In a war economy, the public obligation is to do whatis necessary: to support the military effort, to protect and defend the hometerritory, to stabilize the economy itself, and, especially, to maintain thephysical well-being, solidarity, and morale of the people. These may not be easytasks in the months ahead.
We are facing an economic war--but not exactly a war economy. That means weget the dislocation without the usual growth. The impact of the September 11attacks now includes a 14.4 percent drop in stock prices in the first week andcollapse in sectors related to travel and leisure, notably airlines, hotels, andresorts. As these events cascade through the economy, they will weaken fragilehousehold balance sheets and precipitate steep cuts in consumer spending. This,in turn, will deepen layoffs and depress economic activity. The ensuing recessioncould be severe.
This is not merely a shock to a healthy system, requiring only limitedmeasures to restore confidence and stimulate spending. Since 1997 consumers havebeen financing consumption in excess of income. Those who had stock-marketwinnings borrowed against them. Those who did not borrowed anyway. But capitalgains turned negative 16 months ago, and consumers are in no position to borrowmore. What has happened since September 11 consolidates and accelerates apullback that was already well under way.
Estimates last summer by my Levy Institute colleague Wynne Godley were thatunemployment would have to rise to 7.4 percent just to bring household expenditures into line with income. Unemployment would rise as high as 9.0percent, Godley estimated, if households returned to normal post-World War IIsaving levels. That was before the recent events.
There is thus no chance that events will right themselves in a few weeks orthat we will be saved by productivity growth, as Federal Reserve Chairman AlanGreenspan professes to believe; nor will the economy be rescued by lower interestrates or the provisions of the recent tax act, most of which take effect after2004. Rather, we are in for a crisis; the sooner this is recognized and actedupon, the better.
Normally in wartime, largescale support to the domestic economyis not needed, because of vast increases in military expenditure. But what weface so far is a veneer of military action over a worldwide diplomatic and policeoffensive. In a $10-trillion economy, the $40 billion already appropriated forthe military and for relief is minor.
Including the airline bailout, further programs exceeding $100 billion maysoon appear, including unemployment insurance, extended tax rebates, andpayroll-tax relief. But all of this is not likely to be sufficient. Indeed, theconcept of "stimulus" should be discarded in favor of the objective of economicstabilization--implying a sustained effort commensurate with the crisis as it unfolds.
Business and capital-gains tax cuts are useless here. Without profits, reducedtaxes on profits have no effect. And without sales, investment is not likely evenif the tax regime favors it. The logic and also the motives of those proposingsuch measures are to be suspected. All wars attract profiteers.
Personal tax cuts pose another problem, even if aimed properly at workinghouseholds: They may not be sufficient if anxious consumers are in a mood toincrease their reserves. Of the available tax-cutting options, temporary cuts inpayroll 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 ofthis simple and progressive measure. And if Social Security reserves contributeto relief of the present national crisis, then we have a solemn moral obligationnot to use that contribution as an excuse to cut benefits later. To repair thelong-term damage to federal finances, Congress should repeal the tax cutsscheduled to take effect after 2004. That will help bring down long-term interestrates.
The cautious men are in charge at the moment; their attitude can only bringdisaster. There is no danger of overdoing fiscal policy anymore; inflationstimulated by excess demand is not even a remote threat. The initial programcould easily be three times what has been so far proposed.
Increases in spending on public health, education, transportation, and otherareas are absolutely needed and should be funded liberally. But a new program ofrevenue sharing is most readily implemented, least likely to be dissipated insaving or imports, and also the least partisan in concept. Direct purchases bystate and local governments now comprise nearly 10 percent of gross domesticproduct; they have been rising rapidly in the past few years and will fallrapidly as revenues are curtailed. To prevent this and create new capacity forstate and local action, including direct job creation and social aid, revenuesharing could be on the order of $300 billion this emergency year, with aphasedown as events warrant. This would give state and local governments newfiscal capacity that they can use at once to avert tax increases and even permittax holidays for local property and sales taxes.
How about monetary issues? Federal Reserve policy has completely lost domesticeffect. Cuts in interest rates on September 17 had no discernible impact on thelargest one-week decline in stock prices since 1933 and also none on economicactivity. In wartime the Federal Reserve plays very little role; it must simplybring down long-term bond rates and hold them down. But even then, wartimemonetary policy runs into a contradiction: It is inconsistent with a stabledollar, openly traded.
Here, the analogy to World War II mobilization is also misleading. BeforeWorld War II, the United States was the world's creditor nation; it enjoyedenergy self-sufficiency and did not run a large trade deficit. None of theseconditions now hold. As a result, a high-order Keynesian response will haveglobal financial repercussions. To finance a major military or domestic economiceffort, or both, risks driving down the dollar on world capital markets.
Lower interest rates worldwide after September 11 have kept the dollar up. Inthe short run, the recession will cut imports and improve the trade account; oiland gas prices may well decline. But in a global slump falling exports will addto our miseries; moreover, oil supplies could be disrupted in a wider war. Andimports will rise again if large-scale Keynesian policies take hold.
Any of these scenarios could gravely destabilize the dollar. The naturalreaction of the Federal Reserve would then be to raise interest rates, deepeningthe slump. Indeed, the Fed's opposition to economic-stabilization efforts now mayrest more on unacknowledged dollar fears than on anything else.
What is to be done about this risk? The old reality in global finance is thatdebtors cannot run wars--or economic-recovery programs--without the organizedassistance of their friends and allies. This, in turn, requires our commitment toa more stable and successful global financial system afterward.
The further reality is that the United States needs the sustained support ofthe world community for diplomatic, intelligence, and military purposes. Thiscannot be assumed to come for free--especially not from countries that have notbenefited at all from the modern global order. A new and more just and stableglobal financial order will therefore have to emerge from the present crisis orwe will eventually become mired indefinitely in fruitless and unending militarystruggles, with fewer and fewer reliable allies.
The modern system of floating exchange rates and unregulated internationalcapital markets is only 30 years old. It may very well now prove unable tosupport a return to prosperity in the United States. This being so, planning fora transition toward a more stable system should begin soon; we may need to fixparities with the euro, yen, and sterling before long. And comprehensive debtrelief for cooperating countries--Pakistan, to begin with--is needed now, as adown payment on a system of stable development finance after this conflict.
Finally, there is compelling reason to examine the structural sources of theU.S. trade position. Oil is a major factor; cars are a larger factor still.Reconstruction of our transportation networks and housing patterns so that theyrely far less heavily on oil and on automobiles (and on airlines) may be thenecessary domestic adjunct of real security abroad. A major national initiativein transportation and urban housing, planned now and launched soon, would alsohelp absorb resources presently being released into unemployment by the privatesector.
These are the first steps. If widespread unemployment or inflation cannot beavoided by preemptive means, then the entire experience of the New Deal and thewar economy will seem pertinent once again.
