For the supply-side types who support tax cuts because they promote economic growth by reducing economic distortions, I guess it's time to start writing the inevitable "think how bad things would have been without the tax cuts" columns. But as you are writing and find yourself tempted to call for further tax cuts to avoid a recession, remember that using tax policy to stimulate the economy and reduce the severity of downturns is Keynesian economics, not supply-side policy, something that many of you have confused in the past. I am not at all opposed to interventions to stabilize the economy, though tax policy is just one of many options (and who gets the tax cuts matters as well), but let's not pretend that using tax policy to stimulate the economy is faithful to supply-side ideals.
Could we please not? Could we please not have this discussion?
The economy has several clear problems:
- Mortgage-backed securities turn out to be much riskier than people thought, which is causing both solvency and liquidity problems in the financial sector.
- Subprime borrowers are in big trouble, which could blight many urban areas with foreclosed and shuttered houses
- The subprime borrowers won't feel so hot, either
- Everyone's going to be spending less money, because they're heavily in debt and can no longer use their houses as piggy banks
Central banks have always drawn a line between illiquidity and insolvency. Illiquidity is often viewed as something temporary, an aberration where central bank intervention is permissible. Insolvency, on the other hand, is viewed as something fundamental and abominable and thus to be discouraged. Central bank intervention to restore liquidity to an illiquid market would simply bring prices back to fundamentals. Intervening to bail out insolvent firms would, however, encourage irresponsible behaviour and should be resisted. At least, so the catechism goes.
Central bankers know, though, that the line between illiquidity and insolvency is an extremely fuzzy one, made more so with developments in financial markets. Take, for instance, a mortgage loan made against a house. If the housing market is liquid, loans are easier to come by. The reason is obvious. One of the biggest costs to a lender is that if the borrower defaults, the house has to be repossessed and resold with substantial costs. If, however, houses are selling like hot cakes, then the cost of repossession and resale is likely to be small. Housing loans will appear low risk, the risk premium lenders will charge will be small and housing credit will be plentiful. In turn, this will increase the volume of house sales, increasing liquidity in housing markets. Liquidity thus tends to be self-fulfilling.
But this leads to a problem in assessing whether lenders have been irresponsible or not. A mortgage loan might be perfectly sensible and appropriately priced taking the continued liquidity of the housing market as given. And the same loan may be viewed as reckless, driving a mortgage lender into insolvency, if liquidity in the housing market dries up.
I find it hard to see how these problems could be either created or destroyed by tax cuts, whether the stimulus you crave is demand- or supply-side. Not only do subprime borrowers not get much in the way of tax cuts, what with being fairly low income and all, but also, they haven't gotten much out of whatever recent economic growth you want to attribute to the Bush tax cuts. On the other side, making hedge fund managers richer wouldn't make them any more solvent. And either fiscal or supply side stimulus would have to be spectacularly amazing to cover the amount of extra spending America has done over the last few years. So couldn't we put away the op-eds on tax cuts for a while, and think about ways to address the housing mess? And please, no arguments for more tax cuts . . . even if fiscal or supply side stimulus were appropriate, they don't work fast enough to stop a financial crisis.
Actually, though, I have to say that I'm pretty impressed with how the debate has gone so far. To be fair, I mostly read the financial pages--but on those pages, there is a serious debate between people who are clearly interested in fixing the damn problem. There is passionate disagreement, but little fulmination about the morals of the borrowers or lenders, or the people arguing for different solutions. It may be the first time in my life I've ever witnessed an economic argument where almost everyone involved seems to feel that the matter is too important to risk hurling ideological brickbats.
(Please, don't send me nutty columns from the left or right wing press; no one's paying attention to the loons right now, and frankly, I just don't want to know.)
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