Economic Policy: Don’t Fight The Next War With The Last War’s Tactics

The NY Times business section had several articles yesterday on the effort by the Bush administration and congress to address the financial problems facing the US economy. I read them all on the plane out to LA.

The Bush administration is looking to push through policies that they used in 2001 to address the last economic downturn. Treasury Secretary Hank Paulson says, “The research I’ve seen indicates that the programs in 2001 clearly worked.” Those programs include a tax rebate of $300 to $600 per household and a tax incentive for businesses to invest in plant and equipment.

Those measures may have worked in 2001, but I am not sure they will work this time. When treating a patient, doctors focus on the problems a patient is currently facing, not what they were facing seven years ago.

In late 2001/early 2002, the economy was suffering from the triple whammy of a stock market downturn including a full-blown meltdown in the NASDAQ, the shock induced by 9/11, and uncertainty around our government’s response (which was resolved by the invasion of Iraq). Businesses were holding back from hiring and investing and the consumer was holding off from spending. So it makes total sense to me that a tax rebate and business incentives were the proper stimulus.

This time around, we are facing very different issues. The primary problem our economy faces is a financial system that is badly damaged by the implosion of the housing bubble. In addition, consumers have lost a lot of paper wealth in their homes. This paper wealth was a large source of funds for the consumer in the past five years via home equity loans and other forms of mortgages. The banking system is in a risk adverse phase and it is unlikely that consumers will be able to tap other forms of debt like credit cards to make up for the loss of home equity finance. We have a credit crunch on our hands.

The large financial institutions have gone overseas to fix their balance sheets, tapping the growing pools of capital in the middle east and asia. But just because they have shorn up their balance sheets doesn’t mean they will start lending again.

Meanwhile the US government is also in a bit of a pickle. We have large budget deficits that we have also been funding with debt bought by foreign investors and governments. The US dollar has been falling for six years against most of the major currencies and US government debt is worth less and less every day because it is dollar denominated. I suspect the US government is also facing its own credit crunch.

We can try the economic stimulus that worked in 2001/2002. Maybe it will make consumers feel better and they’ll start spending again. Maybe that’s all it will take to get the housing market to bottom and banks and other financial institutions will start lending again.

But I think we need to focus on measures that will address the credit crunch for consumers and our government. And they are different problems that require different solutions. We need a very easy monetary policy right now. We need to make it so that banks and other financial institutions can make a lot of money lending right now. Only then will they re-open their balance sheets and start lending.

I think using fiscal policy to address the economic problems we face is a mistake. We should not go deeper into debt as a country. First and foremost, we need to restore confidence in the US economy and government credit. We need to balance our budget and stop living beyond our means (as a nation and as individuals).

Back in the late 80s and early 90s, the Soviet Union essentially went bankrupt because it could no longer afford to keep pace with the United States militarily and economically. Many point to the Afghanistan war as the straw that broke the camel’s back.

The US is in a similar position with our war in Iraq. We are burning through billions of dollars fighting a largely unilateral war in Iraq that we can no longer afford. We must leave Iraq as soon as possible as a first step in getting our financial house in order.

We must also tax our citizens at a rate that is necessary to cover our expenses. We can reduce our government expenses if we have the political willpower to do that. But if we don’t then we need to tax our citizens to cover our bills. Since the early 80s (with a short and successful departure in the Clinton/Rubin era), our government has taken the approach of reducing taxes in advance of reducing spending. We’ve never gotten the corresponding reduction in spending and instead have borrowed trillions from overseas. That must stop.

And we must have economic policies that incent our citizens to save instead of spend. I think its time for rethinking our entire federal tax system. What if we eliminated the income tax for taxpayers who make less than $250,000 per year (indexed with inflation)? What if we replaced the lost income with a broad based sales tax? And what if we stopped taxing income from investments of less than $250,000 per year per taxpayer (again indexed with inflation). Want to think radically? What if we stopped allowing taxpayers to deduct any form of debt including home mortgages?

I am not saying we should do any of these things. All of them will cause huge market dislocations and it’s certainly not time to make homes less valuable by removing the mortgage deduction. But we are a debtor nation. We have a balance sheet problem as a country and as citizens. We need to wake up and realize that and do something about it.

These are difficult choices that I am certain we do not have the political will to implement without serious pain. So instead we’ll put a bandaid on. And it might work in the short term. But it won’t work in the long term. I think we are headed toward bankruptcy in this country, on a governmental level and on a consumer level, unless we change our stripes.