A Moment For Fiscal Courage

By Sebastian Mallaby
Monday, August 11, 2008

One year ago, it seemed reasonable to hope that the mortgage crisis would be contained. Since then, just about everything that could go wrong has gone wrong. The crisis has spread through the financial system and is metastasizing into a global slowdown. It cries out for a bolder government response than we have seen so far. So here is a test for candidates McCain and Obama: Which of you would provide it?

When the mortgage market crashed, it was plain that billions of dollars of real estate loans would not be repaid, leaving enormous holes in financial sector balance sheets. But the beauty of global capitalism is that fresh billions can be found. The Chinese and Arab governments were accumulating savings faster than American lenders were squandering them, so it was simply a matter of transferring the cash from one place to another.

Sure enough, U.S. financial institutions promptly raised billions in fresh capital, including more than $30 billion in December and January from sovereign wealth funds abroad. As my Council on Foreign Relations colleague Brad Setser points out, this infusion dwarfed the bailout packages that the International Monetary Fund arranged in past emerging-markets crises.

But after these capital infusions, the real trouble started. It turned out that the banks had low-balled what they might have lost, so the foreign rescuers were hit with nasty surprises. Understandably, they became leery of providing further infusions. Financial institutions had to conserve capital by calling in loans. The mortgage mess became a credit crunch.

Once that happened, the economy slowed more than it would have otherwise. The slower economy caused real estate prices to fall further, which meant that more losses showed up in the banks' mortgage portfolios. So the banks' need for fresh capital increased -- and is still increasing. But because they have forfeited the confidence of the capital providers, banks are hard-pressed to raise funds.

If the banks' lack of transparency was the first reason the crisis metastasized, the second was oil and food inflation. This shock frightened consumers at home and abroad, slowing spending and growth; it forced central banks to raise interest rates to combat inflation, compounding the slowdown. A year ago, there were hopes that the U.S. downturn would be cushioned by strong demand for exports from buoyant economies abroad. Now the euro zone is growing more slowly than the United States, and even Asia is cooling.

The upshot is that things are desperate. The unemployment rate in the headlines (which understates the real number) is heading toward 6 percent; home prices are falling hard; and the two forces that have averted outright recession -- a timely fiscal stimulus and strong growth abroad -- are fading. The Fed has cut interest rates as much as possible given the worry about inflation. Foreign central banks are similarly boxed in. With the world's inability to agree on anything, there's no prospect of a coordinated global response -- witness the breakdown in trade talks. And so the United States must act using the only tool it has: It is time for a second stimulus.

Barack Obama, to his credit, has called for a modest stimulus, but there are questions about its size and design. Thanks to the Bush administration's crazy tax cuts, the federal budget is drowning in red ink. A further expansion of the deficit -- which is already set to surpass $500 billion next year -- could worry the markets, perhaps driving up interest rates and undermining the intended boost to the economy. So the stimulus has to be packaged with a signal that it won't bust the budget.

Obama deals with that imperative by keeping the stimulus modest and saying he would pay for it with a tax on oil companies' windfall profits. This is better than proposing nothing. Windfall-profit taxes reduce incentives for oil companies to search for new oil, but, to be fair, oil at $100-plus per barrel creates a sufficiently powerful incentive that the tax's damage would be marginal. Yet while Obama's plan is better than John McCain's lack of a plan, it is not the bold stroke that it should be. The best way to demonstrate that a stimulus won't bust the budget and, therefore, to create room for a bigger one is to address the budget's greatest problem head-on. A short-term stimulus should be coupled with a medium-term plan to fix entitlements.

Yeah, right, you're thinking; telling politicians to fix entitlements is like telling alcoholics to drink milk. But if today's economic mess teaches anything, it is the danger of mortgaging the future and living beyond one's means. The federal entitlement programs, which are projected to drive an eightfold increase in the nation's debt-to-GDP ratio by 2050, are the governmental equivalent of a no-doc loan with a spring-loaded reset. If ever there will be a time to speak honestly with the American people about entitlements, surely this is it.


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