Time for a Mid-Course Correction in Economic Policy

The economic proposals unveiled this week by the Administration suggest that the President’s determination to target his policies for the long-term has led the White House to misread the economy today. Allowing firms to deduct their capital investments in the year they occur instead of slowly depreciating those costs, and expanding the R&D tax credit and making it permanent are measures that can help sustain growth once it returns, but they won’t lift the economy’s current faltering pace. To do that, they need a midcourse correction aimed directly at the economic distortions which brought down the economy and produced today’s abnormally slow and halting recovery. It’s time for presidential leadership and big initiatives, starting with the housing market.

Since 2009, when the White House famously forecast that strong growth would return this year and unemployment would top out at 8 percent, their program has relied on models and analyses that see the current period as part of a normal business cycle. If only that were so, because then the massive fiscal and monetary stimulus of the last 18 months would, indeed, have produced the robust V-shaped recovery they expected. But that isn’t the economic hand we’ve been dealt. Much like the sorry story of post-bubble Japan in the 1990s, the structural distortions in housing and finance which brought on our crisis remain largely unaffected by stimulus. While all that stimulus stopped our slide towards a depression, it was neither sufficiently large nor long-lasting to offset the structural problems.   

So, the banking system, still saddled with hundreds of billions of dollars in shaky mortgage-backed assets and fighting additional drag from falling values in commercial real estate and European debt, remains too weak and wary to resume normal lending to most businesses. The problems with housing have even more far-reaching effects for the recovery. With high unemployment dragging on – as it typically does following a financial crisis – housing foreclosures are stuck at three times normal levels, pulling down the value of most Americans’ homes. This continuing decline in housing values not only has left 23 percent of households with mortgages under water. It also continues to eat away at the net wealth of everyone who owns their own homes, producing a “negative wealth effect” that leaves most Americans, much like the banks, too financially weak and wary to resume normal spending.

Even if a second round of stimulus were possible politically, it wouldn’t cure these structural problems with any greater success than the first round. Until the administration and Congress tackle the forces holding down consumption spending and business lending – or wait another half-decade for this dismal cycle to run its course – the American economy will remain weak and unemployment high.  

A real opportunity here lies in a new approach to keep Americans in their homes and so help stabilize housing values. Subsidies for banks to rewrite troubled mortgages haven’t worked, because the approach glosses over the weakness of the banks and the way they conduct business. Even if these institutions were in better shape, very few bankers are willing to extend new credit to people who couldn’t keep up with their mortgages. Only a government can assume such risks.    

The best approach for this would be a new two part program aimed at housing and unemployment. The first part is a loan program, modeled on student loans, to help Americans with troubled mortgages. Those families could apply for five-to-ten year government loans to stave off foreclosures, with the repayment schedules linked to people’s incomes recovering. With many fewer foreclosures, housing values could stabilize and staunch the negative wealth effect now holding down consumption. The second part of the new program would reduce the cost to businesses of creating new jobs, by expanding and extending the administration’s modest cuts in an employer’s payroll taxes for new hires, the approach that CBO calls the most effective way to jumpstart job creation. Every new job will enable another family to earn the income needed to help keep up with their mortgage, further stabilizing housing values and so ultimately supporting consumption.

If the economy were poised to take off, the Administration’s proposals for another $50 billion in infrastructure spending and $200 billion in tax breaks for small businesses might help. Unhappily, that’s not the case. But the President has time to seize the opportunity to make a mid-course correction, and put in place the foundation for a strong recovery in, say, 2012.