Dear Mr. President: By now, you are painfully aware of the gravity of the economic crisis you will soon inherit. It is clear that this is no ordinary business-cycle downturn. The crisis is the product of the bursting of one of the largest credit and asset bubbles in modern financial history that has set off a painful deleveraging process in America's household and financial sectors. This deleveraging process has now spread across other sectors of the world economy. In fact, few countries have been immune from falling asset prices and collapsing financial institutions, or from failing demand for their goods and services. This is the stuff great depressions are made of, and that is why Time magazine devoted its November 24 cover to you, Mr. President, in the guise of FDR.
Unfortunately, the outgoing administration was often one step behind the curve in dealing with this fast-moving crisis. You will therefore need to anticipate the condition the economy will be in when you take office and the risks that require your urgent attention. Over the past several months, the Federal Reserve and Treasury have undertaken extraordinary measures--from extending federal guarantees to most parts of the financial system to direct capital injections into the nation's leading banks--to unfreeze the credit markets and prevent the collapse of the nation's economy. The European Central Bank and the central banks of Britain, Switzerland, Japan, and other countries have also stepped forward to inject money into the world's banking systems. Nearly all of the G-20 economies have approved some form of stimulus to try to offset the downward pressure on their economies.
Yet, as you know, these measures have not been enough to stop the rapid deterioration of the economy. By the time you take office, unemployment will have ticked up another point or two; more businesses, including U.S. automakers, will be on the brink of failure; and budget-strapped state and local governments will have been forced to lay off more people and cut social services. Thus, there is a risk that cascading job losses and bankruptcies could further destabilize the American financial system, adding to the danger of deflation taking hold. What is worse, the crisis will have taken its toll on a number of emerging and newly developed economies, requiring more international rescues of the kind that have already been undertaken in the cases of Iceland and Hungary.
It is therefore not too much of an exaggeration to say that the fate of the world economy rests on the recovery program you pursue upon taking office. It also depends upon the international cooperation you are able to organize around a coordinated global economic recovery.
As you surely recognize, this crisis is increasingly global in scope and is clearly too big for the United States to handle alone. We will need to see more coordinated rate cuts, financial injections, sovereign debt rescues, and fiscal policy expansion on the part of G-20 governments if we hope to avoid a deep and protracted world recession--if not a global depression. At the same time, you must design your economic recovery program not just with the goal of preventing the worst from happening. You must also structure the program with the objective of putting the American and world economies onto a new, more-sustainable growth path--one that does not depend upon debt-financed consumption in the United States to drive global economic growth, as it has over the past decade. In this sense, you will be judged not only on whether you have avoided the worst but also on whether your program has made the U.S. and world economies stronger and more productive in the longer term.
The two-year economic recovery package you have broadly outlined--extension of unemployment benefits, assistance to state and local governments, middle-class tax cuts, incentives for green technology, and some infrastructure spending--is a clear improvement over the first stimulus package Congress passed in February 2008. Yet it still falls far short of what is needed given the nature of the economic crisis.
To begin with, your program is too short in duration to generate a sustainable recovery. I know you have been told by your economic advisers that stimulus is best if it is made temporary, especially if you are concerned about inflation down the road. But as the experience of Japan in the 1990s suggests, economies suffering from burst credit and housing bubbles tend to relapse once the short-term stimulus is taken away.
This recession could be particularly long because many American households are seriously over-leveraged and are experiencing a decline in the value of their homes. With home prices falling, many households are no longer able to maintain consumption levels by tapping home equity as they have in the past. Moreover, with unemployment rising, they cannot easily or quickly replace the credit they previously relied on with new sources of income. Thus they will have no choice but to cut consumption and increase savings. In light of the fact that housing markets by their nature are slow to correct, this household deleveraging process could take years to play out. Household consumption, which at its peak accounted for more than 70 percent of the economy, may thus be a drag for some time to come--at least until wages rise or home values begin to increase again.
Second, your program, although bigger than the initial proposal, is still too modest to make a substantial difference to an economy damaged by the unwinding of the bursting of the housing and credit bubbles. You should note that economists as politically diverse as Paul Krugman, Stephen Roach, and Ben Stein agree that you should err on the side of overkill and that a massive recovery package is called for. Even the bursting of the tech bubble in April 2000, which had relatively little impact on most Americans and resulted in only a modest increase in unemployment, required a fiscal stimulus the equivalent of more than 6 percent of gross domestic product (GDP) (measured by the increase in the budget deficit) over a three-year period, in addition to 16 cuts in the federal funds rates to 1 percent. In light of the much larger effect housing and credit has on consumption and employment, the unwinding of the housing and credit bubbles will require an even larger stimulus.
Third, even with the addition of incentives for green technology and increased infrastructure spending, your package is still too heavily weighted toward short-term consumption and not enough on job-creating investment. Thus, to the extent your package is successful, it will merely reinforce a suboptimal and ultimately unsustainable pattern of economic growth that over the past decade has been too dependent on debt-financed consumption and inflated asset prices. The root cause of this sub-optimal pattern of growth has been the excess savings generated by the Asian export economies and the petro-dollar states of the Persian Gulf, which were recycled into the U.S. financial system, fueling the credit and housing bubbles. The housing bubble in turn helped inflate consumption, as U.S. households took advantage of poorly regulated new...