Pull the Fiscal Policy Lever
November 9, 2002

Now what? The economy is slumping with consumer confidence at a nine-year low. The prospect of war with Iraq is depressing the competitive spirits of business. The Fed boldly took out a recovery insurance policy by cutting its benchmark interest rate—the fed funds rate—half-a-point to 1.25 percent. Still, monetary stimulus is losing effectiveness with the fed funds rate at its lowest level since the summer of 1961. No, with mid-term elections over, and Republicans gaining a dramatic margin of power in Washington, it's time for Congress and the White House to prime the pump of a sputtering economy.

Fast action on the fiscal side is called for with the risk of debt deflation in the United States greater than at any time since the 1930s. Debt deflation is a dangerous economic condition. Here's the dynamic: Falling prices make meeting debt payments increasingly onerous. Heavily indebted business and consumers cut back to meet interest payments. The cutbacks depress the economy. Prices fall further. Debt becomes more expensive. Bankruptcies rise. And so on in a vicious downward spiral.

Deflation is gathering momentum around the world. Prices are falling in Asia, especially in China. Switzerland's consumer price index has slipped into negative territory. America's broad gross domestic product price measure is at its lowest level since 1954. Americans have borrowed a lot of money, too. Here's an alarming statistic: Nearly one-fifth of households that earn less than $50,000 a year had a debt service burden of greater than 40 percent.

So far, the Fed has been the economy's stalwart supporter. Chairman Alan Greenspan has convinced his colleagues to aggressively slash the fed funds rate last year and this year. U.S. fiscal policy has buttressed the economy, too, with a $250 billion federal budget surplus transformed into a $160 billion deficit.

Still, fiscal policy has been largely inept. The Administration's tax cut, largely skewed toward the wealthy in future years, has done little for the economy. The economic summit in Waco was a joke. Congress and the White House have failed to deal forcefully with the corporate accounting scandals—just think of the disastrous tenure of Harvey Pitt, who recently resigned as chairman of the SEC.

It's time for Washington to abandon the tired, nasty politics of partisan gridlock. Forget ideas such as lowering the capital gains tax rate, which would do little to stimulate the economy. Instead, money should go toward supporting lower- and middle-income households that need some extra income to make ends meet in troubled times. For instance, unemployment benefits should be extended rather than allow to expire. A temporary cut in the payroll taxes is another savvy tactic.

To be sure, deflation is still considered a remote possibility by many economists and policymakers. But the economic price for being wrong about deflation is far too high. Washington should pull out all the stops to prevent its emergence, and to keep deflation relegated to the history books.

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