The President's men are beginning to worry that there may be no easy path out of this recession. Last month in this space, I explained why an investment-led recovery is the best way to jump-start the economy. Let me now describe why it is probably the only way. Consider the alternatives:
Monetary easing. With fiscal stimulus ruled out by huge deficits, the Federal Reserve is trying to revive the economy with cheap money. But here, the problem is anxious banks and a shortage of creditworthy borrowers. The culprit is the fallout from the financial excesses of the 1980s, compounded by the Administration's own behavior. The Federal Deposit Insurance Corp. and Resolution Trust Corp. are now the nation's biggest holders of commercial real estate. The Bush Administration detests the idea of the government owning commercial property and, along with the rest of America, is focused on short-term balance sheets. Thus, in a soft real estate market, the government keeps dumping properties to raise cash. This depresses the rents that can be charged by viable, privately owned properties and pulls them into default, too-further increasing bank losses. Hence, the bank/real estate collapse keeps feeding on itself, with an assist from the Administration's fire sale.
In this climate, cheaper money does only so much. Very low interest rates stimulate consumer spending, but the erosion of asset values and purchasing power may have reached a point where cheap money by itself is powerless to ignite a general recovery. The stimulative effect of low interest rates is also offset by the fact that America's "creditors" include tens of millions of retired people whose savings are in bank CDs, money-market funds, and Treasury securities. Every cut in interest rates reduces their purchasing power.
Capital-gains relief. In the late 1970s, those arguing for capital-gains tax cuts made three claims. First, higher aftertax returns on capital would induce more savings and investment. Second, capital-gains breaks would stimulate more sales of appreciated stock and hence would boost tax revenues. And third, by lowering capital costs, capital-gains breaks would make U.S. industry more competitive.
The effect of the tax cuts of 1978 and 1981 disproves each claim. Capital income got tax favoritism, but savings rates fell. Investment rates were maintained (barely) by foreign borrowing. Despite the supposed "unlocking" effect, there was a onetime sell-off of appreciated stock, but higher revenues only partly offset lower rates. If anything, the real economy today suffers from too much financial trading, not too little. And the market is dominated by pension funds and life-insurance companies whose capital gains are not taxable at all. As for competitiveness, lower capital costs are indeed desirable over the long term. However, industry mainly invests when it smells customers, who are not in evidence today. Low interest rates also reduce capital costs; but in this recession, lower interest rates have had little impact on investment. President Bush was right when he called the idea voodoo economics the first time around.
Middle-class tax relief. Although more attractive politically, the Democratic program of tax cuts for the middle class is also unconvincing as a recovery strategy. Why? Because the proposed cuts are deficit-neutral. Senator Lloyd Bentsen's (D-Tex.) proposal to shift some defense spending to tax relief might contract the domestic economy, because consumers have a higher appetite for imports than the Pentagon does. The Gore-Downey alternative-taxing the rich to relieve the middle class-is better, since the middle class spends more of its income than the rich. Still, a deficit-neutral tax cut is mildly stimulative at best unless it involves massive public outlays.
That leaves public investment. The virtue of public investment is that 100" on the dollar actually get invested, unlike a tax break. Although nominally public, most such investment quickly winds up back in the private sector, for the contractors are invariably private businesses. Public investment connotes old-fashioned public works. But it can also mean technology-stimulating projects such as high-speed rail and optical-fiber networks.
Public investment feeds private payrolls. Some public investment may be wasteful-but not half as wasteful as the hundreds of billions of dollars in useless office buildings brought to you by the genius of the private market. A program of public investment could even justify increased borrowing via a capital budget, since the borrowing would be dedicated to investment rather than to consumption.
Can a public-investment cure do the job quickly enough? In 1941, when the nation mobilized for war, unemployment melted from 11.8% to 2% in just six months. What prevents the Administration from embracing this cure? The same thing that feeds the self-defeating fire sale of commercial real estate-ideology. Yet when it proved politically expedient, President Bush swallowed his principles on both the civil rights bill and on the extension of unemployment compensation. It remains to be seen whether Bush will be sufficiently desperate or sufficiently opportunistic to embrace that old Keynesian devil, public works.