Simply put, to address the weakness of the U.S. economy we need an “Operation Twist” from Congress, not from the Federal Reserve.
For the past 25 years, as interest rates declined, our propensity to borrow grew as the cost of borrowing fell. Each time the economy stalled, the Federal Reserve found it easy to restart growth by encouraging us to borrow a bit more through the “credit channel” of monetary policy. But as we work off our national credit binge, this process no longer works the way it used to.
When the Fed signaled last year that it would expand its balance sheet by buying more Treasury securities, the hope was that this would encourage investors to drive up the value of stocks and bonds and that the wealth effect would encourage greater household and business confidence, leading to more investment and more jobs.
Any real chance for success required that Congress follow through to stimulate business investment. But during last year’s lame duck session, Congress and the administration were capable only of extending the Bush-era tax cuts and dropping payroll taxes — both principally support for consumption. Over the following months, they dragged down business and household confidence by bringing us to the brink of default and recession.
Now we begin again. The Fed’s extraordinary statement last month that it would hold down short-term interest rates for two years powerfully pulled down long-term rates, again supporting stock and bond prices. The Fed is debating whether to pull down long-term rates further through a twist in its balance sheet, by selling short-term Treasurys and buying longer-term ones. This will do little to give us promptly what we need: investment.
Our propensity to borrow is giving way to a propensity to save. Aging baby boomers are more likely to be encouraged by low rates to save more, not borrow more. Businesses are constrained from investing not because of high interest rates but because of a lack of confidence in the strength of the economy, high corporate taxes relative to the rest of the world, and uncertainty about future policies.
With household and corporate savings rising, we need to stimulate both the private and public sectors to turn these savings into investment. There is little the Fed can do to help this transition but much that Congress should do.
Congress should act now to reduce significantly the path of spending on entitlements over the next 30 years but, because of the weak economy, it should not cut spending over the next two years.
The more important twist in fiscal policy that we need from Congress is not in the level of expenditures but in their composition. We need less spending on those things that merely support consumption and more support for those things that stimulate investment — now and in the future.
This should take the form of more genuine, direct investment in roads, bridges, railways, ports and other lasting infrastructure that will speed our products to global markets. We need more, not less, federal support for research and development. We should eliminate capital gains taxes on long-held assets and allow rapid depreciation for investment in new factories. Even better would be to significantly lower the corporate tax rate and eliminate all corporate tax credits and preferences, which would encourage the relocation from abroad of profitable activities and jobs.
Let’s make clear that the best ideas — in spending and in tax policy — will be those that stimulate the most investment. This is not a matter of ideology but of pragmatic self-interest: Jobs come from investment. Lower income taxes do not, by themselves, create investment; lower taxes on investment create more investment. Federal spending for consumption does not create as much investment as does targeted federal spending and incentives for investment. The differences are real.
The Fed should resist the temptation to drive interest rates yet lower just because it can. Congress should stop our over-reliance on the Fed by twisting fiscal policy away from transfer payments that subsidize consumption and toward policies that support both public and private investment.
The writer, Treasury undersecretary for domestic finance from August 2001 to October 2003, is a senior managing director and head of fixed income at BlackRock.