own interests), the chances of a flight from the dollar would come down. Second, the package should ideally include commitments -- including postdated tax increases and reform of the budget process -- that would reassure investors that Washington will bring the deficit back under control once the crisis is over.
Well, all this is a very tall order -- especially (did I mention?) with a presidential election to complicate matters. If I could think of an alternative, I would tell you what it was.