History has delivered Barack Obama the greatest economic crisis since the one that greeted Franklin Roosevelt. As in 1933, the crisis is the direct result of free-market ideology and conservative misrule, which once again stand disgraced. This creates a once-in-a-century opportunity for Obama to redeem American progressivism as the nation's majority philosophy, with government playing a far more active role in the economy -- not just to produce a recovery but to restore a more egalitarian and secure society. However, this opportunity also produces an equally huge risk of failing, which would be seen as a failure of liberal government. Conservative ideology and Republican rule would come roaring back.
Success requires bold, immediate action. First and foremost, Obama must pull back the economy from the brink of depression. Only if he masters this primary challenge and points the economy toward recovery will he gain the political capital needed for the other hurdles -- from reform of collapsing health and pension systems to the long-term conversion of the energy economy.
If Obama uses activist government to spare us a depression, he will reap immense political, economic, and ideological benefits. First, by demonstrating an economy on the mend and delivering practical help, he could consolidate his congressional majority in 2010 as FDR did his in 1934, rather than suffering the midterm loss more characteristic of a new president. Second, by using large-scale anti-depression spending to rebuild affirmative government, Obama could restore the bond between taxpayer and valued public services. And third, these economic achievements, as narrated by an eloquent president, could create an ideological revolution. A managed form of capitalism would become America's majority philosophy once more. That, in turn, would give Obama the credibility to win the even more difficult structural reforms such as green energy and universal health care.
Lincoln declared, "With public sentiment nothing can fail; without it nothing can succeed." Much of what's urgently needed remains well beyond the bounds of accepted wisdom. It will take presidential definition of the crisis to move public opinion to the point of embracing large-scale relief. In a deep economic crisis, expansive outlays that were unthinkable six months ago are suddenly barely adequate. But bringing about that change requires transforming presidential leadership.
The new administration faces several fateful choices. How much money should be spent in the initial stimulus package? How much of it should be tax relief versus new government outlay? How much spending should be deficit-financed? How big should a permanent increase in public outlay be? When should major reforms such as universal health insurance be attempted? Obama's answers to these questions will determine not just whether an immediate economic recovery is possible but whether he will be a truly transformative president.
How Much Stimulus?
The emerging consensus calls for an initial stimulus of $500 billion to $700 billion. That seems huge -- about 4 percent of gross domestic product. But forecasters now project a decline in GDP higher than that rate. Despite these dire risks, Republicans, along with some Blue Dog Democrats, still oppose large-scale deficit spending. In November, House Republican Leader John Boehner declared, "We're in tough economic times. ... More Washington spending isn't the answer." Congress will only be compelled to spend on an adequate scale if Obama is able to explain the stakes and build broad public support.
Since Nov. 4, the media has focused on the early New Deal. But the New Deal never cured the Depression. In the 1930s, Roosevelt's peak deficits were 5 percent to 6 percent of GDP, and he sandbagged his own recovery by pursuing budget balance in 1937. It took the more heroic government intervention of World War II, with deficits as large as 30 percent of GDP, to finally put the Depression behind us.
This time around, we will not need emergency mobilization at that scale (one hopes), but we could easily need deficit spending of 10 percent of GDP, or $1.4 trillion a year for two years. Better initially to spend too much than too little, or Obama, like Hoover, could find himself chasing a depression downward.
Tax Cuts or Public Spending?
Obama needs to deliver some tax relief, if only to keep his campaign promises. During the campaign, he promised middle-class tax cuts totaling nearly $200 billion a year. But a $1,000 tax rebate is puny if you've lost your job. The lion's share of stimulus should be public outlay. Economist Peter Morici calculates that a tax cut of $100 billion produces a net economic stimulus of $125 billion, when multiplier benefits are factored in, while $100 billion of infrastructure investment has the far more potent eventual effects of $350 billion. In a deepening recession, public spending delivers both more economic punch and more political benefit. Citizens once again experience the positive uses of government, not just the negative gains of government cutting taxes. The right has understood this better than the center-left -- which is why conservative pundit Bill Kristol issued that famous memo urging Republicans to oppose the Clinton health plan "sight unseen."
For starters, Washington should plug deepening shortfalls in state and local budgets, which could easily exceed $100 billion in 2009. In a recession, every cut in a public service, every layoff of a public employee, is needless and perverse. The infrastructure backlog is estimated at $1.6 trillion by the American Society of Civil Engineers. These basic outlays make the economy more productive, provide middle-class jobs that can't be exported, and over time will underwrite conversion to a clean-energy economy. It may begin as an emergency "stimulus," but expanded public spending needs to be seen as an eight-year project to restore effective government to a valued role in the economy.
How Much Deficit?
During the worst phase of the downturn, annual deficits of 10 percent of GDP would raise the national debt held by the public from its present 40 percent of GDP to around 60 percent. That sounds huge but is modest by historical and international standards. After World War II, the public debt was over 110 percent of GDP. But that wartime debt recapitalized American industry, made America a world leader in science and technology, and retrained and re-employed a generation of American workers. As a result, that virtuous debt catalyzed a 25-year postwar boom -- which was built on real rather than purely financial growth, and a period when income distribution actually became more equal. By the 1970s, that wartime debt was paid down; under Carter, the ratio of public debt to GDP bottomed out at about 26 percent. After 2010, once growth resumed, the debt ratio would similarly come down.
After basic recovery, most new domestic spending should be paid for by tax reform. Taxing millionaires and spending the money on public projects is stimulative even if deficit-neutral, because all the money gets spent and gets spent at home. The Internal Revenue Service has estimated a tax gap of at least $300 billion in evaded but collectible taxes. Another $100 billion to $200 billion a year could be collected through a "Tobin Tax" on short-term financial transactions, which is good policy in its own right. Raising tax rates in the top income brackets could produce another $200 billion, only some of which would go for tax relief for the middle and bottom. Total net revenue gain: about $600 billion.
Timing the Structural Reforms.
Recapitalizing banks, getting credit flowing again, and preventing a deepening epidemic of home foreclosures can't wait. These reforms, like the stimulus, need to be done in the first six months. Otherwise, a wounded financial system will continue dragging the rest of the economy downward.
To brake the slide in housing prices, government needs to refinance distressed mortgages directly and not rely on voluntary bank refinancing. As it reforms the financial system with public funds, the government should start acting like an owner, putting public representatives on boards and if necessary, replacing chief executives. If privately owned banks are too traumatized to resume lending, government may well need to nationalize a bank or two. That's far less radical than it seems. The Federal Deposit Insurance Corporation does exactly that when it takes over a failed bank, and typically operates the bank much more effectively than the ousted former managers.
When it comes to the auto industry, Obama and the Democrats are right to insist on a plan for restructuring the industry before giving the automakers more than interim relief. Rather than passively waiting for Detroit's plan, the new administration should be actively engaged in the planning. In 1941-1942, the entire auto industry retooled from civilian cars to tanks and planes. As part of Obama's bargain, the automakers could retool in 2009-2010 to produce clean, fuel-efficient cars. Massive government aid gives the administration the leverage to demand nothing less.
Obama should wait a year on comprehensive health reform. Expanded spending on children's health and increased public-health outlays should be part of the initial stimulus. But remaking the whole health system is the heaviest lift of all. If Obama gets this wrong, he will just add costs to an inefficient system, adding pressures to cut care in order to moderate cost inflation. It's far better to wait until he has built the political capital and popular support to do this right.
Like the health system, the private pension system is also collapsing. Economist Teresa Ghilarducci argues that it's time to declare the 401k experiment a failure and to provide reliable and universal pensions, funded by real pools of capital, as effectively a second tier of Social Security. This large reform will also have to wait a year or two.
Recovery must come first. I don't doubt Obama's incrementalist tendencies. But neither do I doubt his intelligence, boldness, and desire to succeed. The new reality demands that Obama think big and seize the moment.
