Should taxes be cut to revive the comatose recovery? In a weak economy such as the one we have today, fiscal action would normally be appropriate. But not here and not now. Congress is best advised to close the Pandora's box of tax-cutting plans quickly, before too many undesirables get out. This is a conclusion I come to reluctantly. It would certainly not have been my view a decade ago in a similarly stalled recovery, and I hope it will not be my view a decade from now. But after the unseemly budget spectacles of the past 10 years, it seems best to keep the fiscal arm tied tightly behind our backs for now. In thinking through the merits and demerits of the myriad tax-cut proposals currently elevating political pulses, we must distinguish between tax cuts that are balanced by equal tax increases and those that are not.
A plan in the first category is permissible under the 1990 budget agreement. But it would not provide a wake-up call for the economy and so should not be marketed as Geritol for an anemic recovery. In a balanced-budget package, the tax-cut component would be a stimulant, but the tax hike would be a depressant of roughly equal magnitude. Recent history provides a case for raising taxes on the rich in order to lower them on the poor and middle class. But that case rests squarely on grounds of social justice, not fiscal stimulus.
HISTORY LESSON. Then why not support a simple redistributive tax package right now? I answer with another question: Who in America believes that our current President and Congress can, in an election year, craft a finely balanced bill that will deftly redistribute the tax burden without disturbing the fiscal balance? At other times and other places, I would be in favor of such a proposal. But not here and not now.
But what about unbalanced tax cuts that, while they bust the 1990 budget agreement, can at least be expected to give the economy a boost? Should we enact one? My answer, once again, is not here and not now.
First, we should not ignore the possibility that the recovery will pick up steam of its own accord, rendering any new fiscal stimulus not just unnecessary but counterproductive. This scenario looked far more likely a few months ago than it does today. But history teaches that recoveries sometimes pause before resuming their upward climb.
Second, tax cuts might not even work in the current environment, in which fiscal pronouncements are routinely disbelieved. Suppose a relatively small tax reduction--and the huge budget deficit precludes more--induces a relatively large adverse reaction in the bond market. Then, rising interest rates might cancel out any stimulus from the tax cut, leaving the deficit larger and the economy no better off. This "Wall Street view" of fiscal stimulus is one I have often denigrated in the past: The historical evidence is certainly against it. But it sounds eerily plausible today.
As part of the sorry legacy of the 1980s, the bond market seems to have contracted a chronic case of the federal-budget jitters. This ailment was not cured by the five-year budget agreement of October, 1990, which, despite its bad press, was a big improvement over its predecessors. By remaining intact for a full 14 months, the agreement has already outlived the life expectancy predicted by the skeptics. Abrogating it now would destroy whatever meager fiscal credibility remains--and might even send the bond market into a tizzy.
MORE SPUTTERING? Third, in deciding what to do today, we must not lose sight of tomorrow. America's long-run problem is too little investment, not too much. A fiscal expansion that raises the deficit and interest rates is hostile to investment and therefore exacerbates the long-run problem. By contrast, a pick up in monetary expansion that lowers interest rates and promotes investment takes a step in the right long-run direction.
As we know, there has been a long-running debate within the Federal Reserve Bank over how hard to push the economy. So far, the Fed's performance has been good, if a bit timid. But if fiscal policy assumes the burden of supporting the recovery, the pressure will be taken off the Fed. I think we should keep it on. Central bankers perform better when they are sweating.
Some economists would push this last argument even further. Many believe that the Fed tries to use its control over short-term interest rates to steer the economy along a target growth path for gross national product. If this view is correct, then any additional forward momentum from fiscal policy will be automatically and fully offset by a throttling back of monetary policy. Such a shift of the policy mix toward bigger deficits and tighter money is precisely what Reaganomics gave us in the early 1980s. We do not need another dose now.
One question remains: If fiscal stimulus is not applied and the recovery continues to sputter, then what? The answer is implicit in what I have already said. Chairman Greenspan & Co., the country is relying on you. Please do your duty. We have a long way to go before the federal funds rate hits zero.