Hoover Daily Report

How Not to Fix the Economy

via Wall Street Journal
Thursday, December 13, 2007
Image credit: 
Antonio Guillem, Shutterstock

Six years into expansion following the 2001 recession, the post-Y2K collapse of the stock-market bubble and the terrorist attacks of Sept. 11, 2001, the economy is sharply slowing. The risk of recession is growing.

But neither the direct effect of the subprime interest resets, nor the direct financial losses related to subprime lending, are sufficient, even in combination, to cause a recession. Even if two million households facing subprime resets reduced their consumption 25%, overall national consumption would decrease just 0.3%. A consumption drag must extend far more broadly than that -- perhaps from falling home and high energy prices -- to be a major macroeconomic event.

The Organization for Economic Cooperation and Development estimates $300 billion investor losses centered in real estate. That is just one-half of 1% of Americans' net worth. In a $14 trillion economy, such losses can be absorbed. But as other financing is delayed (commercial and industrial lending, and commercial paper outstanding, are both down sharply), the harm will spread to the general economy and its firms and workers. That is what economic policy should aim to mitigate.

Fed Chairman Ben Bernanke has the delicate and difficult task of preventing recession while limiting the risk of subsequent inflation or creating a "Bernanke put" in the markets. Indeed, Mr. Bernanke sent a message Tuesday with his quarter of a percentage point rate cut -- his goal is not to bolster stocks or bail out the housing market with easy money. This is especially prudent given that his predecessor, Alan Greenspan, admirably combated recession and ensured against deflation by quickly lowering the federal-funds rate to 1%, and keeping it low. However, by eventually raising rates very slowly, even after the surge from the 2003 tax cut, the speculative excess was extended and worsened.

The Fed is and should be gradually lowering rates to combat recession risks, although credit conditions will limit the stimulus. But the Fed's actions and communications must reinforce the commitment to price stability, in order to maintain confidence and credibility. The worst outcome would be the small but real possibility of future inflation pressure.

In the subprime case, collateralized subprime mortgages -- originating with no income verification, little if any down payment, and very low starting teaser rates -- were marketed as relatively safe bundles. The financial firms failed to adequately identify, price and hedge the risk. Top executives at leading banks said they had not even heard of some of these complex structures before off-balance-sheet loans went bad. The lack of transparency and risk management caused financial markets to lose confidence.

Subprime mortgages are unlikely to be the end of the story: The same people who will struggle with mortgage interest resets have credit cards, the receivables from which are also collateralized, and prime mortgages and other lending are troubled.

What is the proper role of economic policy in dealing with these problems? Workouts, not bailouts. The worst idea out there is a broad interest-rate (and/or foreclosure) freeze for borrowers, which throws into question the sanctity of private contracts and thus deters investment. The administration must reconfirm its narrow freeze is really voluntary among the lenders, not imposed.

Even worse policies could be just around the corner. Protectionism and calls for more regulation and higher taxes on upper-income earners and capital are emanating from Capitol Hill and the campaign trail; some are even demonizing globalization and corporate America. This doesn't build confidence in the future of the economy. It is rather the poisonous mix (along with the Fed's mistakes) that turned a bad downturn into the Great Depression.

At a debate among the economic advisers to the presidential candidates in Washington last month, the advisers to the Clinton, Obama and Edwards campaigns lauded soft- or hard-core protectionism, higher marginal tax rates, uncapping Social Security taxes, a bevy of new spending programs and refundable tax credits for every perceived problem, and argued that the Bush tax cuts were the cause of all economic ills.

That's bad economics and even worse history. The fundamental flaw in this approach is the unwarranted assumption that it will help the middle class. Of course, it will create some temporary relief. But it will do so at the cost of lower future wages from depressed capital formation, and a risk of dependency on ineffective, inefficient government programs. The Europeans' mediocre performance attests to the danger of high taxes and bloated social-welfare spending, which have driven their standard of living down 30% relative to the U.S. in little more than a generation.

Revoking the 2001 and 2003 top marginal tax rate reductions and uncapping Social Security taxes, and adding the proposal by House Ways and Means Chairman Charlie Rangel for an additional 4.6% tax rate on adjusted gross income as part of his AMT fix, results in a tripling of the federal taxes on dividends, an almost doubling of the tax on capital gains -- and sharply reduced work and investment incentives. The combined (including California state) top marginal tax rate reaches almost 70%, which is back to the ruinous levels of the 1970s.

The tax share of GDP, already somewhat above the historical average, rises automatically in normal economic times. It is scheduled to reach about 20% (a level reached only during wars, bad inflations and/or bubbles) in a few years, and about 24% in a couple of decades because of real bracket creep, the alternative minimum tax, the expiring tax cuts and other factors.

The long boom of the last quarter century was fostered by low inflation and low tax rates. Sound policy requires far more stringent control of spending growth, and large legislated tax reductions, focused on marginal personal income and corporate tax rates. That change is essential for long-term growth. It should be legislated now to help restore confidence and investment in the future, especially so as the economy weakens.

Mr. Boskin, professor of economics at Stanford University and senior fellow at the Hoover Institution, was chairman of the Council of Economic Advisers under President George H.W. Bush.