Unstable expectations

President Obama has crafted what looks like a sober, responsible budget, one that gives us a clear sense of the fiscal challenges ahead. But as The Economist notes, he relies on an optimistic economic forecast. What if the downturn last for longer than two years?

Using reasonable policy assumptions, Alan Auerbach of the University of California at Berkeley, and William Gale of the Brookings Institution, think the deficit will bottom out near 5 percent of GDP in 2013 then climb to almost 6 percent by 2019, while debt continues to rise as a share of GDP. That is before the government has to deal with the full impact of the surge in health and pension entitlement costs.

Running a 12 percent deficit this year might not be the best way to keep us in good stead if our goal is a set of stable policies designed to undo the damage done by Bush administration and Alan Greenspan's hyperactive monetary policy. Jeffrey Sachs has a great deal of confidence in President Obama and he is broadly supportive of the Obama economic program. Yet his latest column for Scientific American is a persuasive critique of the rush to stimulate the economy.

We need to avoid reckless short-term swings in policy. Massive deficits and zero interest rates might temporarily perk up spending but at the risk of a collapsing currency, loss of confidence in the government and growing anxieties about the government's ability to pay its debts. That outcome could frustrate rather than speed the recovery of private consumption and investment. Deficit spending in a recession makes sense, but the deficits should remain limited (less than 5 percent of GNP) and our interest rates should be kept far enough above zero to avoid wild future swings.

Rather than cut taxes, Sachs believes, very understandably given the collapse of tax revenues that started long before the downturn, that we actually need to raise them in the next few years. Sachs, who is not exactly Mr. Sunshine when it comes to the economic hole we're in, also expressed optimism about the prospects of the American economy

There is little reason to fear a decade of stagnation, much less a depression. The U.S. economy is technologically dynamic and highly flexible. The world economy has tremendous growth potential if we don't end up in financial and trade conflict, and if the central banks ensure adequate liquidity to avoid panicky runs on banks, businesses and sovereign borrowers. We should understand that the Great Depression itself resulted from a horrendous run on the U.S. banking system in an era without deposit insurance, and when the Fed and Congress did not understand the critical role of a lender of last resort. Moreover, the Gold Standard of the 1930s, which we long ago abandoned, acted like a kind of straightjacket on monetary policies.

Interestingly enough, Sachs sounds a lot like Amar Bhidé, who argued along similar lines in his recent Wall Street Journal op-ed.

Stimulus therapy poses great risks. Years of profligacy have put the federal government in a precarious financial position. We don't have the domestic savings to finance much larger budget deficits. Unlike the Japanese, Americans don't have much stashed away under their mattresses: We are reliant on capital inflows from abroad. An insurrection by bond vigilantes or the long-predicted run on the dollar triggered by fears of a flood of new government debt is a real possibility.

I'm increasingly convinced that the rush to a stimulus package was a serious mistake, including the rush to cut taxes. If Sachs is right and now is the moment for stable policies, we might have been better served by (a) the creation of an Investment Commission to decide on our infrastructure needs and (b) a serious, comprehensive tax reform, like Michael Graetz's Competitive Tax Plan, which introduces a VAT to finance a generous income tax exemption that would remove virtually all working and middle class Americans from the income tax rolls. The Graetz plan has many virtues, not least of which is that it would enhance our long-term growth prospects. In the short term, as Sachs notes, deficit spending is entirely appropriate. But why rush? Increasing unemployment insurance and pumping resources into the FDIC would be more than enough for the first few weeks of a new administration.

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Reihan Salam is a policy advisor at Economics 21, a columnist for The Daily, and a blogger for National Review Online.

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