Ever since the Great Recession began, I have been arguing in these pages that the best way out is to encourage work and thrift, and that to do the opposite, i.e. stimulus spending and debt forgiveness, would only prolong the agony. In a Wall Street Journal article, Gerald O’Driscoll of the Cato Institute makes the same point. Here are the relevant excerpts to his lucid article:
“The housing boom and bust was a classic asset bubble, such as occurred frequently in the 18th and 19th centuries. Easy money working through cheap credit made long-term investments appear more valuable than would otherwise have been the case.
In most cases, investment booms drive industries with sound fundamentals. When the cheap credit keeps flowing, however, fundamentals are forgotten and the process evolves into a mania (to use the old-fashioned term). What cannot be sustained will not be, so the boom ends in a crisis.
In these scenarios, the collapse of demand is a consequence—not the cause—of the bust. Policies to address crises must get cause and effect right.”
“The declines in home values, investor portfolios and 401(k) plans, and the uncertainties surrounding retirement plans, have all had a big impact. The solution lies in restoring balance sheets. For financial firms, that means raising capital. For consumers and businesses alike, that means saving more of their reduced incomes.
Yet public policy has focused almost exclusively on stimulating spending without much regard to why spending, especially consumption, has flagged. Until balance sheets (corporate and household) are restored, increased spending cannot be sustained.
Temporary spending and tax breaks are always dubious, and especially so now when the rational motivation is to save more and consume less. One-off tax credits for homes, for example, merely borrowed sales from the future. These fiscal programs predictably depressed rather than augmented future consumption.
What is in short supply is not liquidity, but savings. The Fed can supply the former but not the latter. Both fiscal and monetary polices need to shift their focus. The Fed has done the heavy lifting and responded more than adequately to liquidity issues. Now there is little further it can do that is beneficial.”
“Low interest rates slow the process of restoring balance sheets by keeping asset prices artificially inflated. They also penalize saving, thus prolonging the process of rebuilding balance sheets.
In the fiscal realm, policy must be reoriented from stimulating consumption to encouraging productive investment (not renewed financial speculation). That means no income-tax increases or costly new mandates. In particular, the Bush tax cuts should not be allowed to expire. No matter how the administration spins it, their expiration would entail a large increase in marginal tax rates in the midst of economic weakness. That would further impede savings and capital accumulation, discouraging firms from expanding and hiring workers. Treasury Secretary Tim Geithner is proposing to repeat the mistake of Herbert Hoover, who persuaded Congress to raise taxes in 1932.
Markets are resilient, but their recovery can be impeded by bad policies. At present, both monetary and fiscal policies are on the wrong track.”
As O’Driscoll says, we need policies that encourage work and savings, not spending. Excess spending was the cause of our current woes. Trying to reinflate the bubble only keeps the bad times rolling along. And creating more cheap money, now that the banking system has been stabilized, will only cause further problems down the road. You heard it here first.