Sept. 6, 2010
With hopes of a V- or U-shaped recovery fading, there is the increasing prospect of an L-shaped future of long stagnation, or even a W-shaped future in which W stands for something worse. The reason for this dismal outlook is economic policy is trapped by failed conventional thinking that can only deliver wage stagnation and prolonged mass unemployment.
Your administration’s current economic recovery program has been marked by four major failings:
- Inadequate fiscal stimulus.
- Failure to cauterize the housing market.
- Failure to cauterize the trade deficit.
- Failure to restore the link between wage and productivity growth.
If your policy team remedies these four failings our economy will quickly begin robust recovery. However, the longer you wait, the greater the challenge because recession creates new facts in the form of bankruptcies, foreclosures, destroyed credit histories, job losses, and factory closures.
1. Let the Bush administration tax cuts expire and use the savings for additional targeted stimulus.
The economy needs a further demand boost to establish recovery momentum. Much of the Bush tax cuts were an income redistribution program favoring the wealthy rather than a stimulus or growth program. That makes extending them bad policy.
The Bush ten percent bracket and marriage provisions should be retained, while everything else should be allowed to expire with the savings used to fund new temporary fiscal stimulus.
Half the funds should be directed to state and local governments to help avoid another round of job losses, this time in state and local government. The other half should fund an immediate lump sum non-taxable payment to all individuals earning less than $50,000 ($100,000 for married couples). This means eighty percent of households will continue benefiting and the total paid to these households will actually increase.
Moreover, the lump-sum design will increase the benefit going to those at the bottom, which will further stimulate demand and also lower income inequality. This temporary stimulus should be repealed once self-sustaining recovery is underway.
2. Cauterize the housing market.
The second critical measure is to cauterize the housing market. Throughout the crisis policy has disproportionately benefited banks and corporations. It has largely failed to help households directly and has instead relied on hopes of trickle-down effects from banks, combined with expensive tax subsidies to attract new home buyers.
The failure to directly help households has been a grievous policy error. Along with banks and corporations, households have needed debt relief but this has not been forthcoming. Banks have resisted meaningful loan modifications, while many households have been unable to refinance mortgages at lower interest rates because of zero or negative home equity. Consequently, the household sector has remained distressed and trapped in a foreclosure tsunami that has traumatized the economy.
Policy must immediately put a floor under existing homeowners. The solution is to use the Federal Housing Administration to refinance Fannie Mae and Freddie Mac mortgages with low or even negative equity and then have Fannie and Freddie repay some of their federal government borrowings. The test criteria should be whether the mortgage is viable once refinanced at low rates.
Additionally, the Federal Reserve must continue with purchases of mortgage backed securities to ensure that mortgage rates stay down until the housing market has stabilized.
Refinancing such mortgages will yield a huge boost to the distressed corner of the household sector that is currently unable to refinance owing to equity constraints. It would reduce foreclosures; boost consumer demand by lowering mortgage payments; and it is urgent because adjustable rate mortgages issued late in the bubble are still resetting upward.
The problem has always been inability to service interest costs, and the foreclosure wave could have been avoided if lower interest servicing had been made immediately available to households. Policy did this for the business sector via the TARP and various Federal Reserve rescue facilities but failed to do so for households.
3. Cauterize the trade deficit.
The third critical measure is to cauterize the trade deficit. The adverse effects of the trade deficit can be understood through the metaphor of a bathtub. Fiscal and monetary stimulus is being poured into the tub through the tap but that demand is leaking out through the plughole of the trade deficit. Moreover, it is not just demand that leaks out, but also jobs and investment owing to off-shoring.
The trade deficit and off-shoring are significantly attributable to China’s under-valued exchange rate, which also forces other countries to under-value their exchange rates to stay competitive. This has resulted in an over-valued dollar which makes the U.S. economy internationally uncompetitive.
With China refusing to correct its under-valued exchange rate, it is long past time for the U.S. to take action to protect itself. That can be done via administrative interventions and legislation making countries with under-valued exchange rates subject to countervailing duties.
There may be costs in the form of trade disruption and retaliation, but the costs of inaction and appeasement are far worse. The problem of under-valued exchange rates was visible a decade ago yet policymakers have failed to take action with devastating consequences. The choice has always been pay now or pay more later. Working families have already paid enormously due to inaction. Continued inaction will compound their devastation.
4. Restore the wage – productivity growth link.
Finally, policy must address the central problem of the last thirty years which is the destruction of the income generating process and severing of the wage – productivity growth link. Rebuilding that link is critical to recovery and shared prosperity, and it requires rebuilding worker bargaining power. One immediate measure is passage of the Employee Free Choice Act that will enable unions to organize on a level playing field.
A second measure is to index the minimum wage to the median wage. That will create a real wage floor and limit wage inequality because the minimum wage will automatically increase as median wages rise with productivity.
5. Do it all.
It is important these measures be done as a comprehensive package. Implemented alone they will be far less successful. Without cauterizing the trade deficit, fiscal stimulus and the benefits from cauterizing the housing market will leak out of the economy. Similarly, increasing union membership and wages will result in an acceleration of job and investment off-shoring. Fixing the trade deficit without fixing the income generation process and lightening households’ debt burden will leave the economy permanently short of demand.
Escaping the Great Recession requires jump-starting the economy by increasing demand. Preventing the economy falling back into stagnation requires rebuilding the income and demand generating process. That is why success needs the full policy package.