2/25/2009 – Economics Not Politics

Everyone has an opinion about the government’s response to the economic crisis so we thought we might as well have our say as well. First of all, virtually no one is blameless. Democrats irresponsibly supported and defended Fannie Mae and Freddie Mac. Republicans irresponsibly allowed our financial institutions to leverage to the hilt and spent like drunken sailors during the Bush years. The Fed totally failed in its regulatory role of financial institutions and fueled the housing bubble with too much liquidity. Banks and mortgage companies made trillions of questionable loans. The ratings agencies failed to properly assess the risks in these securities. Institutions that bought these toxic assets failed to perform prudent due diligence. And finally, many Americans bought homes they couldn’t afford.

Let’s be frank: we are in a deep recession that could get worse especially if there are policy mistakes. In the fourth quarter of 2008, gross domestic product shrank at an annualized rate of 20.8% in South Korea, 12.7% in Japan, 8.2% in Germany, 5.9% in the UK and 6.2% in the US. Alarmingly, declines in industrial production in these countries were even worse. The first quarter of 2009 will not be any better.

The financial crisis morphed into an economic crisis with shocking speed last year. Governments around the world should be focused on two items: stimulating aggregate demand and freeing up finance. The Fed should be given credit for attacking the credit crisis aggressively. The various programs they have enacted have provided needed liquidity and helped heal wounded credit markets.

The recent stimulus package has come under much criticism especially from Republicans who are worried about adding to our deficit. While this concern is laudable, the fact is our deficits are going up regardless of the stimulus package. We are in a deep recession which means tax receipts are plummeting and automatic stabilizers, like unemployment insurance and Medicaid, are rising. The result is expanding deficits. Currently we are experiencing a negative feedback loop: the credit crisis causes banks to limit credit to businesses, businesses cut staff as demand declines, the unemployed stop spending and default on their credit cards and mortgages, banks shut off more credit to businesses, businesses lay more people off, etc….The stimulus package is an attempt to shock our economy and break this negative feedback loop.

Done correctly a stimulus package can work and ultimately keep our deficits from getting larger than they otherwise would. While there were some questionable items in the stimulus package the majority of the package is good policy. The largest part at 38% is tax cuts. This fact doesn’t seem to be getting any attention. Aid for states and the unemployed represents 25% of the total and will most certainly be spent quickly. Infrastructure and education spending is the next biggest and should pay benefits well into the future.

We are very pleased that the Democrats did not raise taxes which would be disastrous. At some point we will have to address our deficits, but we cannot tackle that issue until our economy is on firm footing. And when we do everyone will have to sacrifice through higher taxes, lower spending and fewer benefits.