Sunday, April 12, 2009

Focused and robust stimulus needed for economic recovery

Published in the Standard-Examiner, Ogden, UT, Feb. 6, 2009

Recently the House of Representatives passed the $819 billion stimulus package. It contains $244 billion for tax cuts, $217 billion for state and local governments, $104 billion for infrastructure (public capital expenditures), $120 billion to provide for a safety net, $59 billion for energy-efficiency projects and $54.6 billion for expenditures on human capital (education and training). At the aggregate level a third is devoted to tax cuts of various types and the rest is for direct government spending.

In order to put this stimulus package into perspective, let me briefly point out the genesis of this financial meltdown and the severe recession that could be worse than the recession of the 1980s, which lasted 16 months from peak to trough.

The current crisis started when the housing-market bubble burst and housing prices started plunging accompanied by defaults and foreclosures. That led to the decline in mortgage based securities and other related derivatives. Banks and financial institutions, loaded with those securities, started facing mounting debt and loss of confidence in their survival; that led the investors to pull out money from these institutions, and hence the precipitous decline in stock prices followed. The decline in equity capital and the inability to raise money in the bond market led to the financial meltdown.

The financial collapse dried up the credit flows to consumers and investors and thus the financial crisis spread to the real sector, which produces goods and services. Faced with high mortgage and other debts, homeowners were unable to find refinancing, thus causing defaults and foreclosures. This was followed by decline in consumption spending, retail sales, business contraction, layoffs and increasing unemployment.

The package passed by the House addresses neither the root cause of the crisis, nor is it sufficient in amount and focused to handle the severity of the recession. I am sympathetic to the idea of income tax cuts, payroll tax cuts and spending on safety net programs, but they (excluding unemployment compensation) do not belong in the stimulus package. A separate bill could quickly deal with these taxes and safety net issues. Supply-siders' argument that income tax cuts and payroll tax cuts would provide significant stimulus to the economy is not convincingly supported by any rigorous empirical evidence.

Even though the Fed and Treasury are contemplating actions I am about to propose, I do not notice a sense of urgency. The Fed, in collaboration with the Treasury, should stop the cycle of defaults and foreclosures in the housing market by mandating banks to renegotiate home mortgage loans. They could also insure losses on new loans. A "Bank of Recovery" could be set up to buy toxic assets at book value. On Jan. 20, the Wall Street Journal reported that expected loss rate of total troubled U.S. assets is about 14 percent ($1.3 trillion); it is much smaller for U.S. banks. Buying troubled assets of banks at book value would improve balance sheets of banks and would also infuse more capital. Given these actions, the Treasury could then require banks to unfreeze credit flows from the accumulating excess reserves.

As far as the fiscal policy is concerned, I would like to see the following in the stimulus package:
* corporate tax cut for three years,
* capital gains tax holiday for three years to those who buy stocks and/or corporate bonds in 2009, which would boost equity and/or debt capital,
* continue the postponement of mandatory withdrawals from 401(k) plans for three years to stop the leakage of private capital,
* investment tax credit for new investments over three-year period,
* expanding unemployment compensation for two years,
* and investment on infrastructure, for example, highways, bridges, schools and colleges, broadband, modern electricity grid, promotion of new technologies in energy to reduce oil dependence, health care and medical care technologies, mass transit systems and modernization of airports.

Those who fear mounting deficit at this time may recall that, when the economy was growing after the 2001 recession, we were running budget deficits. This is not the time to wobble on budget deficits. This is the time to take bold action and implement a robust stimulus package. I would prefer a $3 trillion package over a three-year period, with $1 trillion for each year and three-year freeze on CEO salaries, bonuses, other perks and dividends in those businesses who receive tax credits and/or direct subsidies.

Actions in the financial sector and the real sector have to be comprehensive and aggressive, followed by regulatory supervision and enforcement. The stimulus package should stick to programs that genuinely provide jobs in the short run as well as stimulate the private sector to provide jobs in the future.

Conquering this severe recession requires calculated risktaking without fear or timidity. As Mark Twain once said, "Courage is the mastery of fear, not the absence of fear."

Mathur is former chairman of the economics department and professor emeritus of economics at Cleveland State University, Cleveland, Ohio. He resides in Ogden.

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