Feldstein: Problems Run Deeper than Wall Street

Martin Feldstein seems discouraged about the prospects for the economy, and he has little confidence in the ability of monetary or fiscal policy to do anything about it:

America's Problems Run Deeper than Wall Street by Martin Feldstein: ...We are in the midst of a financial crisis caused by the serious mispricing of all kinds of risks and by the collapse of the housing bubble... What started as a problem with sub-prime mortgages has now spread to houses more generally, as well as to other asset classes. The housing problem is contributing to the financial crisis, which in turn is reducing the supply of credit needed to sustain economic activity.

Indeed, the financial crisis has worsened in recent weeks... Ultimately, these financial failures reflect the downward spiral of house prices and the increasing number of homes with negative equity, i.e., with substantial mortgage debt in excess of market values. ...

We cannot be sure about how much further house prices will fall. Experts say another 15% decline is required just to return to the pre-bubble price path. But there is nothing to stop the decline from continuing once it reaches that point. ...

As homeowners with large negative equity default, the foreclosed homes contribute to the excess supply that drives prices down further. And the lower prices lead to more negative equity and therefore to more defaults and foreclosures. It is not clear what will stop this self-reinforcing process.

Declining house prices are key to the financial crisis and the outlook for the economy, because mortgage-backed securities, and the derivatives based on them, are the primary assets that are weakening financial institutions. Until house prices stabilize, these securities cannot be valued with any confidence. And that means that the financial institutions that own them cannot have confidence in the liquidity or solvency of potential counterparties – or even in the value of their own capital. Without this confidence, credit will not flow and economic activity will be constrained.

Moreover, because financial institutions’ assets were bought mainly with borrowed money, the shortage of credit is exacerbated by their need to deleverage. Since raising capital is difficult and costly, they deleverage by lending less.

But the macroeconomic weakness in the US now goes beyond the decreased supply of credit. Falling house prices reduce household wealth and therefore consumer spending. Falling employment lowers wage and salary incomes. The higher prices of food and energy depress real incomes further. And declining economic activity in the rest of the world is lowering demand for US exports.

The US Federal Reserve has, in my judgment, responded appropriately..., but ... monetary policy appears to have lost traction...

The US Congress and the Bush administration enacted a $100 billion tax rebate in an attempt to stimulate consumer spending. Those of us who supported this policy generally knew that history and economic theory implied that such one-time fiscal transfers have little effect, but we thought that this time might be different. ...

In the end, our hopes were frustrated. The official national income accounting data for the second quarter are now available, and they show that the rebates did very little to stimulate spending. More than 80% of the rebate dollars were saved or used to pay down debt. Very little was added to current spending.

So that is where the US is now: in the middle of a financial crisis, with the economy sliding into recession, monetary policy already at maximum easing, and fiscal transfers impotent. That is an unenviable situation, to say the least, for any incoming president.

That is why I continue to argue that government spending is better than tax cuts, especially temporary or one time tax cuts (see the 1975 and 2001 tax rebates), if the goal is to stimulate the economy:

I prefer government spending to tax cuts as a means of stimulating the economy since the effect on aggregate demand is more certain, and spending can be directed toward particular, high employment, high economic return projects such as rebuilding infrastructure and addressing environmental concerns

With tax cuts and rebates, you create an incentive and hope people act on it in a way that stimulates GDP and employment. But there's nothing to guarantee that people will spend the money on goods and services and increase aggregate demand. Instead, they may pay off debts or save the money. With government spending, there is no such uncertainty since government purchases of goods and services impacts aggregate demand directly. In addition, a well designed policy can provide simulus to the economy in the short-run and also address critical infrastructure and other needs that will allow the economy to grow faster in the future.