Will the cure be worse than the disease?

Politicians are scrambling to offer a stimulus package, and Fed Chairman Ben Bernanke is slashing interest rates. But they may be paving the way for a bigger calamity down the road.

By Shawn Tully, editor at large

(Fortune Magazine) -- The wobbly economy is overtaking Iraq as the issue weighing most heavily on the minds of America's voters. And Washington has noticed. The White House and Congress are almost certain to enact some kind of stimulus package. But like all such temporary, feel-good measures, it will generate a quick blip in growth that will quickly evaporate. In reality only one player has the power to do anything swift and decisive: the Federal Reserve. And its chairman, Ben Bernanke, has already made his intentions abundantly clear. Unfortunately, the cure he's prescribing may be worse than the disease.

Just how low will the economy go? There are conflicting signals. It's clear that the economy is losing steam. The plummeting value of America's houses is chilling consumer spending, layoffs are mounting, and banks and other creditors burned by the subprime crisis are far more reluctant to lend to everyone from small-business owners to private equity firms. But GDP increased by 4.9% in the third quarter, and economists estimate that GDP was still growing in the fourth quarter. Exports are strong, thanks to the weak dollar. The Fed did a brilliant job last summer by flooding the banks with money to prevent a full-scale credit crunch. Credit is far more expensive today, but it's also becoming more plentiful, as demonstrated by the falling rates on everything from LIBOR - the rate at which international banks lend to each other - to junk bonds. So while a recession is a real possibility, it's not inevitable - even the Fed is not forecasting one this year. And if we do get one, it may be brief and shallow, like the one we had in 2001 - with economic growth falling by perhaps half a percentage point for a couple of quarters, and unemployment rising from its current 5% to 5.5% or 6%.

By cutting rates early and often, Bernanke is acting as though a recession - even a mild one - would be a calamity that must be avoided at all costs. He has already reduced the Fed funds rate (which banks pay when they borrow from each other) by one point, to 4.25%, and promises to "take substantive additional action as needed to support growth," a pledge that Wall Street interprets as meaning at least another half-point cut at the Fed's meeting on Jan. 29, if not sooner.

Many on Wall Street back Bernanke. "I'll defend the Fed," says Bear Stearns chief economist David Malpass. "Part of the slowdown is the result of banks' tightening credit, and you help that by lowering the Fed funds rate." Mickey Levy of Bank of America agrees: "You need to lower rates to offset the drag on housing."

But Bernanke is setting the stage for an even bigger recession down the road. Just as the ultra-low rates of the early 2000s created many of the problems we're experiencing today, pumping money into the system would probably stoke inflation, forcing the Fed to hike rates sharply in the near future. "It's better to take a small recession and kill inflation immediately instead of facing high inflation and a really big recession later," says Carnegie Mellon economist Allan Meltzer.

Meltzer, who is finishing the second volume of his history of the Federal Reserve, warns that Bernanke is risking a disastrous replay of the 1970s, when high oil prices fueled double-digit inflation. Every time the Fed started to tighten and unemployment jumped, chairmen G. William Miller and Arthur Burns lost their nerve. They lowered rates to boost job growth, and inflation inevitably revived, causing a vicious price spiral. The Fed let the disease rage for so long that it took draconian action by chairman Paul Volcker in the early 1980s to finally defeat inflation. The price was a deep recession, with unemployment hitting 11% in 1982. "The mentality is the same as in the 1970s," says Meltzer. "'As soon as we get rid of the risk of recession, we'll do something about inflation.' But that comes too late."

Indeed, while the economy is sending mixed messages about growth, the signs of increasing inflation are flashing bright red. For 2007 the consumer price index rose 4.1%, the biggest annual increase in 17 years. Gold, historically a reliable harbinger of inflation, set an all-time high of more than $900 an ounce. The dollar is languishing at a record low against the euro and a weighted basket of international currencies. "Flooding the market with liquidity is a disaster for the purchasing power of the dollar," says David Gitlitz, chief economist for Trend Macrolytics.

The Fed's supporters tend to downplay those dangers. They contend that the inflation surge is being driven largely by energy costs. Since oil isn't likely to rise from its near-$100 level, inflation is likely to tail off in 2008. "That argument is wrong," says Brian Wesbury, chief economist with First Trust Portfolios, an asset-management firm. "As people spend less to drive to the golf course, they will spend the extra money on golf clubs or other products. The Fed wants to reflate the economy, so the money that went into higher oil prices will drive up the prices of other goods."

Fed supporters also point out that the yield on ten-year Treasury bonds stands at just 3.8%, a figure that implies that investors expect inflation to be around 2% in future years. So if inflation is really expected to rage, why aren't interest rates far higher? The explanation is twofold. First, government bonds are hardly a foolproof forecaster. For example, five years ago Treasury yields were predicting 2% inflation over the next five years, and the actual figure was 3%, or 50% higher. Second, investors are so skittish about most stocks and corporate bonds that they're paying a huge premium for safe investments, chiefly U.S. Treasuries. "It's all about a flight to safety," says Meltzer. Stand by for a major rise in yields as the reality of looming inflation sinks in.

So what is the right course for the Fed? Bernanke should hold the Fed funds rate exactly where it is now, at 4.25%. Standing pat might well push the economy into a recession. But the Fed's newfound vigilance on inflation would boost the dollar, effectively lowering the prices of oil and other imports. America would suffer a short downturn and restore price stability, paving the way to a strong recovery in 2010 or 2011.

Sadly, the Fed has already chosen sides. It's likely to lower rates every time growth slows or joblessness rises. As a result, it will never tame inflation until it becomes a clawing, bellowing threat. Then we'll have to suffer a real recession, the kind we suffered in the aftermath of a time we should study and shouldn't forget - the 1970s.

How to Pull Out of a Recession—the Fastest and Most Ethical Way, Not the Bush Way

By Matthew Rothschild, January 11, 2008

Even Bush has finally figured out that the economy is facing “some challenges,” as he so delicately put it.

As a solution, he is sure to propose making permanent the tax breaks for the rich that he’s already put in place.

But there are two problems with this: one ethical, the other economic.

The ethical problem is that the top 1% has already made out like bandits. Their slice of the income pie has grown dramatically over the past few years, while the slices for almost everybody else have shrunk.

The economic problem is that extending the tax cuts won’t do anything in the here and now, because those cuts are already in place for the next two years.

On top of that, the economic stimulus from giving the superrich some more money would be next to nothing compared with the stimulus you’d get if you gave almost everybody else some serious tax relief right now.

It is a good idea to cut taxes in a recession.

But those breaks should go to the people who need them, and who will then turn around and spend the extra money they have.

Another way, other than just relying on the Fed to lower interest rates, is for the government to spend more money on urgently needed domestic projects, like rebuilding bridges, which should be an easy sell, given the St. Paul disaster.

Or, as the progressive economist Dean Baker suggests, the government could focus on environmentally sane options.

“There are many ways to make a stimulus package at least partly green,” he writes. “For example, we can have generous tax credits for people to install more insulation in their homes, solar panels or other improvements that will reduce energy use. This would be an effective way to reemploy many of the construction workers who are losing their jobs. . . . We can also give people money and a powerful incentive to use mass transit by giving transit agencies money to reduce fares. If we gave public transit agencies enough money to reduce transit fares by $1 a trip, over the course of a year this would provide the same stimulus as giving a $500 tax rebate to every user of public transit.”

But the kind of government spending that Bush prefers is on the military, especially the Iraq War.

Look what we could have bought instead of that disaster.

“The $500 billion that Bush has squandered in Iraq could have paid for 4 million new housing units, or hired 8 million new teachers. And the $2 trillion we may end up spending on this war could pay for universal health care for 12 years,” Anita Dances of the National Priorities Project points out in a recent piece for the Progressive Media Project.

What’s more, that domestic spending would have been far better for the economy.

“Not all government spending is equal,” she notes. “Every billion dollars spent on the military results – directly and indirectly – in fewer jobs and lower quality jobs than a billion dollars spent on education, a recent analysis published by the Political Economy Research Institute showed. That is, the effects of military spending ripple through the economy with much less vigor than government spending on other programs. Plus, domestic spending has a longer lasting impact on the economy. A well-educated, healthy workforce, along with investment in infrastructure, will fuel the new industries of tomorrow.”

When facing a recession, we always need to ask: What kind of tax cuts? What kind of deficit spending? For whom, and for what?

Yet another way to ease out of a recession is to increase federal spending to local and state governments, which suffer a budget shortfall during slowdowns but are usually required by law to be in balance. To get there, they then slash their own funding, laying thousands of people off.

We’re seeing that prospect right in front of our eyes in California, where Governor Arnold Schwarzenegger has declared a fiscal state of emergency and is calling for 10 percent cuts in almost every department. That will not only send California’s economy into a tailspin but it may drag the entire country’s economy off the cliff.

More fundamental proposals could also lift us out of recession. Economist Robert Pollin spells some of these out in a recent article in New Labor Forum entitled “A People’s Economy Is Possible.”

He calls for the creation of one million new jobs in “health care, education, and energy conservation.” He also advocates “extending public medical insurance” to every single American who doesn’t have it today, and greatly expanding educational opportunities.

Pollin recognizes that this would increase the budget deficit in the short term. But he convincingly argues that this concern is overblown. “The primary problem with the U.S. Treasury’s fiscal stance is not the size of the deficit, per se, but how the money is being spent.”

It is not the time to worry about the budget deficit when a recession is upon us. It is the time to figure how best to kick start the economy in an ethical manner.

And don’t look to Bush for that.