Wall Street Journal, January 6, 2003
Anticipating White House plans for another round of tax cuts, Democrats are sounding a lot like Herbert Hoover. They're preaching fiscal austerity when thetimes demand just the opposite. My former cabinet colleague Robert Rubin warns that a big increase in the federal deficit could choke off any recovery, creating a "deficit premium" that pushes up long-term interest rates.Some Democrats are even resisting the administration's request to increase the debt limit. "By raising the debt ceiling to pay for the president's tax cuts andhis other spending, the Bush administration is wanting our children and grandchildren to pay our bills," scolds North Dakota Senator Kent Conrad,senior Democrat on the Senate Budget Committee.
These Democrat deficit hawks have it all wrong. The economy needs a fiscal stimulus right now, which means the federal government has to run large deficits. Monetary policy can't do it alone. With the federal funds rate now at1.25 percent, the Federal Reserve has just about reached the end of its tether.
Yet this so-called recovery continues to be one the most anemic on record. Pre-Christmas sales were awful. Factory orders on big-ticket items plunged in November. Unemployment remains up there at 6 percent, with over 8 million people out of work and a million more too discouraged to look for jobs.
If nothing is done we'll probably come out of the doldrums by 2004. Weak recoveries typically grow stronger when businesses have to replace depleted inventories and aging equipment. But there's a significant danger that the usual pattern won't hold this time. The recession just ended was hardly typical. It began with a giant implosion of the over-hyped and -sold tech and telecom sectors, followed by an unprecedented act of terrorism. Consumers have been the only bright lights in the economic firmament, but with personal debt mounting and jobs more precarious, their shine is fading. Consumer confidence plummeted in December, the sixth decline in seven months. Consumers got stingy this Christmas, and may remain that way for some time. State and city governments, meanwhile, are slashing spending and raising taxes.
Much of the rest of the world is teetering. "Heightened geopoliticalrisks," to use the Federal Reserve's felicitous phrase, are turning decidedly upward. Oil prices are rising, Europe is sinking into recession, Japan remains comatose, and China is busy swamping the global economy with low-cost manufactured goods.
In short, there's way too much capacity relative to total demand. Under these circumstances, federal deficits are necessary to avoid continued sluggishness and protect against deflation. Contrary to the Democrat's deficit hawks, the current economy isn't at all like the early 1990s, when deficits had to be trimmed. The recession of 1990-91 came after years of fiscal profligacy which finally forced the Fed to push short-term rates into the stratosphere in order to avoid inflation. Even when the Fed loosened the reigns in 1992, long-term rates stayed high because large structural deficits continued to signal inflation just around the corner. Now it's just the reverse. The economy is suffering from underutilization. There's no inflation in sight. Deflation is the bigger threat.
The coming debate should be about what kind of deficit-induced stimulus can most quickly and effectively pump up demand. The $50 to $60 billion estimated cost of war with Iraq this year is a blip in a $10 trillion economy. Even if the eventual cost is closer to the $100 to $200 billion estimated by Lawrence Linsay, the president's recently deposed economic advisor, that sum wouldn't work its way into the economy fast enough to have much effect. It makes more sense for the federal government to help strapped state governments pay for programs already underway.
Tax cuts should be judged by the same criterion. With so much unused capacity, cuts aimed at business won't generate much additional spending on plant and equipment. Businesses wanting to expand can already get dirt-cheap loans. The private sector won't get serious about new capital investment until executives are reasonably sure customers will buy whatever additional goods and services the capital produces.
Accordingly, the most useful tax cuts would induce consumers to spend more. Middle and lower-income people are more likely to spend any additional after-tax income they receive than the very wealthy. And because most workers pay more in payroll taxes than in income taxes, the surest and fastest way to get more money into their pockets is to give them a payroll-tax holiday this year. Exempt the first $20,000 of income from the payroll tax and the typical two-income family would get a $2,500 bonus, meaning almost $150 billion of new spending on goods and services. Employers would also be freed from paying theirportion of the tax, making labor cheaper and encouraging them to keep more people employed.
Temporary cuts that increase overall demand for what the economy can now produce are different from permanent cuts aimed at enlarging the nation's productive capacity in future years. The former are clearly justified when, as now, the nation is struggling to recover from a slump. These are likely to be more effective for the current situation than supply-side cuts.
There's no reason for a supply-side experiment now, in any event. The recovery won't be spurred by making the 2001 tax cuts permanent or reducing taxes on dividends. Improving the economy's long-term capacity is an important goal, to be sure, and some supply-side measures might accomplish this even if they enlarged the deficit. (Democratic supply-siders like me would rather run deficits to invest more in our nation's schools, public transit, and health care.) But this large debate is beside the point right now. The immediate problem is on the demand side.
We need to restore growth and utilize our economic capacity before we try to increase growth and enlarge that capacity. In the looming battle over fiscal policy, Senate Democrats will be perfectly positioned to draw this important distinction. Contrary to what Democrat deficit hawks tell them, Senate Democrats should welcome budget deficits that pump up demand in the short term.
But they can and should muster the forty votes necessary to block permanent supply-side tax cuts. Save the supply-side debate until the economy is back on track.
