In a war economy, the public obligation is to do what
is necessary: to support the military effort, to protect and defend the home
territory, to stabilize the economy itself, and, especially, to maintain the
physical well-being, solidarity, and morale of the people. These may not be easy
tasks in the months ahead.
We are facing an economic war--but not exactly a war economy. That means we
get the dislocation without the usual growth. The impact of the September 11
attacks now includes a 14.4 percent drop in stock prices in the first week and
collapse in sectors related to travel and leisure, notably airlines, hotels, and
resorts. As these events cascade through the economy, they will weaken fragile
household balance sheets and precipitate steep cuts in consumer spending. This,
in turn, will deepen layoffs and depress economic activity. The ensuing recession
could be severe.
This is not merely a shock to a healthy system, requiring only limited
measures to restore confidence and stimulate spending. Since 1997 consumers have
been financing consumption in excess of income. Those who had stock-market
winnings borrowed against them. Those who did not borrowed anyway. But capital
gains turned negative 16 months ago, and consumers are in no position to borrow
more. What has happened since September 11 consolidates and accelerates a
pullback that was already well under way.
Estimates last summer by my Levy Institute colleague Wynne Godley were that
unemployment would have to rise to 7.4 percent just to bring household
expenditures into line with income. Unemployment would rise as high as 9.0
percent, Godley estimated, if households returned to normal post-World War II
saving levels. That was before the recent events.
There is thus no chance that events will right themselves in a few weeks or
that we will be saved by productivity growth, as Federal Reserve Chairman Alan
Greenspan professes to believe; nor will the economy be rescued by lower interest
rates or the provisions of the recent tax act, most of which take effect after
2004. Rather, we are in for a crisis; the sooner this is recognized and acted
upon, the better.
Normally in wartime, largescale support to the domestic economy
is not needed, because of vast increases in military expenditure. But what we
face so far is a veneer of military action over a worldwide diplomatic and police
offensive. In a $10-trillion economy, the $40 billion already appropriated for
the military and for relief is minor.
Including the airline bailout, further programs exceeding $100 billion may
soon appear, including unemployment insurance, extended tax rebates, and
payroll-tax relief. But all of this is not likely to be sufficient. Indeed, the
concept of "stimulus" should be discarded in favor of the objective of economic
stabilization--implying a sustained effort commensurate with the crisis as
Business and capital-gains tax cuts are useless here. Without profits, reduced
taxes on profits have no effect. And without sales, investment is not likely even
if the tax regime favors it. The logic and also the motives of those proposing
such measures are to be suspected. All wars attract profiteers.
Personal tax cuts pose another problem, even if aimed properly at working
households: They may not be sufficient if anxious consumers are in a mood to
increase their reserves. Of the available tax-cutting options, temporary cuts in
payroll taxes are the best, since they will immediately boost take-home pay.
Shibboleths about the Social Security trust funds should not stand in the way of
this simple and progressive measure. And if Social Security reserves contribute
to relief of the present national crisis, then we have a solemn moral obligation
not to use that contribution as an excuse to cut benefits later. To repair the
long-term damage to federal finances, Congress should repeal the tax cuts
scheduled to take effect after 2004. That will help bring down long-term interest
The cautious men are in charge at the moment; their attitude can only bring
disaster. There is no danger of overdoing fiscal policy anymore; inflation
stimulated by excess demand is not even a remote threat. The initial program
could easily be three times what has been so far proposed.
Increases in spending on public health, education, transportation, and other
areas are absolutely needed and should be funded liberally. But a new program of
revenue sharing is most readily implemented, least likely to be dissipated in
saving or imports, and also the least partisan in concept. Direct purchases by
state and local governments now comprise nearly 10 percent of gross domestic
product; they have been rising rapidly in the past few years and will fall
rapidly as revenues are curtailed. To prevent this and create new capacity for
state and local action, including direct job creation and social aid, revenue
sharing could be on the order of $300 billion this emergency year, with a
phasedown as events warrant. This would give state and local governments new
fiscal capacity that they can use at once to avert tax increases and even permit
tax holidays for local property and sales taxes.
How about monetary issues? Federal Reserve policy has completely lost domestic
effect. Cuts in interest rates on September 17 had no discernible impact on the
largest one-week decline in stock prices since 1933 and also none on economic
activity. In wartime the Federal Reserve plays very little role; it must simply
bring down long-term bond rates and hold them down. But even then, wartime
monetary policy runs into a contradiction: It is inconsistent with a stable
dollar, openly traded.
Here, the analogy to World War II mobilization is also misleading. Before
World War II, the United States was the world's creditor nation; it enjoyed
energy self-sufficiency and did not run a large trade deficit. None of these
conditions now hold. As a result, a high-order Keynesian response will have
global financial repercussions. To finance a major military or domestic economic
effort, or both, risks driving down the dollar on world capital markets.
Lower interest rates worldwide after September 11 have kept the dollar up. In
the short run, the recession will cut imports and improve the trade account; oil
and gas prices may well decline. But in a global slump falling exports will add
to our miseries; moreover, oil supplies could be disrupted in a wider war. And
imports will rise again if large-scale Keynesian policies take hold.
Any of these scenarios could gravely destabilize the dollar. The natural
reaction of the Federal Reserve would then be to raise interest rates, deepening
the slump. Indeed, the Fed's opposition to economic-stabilization efforts now may
rest more on unacknowledged dollar fears than on anything else.
What is to be done about this risk? The old reality in global finance is that
debtors cannot run wars--or economic-recovery programs--without the organized
assistance of their friends and allies. This, in turn, requires our commitment to
a more stable and successful global financial system afterward.
The further reality is that the United States needs the sustained support of
the world community for diplomatic, intelligence, and military purposes. This
cannot be assumed to come for free--especially not from countries that have not
benefited at all from the modern global order. A new and more just and stable
global financial order will therefore have to emerge from the present crisis or
we will eventually become mired indefinitely in fruitless and unending military
struggles, with fewer and fewer reliable allies.
The modern system of floating exchange rates and unregulated international
capital markets is only 30 years old. It may very well now prove unable to
support a return to prosperity in the United States. This being so, planning for
a transition toward a more stable system should begin soon; we may need to fix
parities with the euro, yen, and sterling before long. And comprehensive debt
relief for cooperating countries--Pakistan, to begin with--is needed now, as a
down payment on a system of stable development finance after this conflict.
Finally, there is compelling reason to examine the structural sources of the
U.S. trade position. Oil is a major factor; cars are a larger factor still.
Reconstruction of our transportation networks and housing patterns so that they
rely far less heavily on oil and on automobiles (and on airlines) may be the
necessary domestic adjunct of real security abroad. A major national initiative
in transportation and urban housing, planned now and launched soon, would also
help absorb resources presently being released into unemployment by the private
These are the first steps. If widespread unemployment or inflation cannot be
avoided by preemptive means, then the entire experience of the New Deal and the
war economy will seem pertinent once again.