Originally appeared January 20th in:

(ri sesh' en): n. Econ. a period of general economic decline; specifically, a decline in GDP for two or more consecutive quarters

New incentives, not fiscal stimulus, are the best way to bolster a slowing economy

The recession watch has begun. With the second and third quarter real GDP - our most comprehensive measure of economic activity - coming in at at a robust 3.8 and 4.9 percent, respectively, we wouldn't normally be expecting a recession, but these aren't normal times. The steep housing slump is unlikely to reverse any time soon, and the head-spinning financial market turmoil triggered by subprime slime is bound to take its toll. Paper wealth is melting away. The unemployment rate, which had remained remarkably low and was the chief source of hope, surged in December. That light at the end of the tunnel now seems like a fast train to Georgia. Those good mid-year GDP numbers now remind me of the guy who jumped off a tall building and about half-way down said "so far, so good."

Monetary policy was late to the rescue, but it has been catching up with both traditional and new, creative measures to inject liquidity into the financial system. The Fed has cut its target federal funds rate, the rate at which banks borrow from each other. It has also cut its discount rate, the rate at which it lends to banks. It has liberalized loan terms and collateral requirements for those loans. And, finally, the Fed has literally been auctioning money to banks. It has eased policy substantially, but more ease is needed, sooner rather than later. Once the Federal Open Market Committee, the policy-making arm of the Fed, decides that a substantial move is warranted, I see little reason to wait for the next scheduled meeting at the end of January. Ben, use your speed dial.

One problem is that the Fed's policy tools aren't very well suited to the current crisis in financial markets. If the problem was a shortage of liquidity, it would be solved by now. The bigger problem is that lenders are afraid they won't be repaid, and the interest rate they won't be repaid at makes little difference to them. They worry about what land mines - read that subprime mortgages in mortgage-backed securities - are hidden in counterparties' balance sheets. This crisis is unique, but Fed actions, past and future, should help limit the collateral damage to the overall economy and ease the severity of the impending slowdown, whether it reaches recession proportions or not. Monetary policy is powerful medicine, and a little like sipping vodka: you don't feel it, then you are on the floor. But with monetary policy, as with vodka, memories are short.

With monetary policy not getting the job done, many are calling for fiscal stimulus - more government spending or lower taxes. But while fiscal measures to stimulate the economy are tempting, it's a temptation that should be resisted for several reasons.

First, is timing. By the time it is formulated, passed by Congress, and implemented, the fiscal measure may be the opposite of what is then needed. Second, fiscal policy doesn't work without the appropriate accompanying monetary policy, but if monetary policy is appropriate - meaning more aggressive - then it is probably sufficient without a fiscal component. Fiscal ease, or an increased budget deficit, without appropriate monetary expansion puts upward pressure on interest rates and crowds out private-sector borrowing and spending. We'd just end up substituting government spending for private-sector spending, not a good recipe for growth and prosperity.

Politicians say we should put money in the hands of middle-and low-income people because they are more likely to spend it that those with higher incomes. More redistribution may or may not be desirable for social reasons, but the idea rich folks don't spend their money is ridiculous. Their saving goes into a financial intermediary or financial instruments that provide funds for investment. Taking it to the bank rather than the store is just the first step. The rich generally don't put their money in mattresses.

Old-fashioned stimulus through more net government spending is a poor substitute for supply-side fiscal measures that increase incentives to work and produce. The most important and most effective fiscal measures for now and for the future would be to remove the threat of higher marginal tax rates on both labor and capital that would result from the expiration of the Bush tax-rate cuts. Those reductions should be made permanent as soon as possible, and even augmented, especially the taxes on capital gains and dividends.

Lower tax rates on capital is about as close to a free lunch as it gets. The lower rates, by stimulating more activity, almost always generate more tax revenue. Close behind making the Bush tax cuts permanent in importance would be to reduce significantly the corporate income tax, which is currently internationally noncompetitive, and eliminate the death tax, which dilutes and distorts incentives of small businesses to maximize output and employment. Tax credits for new investment, or the expensing of investment rather than depreciating it, should also be considered. For the longer run, of course, fundamental tax reform is needed - either a low flat income tax or a tax on consumption rather than income.

Professors at universities that don't have good football teams dismiss supply-side tax-rate cuts as ineffective voodoo. That myth stems partly from the fact that the Reagan tax cuts were overhyped and overpromised. Tax revenue didn't rise enough to overcome higher defense spending, but not working as hyped is different from not working. There are levels of tax rates on the Laffer Curve, which depicts tax rates and corresponding tax revenue, where lower tax rates would completely pay for themselves with more revenue, levels where they would lower revenue and levels where they would substantially but not completely pay for themselves.

We are probably in that third category where lower marginal tax rates would substantially, but not completely, pay for themselves. That's good enough for me. It may not be the proverbial free lunch, but it would be an awfully cheap lunch. If supply side marginal tax-rate cuts were good enough for John Kennedy and Ronald Reagan, I don't see why Congress can't get it together.

A new element has complicated the quest for policies to stave off recession - the weakening of an already weak dollar in terms of other major currencies.

The dollar is an important factor in the results of any policy action, and a strong dollar over time is a major positive for the U.S. economy. But, while I favor a strong dollar generally, this is not the time to give up the stimulative effects of the weak dollar. To paraphrase a famous prayer, "Lord give us a strong dollar - but not just yet!" The stimulus to exports and restraint on imports caused by the currently weak dollar is needed to offset housing and other weak sectors of the economy. The current level of the dollar should help our international trade balance for some time to come. For international capital flows, the expected direction of the dollar is more important than its current level; so, soon, if not already, expectations will turn and the dollar will climb back to its rightful place in the sun. We want that. But not just yet!

The bottom line on fiscal stimulus to stave off or ameliorate a recession is this: None is needed for that purpose that wouldn't be good policy under more normal circumstances. Low marginal tax rates on income, capital gains and dividends are always good policy and largely pay for themselves by stimulating economic activity. They need to be lower, but the first urgent priority is to avoid making them higher by letting the Bush tax cuts expire and to make that clear as soon as possible to end the uncertainty.

Corporate tax rates should be lowered at least to the level of those of our trading partners and lower still if we can get our minds around the fact that corporations don't pay taxes, people do. Death taxes are the final insult, coming at an awkward time and on top of all the taxes already paid over the years as income was earned and assets were accumulated. How many more family businesses must be sold or broken up to pay the tax?

Eastern European countries are way ahead of us in fundamental tax reform as they implement flat, low income taxes. Do we have to sink to their previous levels before we have the courage to implement fundamental reform? When will we learn that what is taxed is destroyed; so taxes on consumption that exempt saving is key to continued dynamic income expansion. We don't need election-inspired makeshift rebate goodies from Washington under the guise of economic stimulus. We need to get real with fundamental reform worthy of this great nation.

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