The Economy Needs a Kick in the Pants

It may be time for Washington to take out a modest insurance policy on the economic recovery. Momentum has clearly slowed, leading indicators are falling, corporate layoffs are ticking up, and consumer confidence is declining. The approaching anniversary of the September 11 terrorist attacks and talk of war with Iraq have people skittish about the stock market. Increasingly, the worry is that post-bubble America will mimic Japan's post-bubble decade of stagnation. Washington needs to give the economy a kick in the pants with a new stimulus package. We would start by bringing the scheduled 2004 tax cut forward to this fall and boosting spending on defense and homeland security. In tandem, the Federal Reserve should cut interest rates at its next meeting in September. With inflation very low, the major risk today to the economy is not taking action.

How much stimulus is needed? Maybe $75 billion to $100 billion. Fortunately, there is already plenty of stimulus working its way through the economy. To their credit, Washington policymakers moved quickly last year when the stock market tanked and the economy fell. The Fed cut interest rates faster and steeper than Japan did when its bubble burst, and Congress came up with a hefty tax-rebate plan in record time. New post-September 11 outlays for the military, homeland security, and domestic programs such as agriculture have increased the flow of dollars into the economy.

But it's not enough. After one strong quarter, the rebound has weakened markedly. Factory output today is no higher than it was a year ago. Recent revisions also show that what appeared to be a mild economic slowdown in 2001 was actually a longer, deeper recession. With telecom still a mess, with higher oil prices (up 50% so far this year) taking a big bite out of consumer spending, and with investors still traumatized by corporate crime, Washington must act again. When bubbles burst, demand deflates, and the only answer is to increase spending. Sharply.

CUT TAXES--FAST. President Bush has the right answer to the wrong problem. He is absolutely right in seeking to stimulate investment and growth by suggesting the end to double taxation on dividends, lowering the capital-gains tax, increasing the capital-loss deduction, and increasing contributions to IRAs and 40l(k)s. In the short run, however, the actual economic impact of these proposals would be to raise savings, not spending. Bush's ideas are pro-investment but anti-stimulation. His timing is off. The proposals are good for the long term but could hurt growth in the months ahead.

Cutting interest rates further will help, but not as much as previously. The Federal Reserve has chopped rates down to a 40-year low, successfully buoying demand in the auto and housing markets. But increasingly, people are refinancing to shorten their mortgages from 30 to 15 years, not to cash in on higher house prices. They are, in effect, using refis to save money, not spend it. This too, will not stimulate spending and demand. Just the opposite.

The smart policy move is for Congress to increase federal spending decisively. Cutting the deficit, as some Democrats and a few Republicans are suggesting, is exactly the wrong thing to do in a post-bubble economic slump.

The 2004 tax cut calls for lopping one percentage point off the top four income tax brackets, bringing them down to 37.6%, 34%, 29%, and 26%, respectively. If enacted in October or November, billions of additional dollars would be pumped into taxpayer pockets. Congress might even consider going further and cutting the next two brackets by one percentage point as well, taking them down to 14% and 9%. This would inject billions more into the economy.

SPEED UP OUTLAYS FOR SECURITY. An even more efficient way to stimulate growth would be for Washington to raise spending on the military and homeland defense. People often save a portion of their tax windfall. Government spending, however, on securing airports and ports and buying missiles and jets will go straight into the economy. And much of it will bolster the slack high-tech industry. For example, as the World Trade Center attack highlighted, fire and police departments in every city in America need to upgrade their communications equipment. Companies such as Motorola Inc. (MOT ) stand ready to supply them. Other companies are set to produce "Trusted Traveler" electronic cards to speed business and other travelers through airports. And Silicon Valley entrepreneurs are showing off new handhelds that could detect anthrax and smallpox. Security-related technology and defense electronics can be a major driver for growth in the near future. The new Homeland Defense Dept. could generate a lot of demand--if the Administration and Congress show leadership, establish the right priorities, and move ahead to finance them. With their economic fate so uncertain, Americans could use all the confidence building they can get. Strong action in Washington can help turn the nation's psychology around.

Congress would also be wise to reallocate some of the outsize farm bill it recently passed. For every dollar spent on security and infrastructure, roughly $2 worth of consumption is generated. Subsidizing farmers doesn't have nearly the same multiplier effect on consumption.

Certainly there are long-term concerns about a sharp rise in government spending. The budget surplus has disappeared for the moment, and the deficit will approach $200 billion next year. But the best way to ensure a steady stream of tax revenues and a surplus in the future is to build a solid base for growth. That is the pressing issue confronting America. The recovery's fragility makes it exceedingly vulnerable. Another terrorist attack, a sharp drop in the stock market, and almost certainly a war in Iraq could send it down into a double-dip recession. Right now, the economy needs a kick and only Washington can give it one.

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