“I’ve enjoyed reading the older and newer ideas of my fellow economic policy bloggers to amend, improve and put our stamp on the President-elect’s stimulus package. But, to respond to our moderator’s specific question of the week—my “favorite idea for economic stimulus that still is not getting the attention it should receive,” (I raised it on our blog a few weeks ago) is a tax proposal to bring several hundred billion dollars of capital sitting overseas back home and put it to work in the good old USA.  Here’s some more background.  Believe it or not, there is such thing as a free lunch when it comes to economic stimulus. Congress should consider legislation similar to the successful bipartisan 2004 law that enabled U.S. businesses to invest $360 billion of their foreign earnings in the U.S. at a temporary, reduced tax rate of 5.25%. Many successful U.S.-based companies have generated substantial earnings that could be invested in restoring the economy at virtually no cost to the federal government.  However these earnings are trapped overseas due to U.S. tax laws that many foreign competitors do not face.  
 
In the most recent study by the American Council for Capital Formation (see full study here), Dr. Allen Sinai of Decision Economics, Inc. analyzed the economic benefits that would occur if Congress enacted legislation similar to the 2004 American Jobs Creation Act (AJCA).  Based on an estimated $545 billion of repatriations, Dr. Sinai’s quantitative study concludes:
 
o   Increased U.S. GDP, peaking at an additional $110 billion in 2010
o   Reduction in outstanding debt, which would improve credit availability
o   An average annual increase of $56 billion in new investment over the next 5 years
o   Increased U.S. R&D spending by approximately $7 billion per year over the next five years
o   Job generation within the U.S. economy peaking at 614,000 in 2011
o   Nearly $140 billion in tax revenue over five years from initial cash investment and residual economic activity

The ACCF study also indicates that the U.S. Treasury would receive an average $28 billion per year over five years in tax revenue it would not otherwise get.  This would be generated primarily from the resulting increase in aggregate economic activity through higher personal income, corporate profits, capital gains, social security and excise tax receipts. State governments desperately seeking to shore up budget shortfalls would also see some increase in revenues. 
 
Increased GDP, job creation, debt reduction--all at virtually no cost to the government or taxpayers. That’s a free lunch that should be easy for congress to digest.
 

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We all seem to agree that there needs to be stimulus in the short-run. The disagreement seems to be about whether we have a serious long-run problem and what we should do about it. I agree that revenues have to be part of the solution. I can agree with Jared's suggestion that we should pay for whatever health care we want, perhaps with a new VAT. But are Paul and Jamie or others really arguing that we don't need to do anything on the spending side? Do they believe we should provide new health benefits without a way to pay for them? Do they think that such things as health IT, evidence-based medicine, coordinated care, more emphasis on prevention, and the rest of the litany of reforms combined with universal access is really going to save any serious money over, say, the next decade? And if not, and if the political system balks at a big across-the-board tax hike (which I believe it will), what are they suggesting? That we don't need to worry about structural deficits that are clearly unsustainable and will go off the charts even sooner if we make needed investments in education, infrastructure, energy policy, etc?

Every serious analysis of our fiscal situation that I am aware of has documented that without major policy changes, the retirement of the baby boomers, in concert with rapidly rising health costs, will produce increasingly large and eventually unsustainable budget deficits. Health care reform that includes effective means for cost control would go a long way to address this problem, but more will be needed. At some point, adjustments will have to made in benefits for future retirees, and yes, additional revenues will be necessary.

Bernanke gets on the bandwagon for a second stimulus. Meanwhile, the champion of the first stimulus, Harvard's Martin Feldstein, says it added $80 billion to the national debt and delivered only $20 billion in added economic activity. Is Marty against the second one? He was on this letter from economists criticizing the idea of second stimulus Oct. 8

Jamie and Paul are correct. It is neither helpful nor productive to inveigh against an “entitlement crisis,” or to invoke, as Robert Bixby does, the need for “long-term discipline.” Neither is it useful to scare people with non-contextual numbers like the Peterson’s $53 trillion long-term liability (e.g., it’s the old ‘big number’ ploy--when you want to alarm people, use a big number and don’t put compare it to, say, the growth in income over the next 75 years (the $53t is 6% of GDP over that period, according to Dean Baker)…Walker never did stuff like that when he ran the GAO).

Such vagaries and scare tactics lack the focus we need to deal with the challenges we face, and as their critics have pointed out, such arguments seem to point to one policy response: cutting spending (exhibit A, the question John Maggs has posed for us today). But that is only one side of the fiscal equation. The other side is raising more revenue to pay for the government we want and need.

The fiscal “crisis” is a health-care crisis, both public and private sector, a fact that’s been recognized not just by us EPI’ers, but by Henry Aaron at Brookings and Peter Orszag at the CBO. If anything, we’ll need public health care to be stronger, not weaker, in coming years, and all the best health care proposals—the ones most likely to succeed in expanding coverage and controlling costs—call for a larger role for government, either as a regulator or single payer.

What does this mean for fiscal policy? Simply put, health care reform done right invokes the need to raise more revenues. If we want it, we will have to pay for it. One could make the same argument for the war in Iraq or the bailout package. I don’t like tax increases anymore than you do, but if these public expenditures are so important, then they must be paid for, and not just by cutting spending but by raising more revenue. Not now, of course, as we all agree. But someday.

The problem is, so few players in this debate make this argument, including the Petersons and Bixbys. They cite the need for “tax reform” without, at least to my knowledge, making the tough, politically risky calls for raising taxes to finance the government we need. When Bixby writes, “…current spending promises cannot be financed at today’s level of taxation,” I totally agree, but why does he stop there? Is this code for “cut the entitlements?” Or is it code for “raise taxes?”

I suspect Bob’s answer is, “it’s both,” but let’s hear more about the latter. Where are the Petersons on McCain’s big cut in the corporate tax rate? Why not a huge campaign against that? Gene—how about another TRA86—where we lower the corporate rate and expand the base? And for the sake of pure optics, if not good economics, how about Peterson himself coming out hard against the carried interest loophole. That’s got to be a huge credibility issue for your team. What, exactly, do you mean by “tax reform?” You’re not running for office—tell us what you’re really thinking!

Oh, and to answer the question, Obama understands the need for fiscal stimulus—he’s been way ahead of the field on that. Longer term, he is not Bill Clinton (and I’m not even sure Bob Rubin is Bob Rubin anymore, in the sense that he recognizes the importance of our investment deficit as well as any budget deficits). Obama’s agenda of progressive health care reform and pubic investment, and his defense of that agenda’s importance suggest that he will make the right calls on this, given the chance.

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Whoever is inaugurated in January will face an economic situation that differs materially from the one faced by President Clinton in January 1993. According to statistics then available to policymakers, real GDP had risen for seven successive quarter since reaching a cyclical low in the first quarter of 1991. In the quarters leading up to President Clinton’s inauguration, consumer spending, residential construction, and business investment all rose. After reaching a peak in June 1992, unemployment fell more than 750,000 by January 1993. The unemployment rate fell by 0.6 percentage points between June 1992 and January 1993. Initial claims for unemployment benefits were running almost 100,000 per week below the level of one year earlier. Payroll employment was rising slowly, but fast enough to reduce the number of unemployed workers and the monthly unemployment rate. In short, President Clinton and his advisors had clear evidence the economy was recovering from a recession.

Based on what we know today the next president will not face the rosy prospect of an improving economy next January. The question is, will a weakening economy reduce the urgency of the reforms advocated by the presidential candidates? In the case of Senator Obama, I cannot see why. With respect to federal spending, the two signature elements of his package are (a) restructuring of the income tax code to favor low- and moderate-income taxpayers and boost taxes on families at the top of the income distribution ;and (b) reforming health insurance to broaden the insured population, in part with new government subsidies. It may make sense to delay or curtail the planned tax increases on high-income households, but it’s hard to see the argument for delaying tax cuts for the vast majority of families who do not have incomes over $200,000 or $250,000. In fact, many economists – including me – see strong arguments for offering faster (though temporary) tax relief to most households.

The tougher issue is what to do about health insurance coverage. My view is that it would be foolish to delay health insurance reform because of a weak economy. The deteriorating job market means that more families will lose their health insurance because the family breadwinner is laid off. The cost of ealth insurance for a breadwinner and a couple of dependents is typically at least $12,000 a year. On average, employers pay 80% of those costs - - more than $9,500 a year. Most workers cannot afford to pay $12,000 when they lose their jobs, and so they and their dependents often go without insurance until the laid off worker finds another job offering health coverage. I would very much like to hear the argument of an economist who thinks the loss of insurance coverage is a less important problem when the unemployment rate is 7% and rising rather than 5% and stable.

A couple of the moderators in the presidential debates tried to force the two candidates to concede they will have to give up some or all of their reform plans because of fiscal fallout from the financial crisis. Senator Obama did not make this concession. I wonder whether any of the wise heads asking the next president to delay health insurance reform has reflected on the origins of the nation’s current social protection programs. Social security, unemployment insurance, and many of the federally assisted programs providing aid to indigent children, disabled workers, and the aged were created in the Administration of Franklin Roosevelt. That law, called the Social Security Act, was passed in 1935 in the middle of the worst economic downturn in the nation’s history. Do the wise heads who today urge fiscal caution argue that the country would have been better off if the Social Security Act had been postponed to more prosperous times? Some of them probably do, but many of these wise heads probably also think the Social Security Act was a bad idea. For my part, I think social security and unemployment benefits were good ideas, and I cannot see why it would have been sensible to delay them to a day when the government’s budget had a big surplus.

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Paul Krugman took note of this blog’s discussion on fiscal stimulus, after Jamie Galbraith mounted an argument that has been a favorite cause of Krugman’s since 2004 – that the threat of entitlements has been overstated. Krugman argued that this “imaginary crisis” was being conjured by those who advocate privatization and perhaps the dismantling of Social Security, though that effort has receded and the case for an entitlement crisis is still being made by David Walker and others who were on the other side of that debate. Likewise, Krugman argues that the real problem is the escalating cost of health care, which will make Medicare unbearably expensive.
In short, Krugman seems to be warning that fiscal concerns are an excuse to roll back other priorities, such as universal health care, which is what happened in 1993 when some in the Clinton adminitration argued against a middle class tax cut and a jobs program. Is that likely again in an Obama administration? Is health care reform really enough to tame long-run deficits?

Yes, there is room for fiscal stimulus -- so long as it sticks to the principles of being timely, targeted and temporary. What we don’t have room for are permanent new policies, either on the spending or tax side, that aren’t paid for. While the very real threat of a serious and lengthy recession justifies deficit-financed stimulus in the near-term, we need to keep in mind that our underlying fiscal policy is already on an unsustainable track. Treating the short-term problem should do as little harm as possible to the long-term outlook. Economically speaking, we need to walk and chew gum at the same time.
The goal of additional fiscal stimulus is to boost consumption and avoid a deep recession. Since we are already running a deficit, fiscal stimulus would increase the government’s debt and decrease national saving. The immediate effect would thus run counter to the longer-term goal of promoting economic growth through more adequate saving and investment. We can’t borrow our way to sustainable prosperity any more than the housing bubble could sustain itself on perpetually growing debt. To get the U.S. economy back on a sustainable path, not just over the next few days, weeks, or months, but over the next several years, the U.S. needs to save more. Budget deficits subtract from savings, so deficit spending now is tolerable only if it does not jeopardize that longer-run goal.
It is critical that the next president set clear priorities and be willing to make tradeoffs, so that the policies pursued over the next several years get us back on the path of higher national saving and a stronger economy. We can’t afford to focus only on the present. Beyond the current crisis in the financial sector looms the growing cost of Medicare and Social Security. Contrary to Professor Galbraith’s assertion, the deficits projected under current law, and their adverse affect on savings, investment and economic growth, are no mere “figment of the imagination.” Call it a fiscal crisis or a health care crisis, the bottom line is the same: current spending promises cannot be financed at today’s level of taxation. No amount of fiscal stimulus will change that because it is a structural, not a cyclical, problem. We cannot assume a perpetual inflow of cheap foreign capital to finance our standard of living, nor should we want to. Eventually, we will find ourselves paying higher interest rates to attract such capital and the resulting mortgage on future national incomes will diminish our standard of living.
That is why the best policy response is to combine short-term stimulus with long-term discipline. There is nothing inconsistent in this. If properly designed, fiscal stimulus will not have an adverse impact on the long-term, and long-term discipline will not have an adverse impact on the short-term. We don’t need to sacrifice one to achieve the other, and we need to be clear about the trade-offs ― starting now.

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If I may elaborate on my previous post, at the risk of repeating myself at the top – in the short term, we’ve got a recession of uncertain size and length on our hands. We need to put more money into the hands of those who need it most, not simply for equity reasons but because the things they buy are often the items for which production is most easily expanded. So, yes, “timely, targeted, and temporary” stimulus is in order.

Like many crises, the subprime crisis presents a teaching moment. As Americans realize the painful consequences of leveraging or borrowing to make bad speculative bets, it must be pointed out that some of the federal government’s long-term bets, after paying off for decades, are starting to head south.

This country is facing a “fiscal turning” – a moment in time when the old ways of doing things are obstructing necessary government reforms and new ways of doing things must be found. On health care, education, taxes, infrastructure, and investing in children, we are bumping up against a wall.

Americans are feeling the effects without necessarily knowing the causes. Which is why the Peterson Foundation has, in the short time it has existed, devoted itself to trying to address promises made by Republicans and Democrats alike that essentially commit the entire future government budget before the future is even known. We also are attempting to address a number of issues related to investment in our future such as financial literacy and overconsumption of energy.

Our government is like a dysfunctional family now facing an additional crisis because one member suddenly has gone to the hospital. Other family problems aggravate our ability to respond to the new one. Let’s unite, not divide, on confronting them.

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I appreciate Dr. Galbraith’s attention and regret that he is not more familiar with the work of our Foundation, which only became operational this past spring, or with my own work as Comptroller General of the United States. In that role, I oversaw the Government Accountability Office’s work on financial regulation and testified about the need for regulatory reform and more oversight.

The Peter G. Peterson Foundation is dedicated to raising awareness of key sustainability challenges facing the United States, including our budget, savings, and balance of payments deficits and the need for entitlement, health care and tax reform.

While financial regulation is not part of our mission, we have attempted to engage in a constructive way to help point out lessons from recent failures in the system in order to prevent a similar but larger and potentially more damaging breakdown in the federal government's own finances.

I’d like to invite Dr. Galbraith to respond himself to this larger threat to our country’s economic well-being rather than simply dismiss it as “fantasy.” Not too long ago, many people would have referred to the fall of some of America's largest financial and insurance institutions as "fantasy," and they would have been wrong.

Excuse me for asking an impolite question.

But did David Walker, Eugene Steuerle -- or Peter G. Peterson himself -- devote even five percent of the vast resources that they have lavished in recent years on the supposed "entitlement crisis" to warning about the impending mess on Wall Street?

Did they write anything about it? Did they speak out against the Bush administration's abandonment of supervisory responsibility in the financial system? Did they protest the massive abuse of unsophisticated home buyers by the loan originators in the subprime sector? Did they comment on "liars' loans," "neutron loans" and "toxic waste"? Were they heard about the risks involved in securitizing subprime loans? Did they foresee that credit default swaps could collapse like a house of cards? Did they caution that the stock market might crash, ruining the private retirements of millions of Americans?

If they did, I must have missed it.

Peter G. Peterson is one of the leading figures on Wall Street. Isn't it reasonable to ask, that if he and his team wish to be taken seriously on matters of public finance, that they should have shown some leadership, some wisdom, some insight and some foresight on the disaster brewing in their own backyard?

As the disaster on Wall Street developed, George Soros was heard from. Warren Buffett was heard from. Was Peter G. Peterson heard from? Was David Walker heard from? Was Eugene Steuerle heard from? I think they were not.

What is Mr. Walker's approach to subprime crisis today? His comment above makes his approach clear. It is to use the crisis as a rhetorical springboard, in order to divert the conversation back to what he calls the "super sub-prime crisis associated with the federal government's deteriorating finances..."

But the fact is, the subprime crisis is real. The collapse of interbank lending is real. The collapsing stock market is real. The disintegration of the financial system is real. The collapse of the housing sector is real. The credit crunch and the recession are real. You can see this in the interest rate spreads and in the credit that is unavailable at any price.

Mr. Walker's "super subprime crisis" of the federal government is not real. It is a pure figment of the imagination. It is something Mr. Walker sees in his mind's eye. He sees it in his budget projections. He sees it in his balance sheets, which are the oddest balance sheets I've ever seen, because they have all liabilities and no assets.

But the financial markets do not see it. How can we tell? Because those markets are willing, today, to lend unlimited sums to the Federal Government on supremely favorable terms. What is the 20 year Treasury bond rate? Last month, it was 4.32 percent. That is almost exactly what it was in December 1959, in the last month of the Eisnehower administration. The United States Government wasn't going bankrupt then and it isn't going bankrupt now.

The point is directly relevant to the question posed by National Journal: "is there room for fiscal stimulus?" Of course there is.

Not only that, sustained fiscal expansion (I dislike the term "stimulus" because I do not think that a short-term policy will work) will be essential in the next administration if the financial rescue just undertaken is to succeed. It will be necessary to stabilize the housing sector. It will be necessary to stabilize state and local government spending, undercut by falling property tax revenues. It will be necessary to stabilize the incomes and expenditures, in the aggregate, of the elderly. It will be necessary to finance new capital spending at the federal, state and local levels.

Failure to do this will cause the housing crisis to get worse. And that will cause the losses in the financial sector to multiply, overwhelming all efforts to stabilize finance.

I was at the Peterson Institute the other day. There I heard a very good panel discussion of the financial crisis, featuring Fred Bergsten, Adam Posen, Morris Goldstein and others. All agreed that the deficit would exceed one trillion dollars next year. All agreed on the need for the expansionary and stabilizing steps outlined above. Nobody was defending, in any serious way, the Walker-Steuerle line.

I found this greatly encouraging.

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The financial meltdown brings with it good news and bad news. The bad news is that short-term fiscal restraint--a long shot in any event--is an impossible dream now. Obama's modest tax increases or McCain's spending freeze are probably undesirable in a recession and certainly politically difficult. And, as the other commentators have noted, there will surely be hundreds of billions of additional stimulus.

The good news, though, is the current financial panic and its painful consequences for American families may have crystallized the potential consequences of reckless fiscal policy in a way that all of our analysis and dire warnings have not. It is a valuable teachning moment (and the Peterson Foundation's ad highlighted in John Maggs's article seizes the moment to try to do just that). My hope is that this will give the next president political cover to get us back on course after the recession has passed. Both candidates' economic advisers understand that our current policies are disastrous. Let's hope the winning candidate decides to act on that knowledge.

Previous comments make it clear that we need to move on three different fronts.

Long-term, we have promised people far more than we can deliver efficiently or fairly. Meanwhile, these fiscal constraints are squeezing the budget and crimping our ability to meet new needs and tackle new emergencies. If we don't tackle this issue very soon, we reduce the probability that we can be successful on the other fronts--in part because momentum here can help restore confidence in the financial markets.

Shorter-term, we've got a recession of uncertain size on our hands. I agree that here we need to put money more into the hands of those who need it most, not simply for equity reasons but because the things they buy are often the items for which production is often most easily expanded (because of economies of scale). Again, the flexibility we need here (we don't even know how deep this recession is going to be) can be provided mainly by putting us on a sounder longer-term fiscal path.

Finally, we've still got a bad set of signals, regulations, and incentives in the financial sector of the economy. This includes not just the standard concerns over financial sector regulation, but also the ability of many actors to play "heads I win, tails you lose," and the extraordinary favoritism in the economy for debt over equity.

We can debate which front is most important, but that's not a very fruitful exercise, and it offers politicians excuses to avoid the hard choices required. The best thing we can do now is to move on all fronts simultaneously.

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We are likely to see a fiscal stimulus. The real issues are what form will it take, when will it happen, how big will it be and will it make a difference. Clearly, passing out rebate checks that are financed with foreign borrowing does not make sense. We need to see what form any such stimulus program will take in order to evaluate it. We've heard a number of options, but it's still a moving target at this point.

My concern is, when will Washington wake up and start doing something to defuse the potential "super sub-prime crisis" associated with the federal government's deteriorating finances and imprudent fiscal path?

The new President must do what it takes to restore confidence, effectively and equitably implement the new Emergency Economic Stabilization Act, and get the economy moving again. At the same time, we need to form a "Fiscal Future Commission" in early 2009 that will report back within six months to one year and make a range of recommendations to put our nation on a more prudent and sustainable fiscal path. Nothing less that the future of our country and our families is at stake. The time for leadership rather than laggardship from Washington is now!

Restoring financial markets to reasonable working order is necessary to address the underlying weakness in the economy but it is not sufficient. Turning the economy around requires a boost to aggregate demand that the private economy is not providing and that won’t come from additional monetary stimulus alone. That leaves fiscal stimulus.

As outlined in a Center analysis, (www.cbpp.org/9-26-08bud.htm) three fiscal policy measures are likely to be highly effective as stimulus because they concentrate relief on those most likely to spend the money quickly, thereby pumping dollars into an economy that needs more demand: 1) more generous unemployment insurance benefits; 2) a temporary increase in food stamp benefits to counteract rising food prices; and 3) new resources for struggling states. More robust versions of the measures Congress was unable to enact before leaving for its election recess are a good starting point for a new stimulus package.

It is reasonable to ask how another round of fiscal stimulus will affect the budget deficit and interest rates because of their impact on long-term growth, particularly in light of new budget concerns stemming from the extraordinary actions taken to address the financial crisis. While it would be preferable if Congress paid for the stimulus package once the economy is stronger, as long as the stimulus spending is clearly temporary, as the proposals recommended here are, the impact on the budget deficit and long-term growth should be modest, compared with the benefits of keeping the current economic slump as short and shallow as possible.

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Fiscal policymakers should continue to pursue three broad goals, including: 1) recapitalizing the financial system; 2) keeping homeowners out of foreclosure; and 3) shoring up the broader economy. Efforts to date have been increasingly bold and creative, but more needs to be done to quell the financial panic and mitigate what is shaping up to be a very severe recession.

Economic rescue plan

Despite all the policy efforts, the financial crisis of the past year and panic of the past month have caused significant economic damage. Credit will be impaired for many months to come; confidence has been shattered; and more than $10 trillion in household wealth has evaporated, reducing Americans' net worth nearly 20%. The economy now seems headed for the worst recession since 1980-82, when unemployment reached double-digit rates.

We thus need an economic rescue plan, combining traditional fiscal stimulus and incentives to help the housing market. Expanding the food-stamp program, increasing aid to state and local governments, and even new infrastructure spending would be helpful if launched in time to help the economy next year. Temporary tax incentives to quickly boost housing demand could also be useful. One example might be doubling the mortgage interest deduction for home purchases by owner-occupants in 2009. The bonus deduction could be phased out after, say, three years. The value to the average homebuyer would exceed $5,000, a significant incentive to buy a house sooner rather than later.

Each of these efforts carry substantial costs. The federal budget deficit, which topped $450 billion in the just-ended 2008 fiscal year, could easily exceed $700 billion this year and go even higher next year. Borrowing by the Treasury could top $1 trillion this year. There will also be substantial long-term costs to extricating the government from the financial system. Unintended consequences of all the actions taken in such a short period of time will be considerable. These are problems for another day, however. The financial system is in disarray and the economy's struggles are intensifying. Policymakers are working hard to quell the panic and shore up the economy; but given the magnitude of the crisis and the continuing risks, policymakers must stay aggressive. Whether from a natural disaster, a terrorist attack, or a financial calamity, crises only end with overwhelming government action.

Recapitalization

The $700 billion Troubled Asset Relief Program will succeed in recapitalizing the financial system if the TARP fund is used both for direct equity investments in institutions and to buy mortgage assets via reverse auctions. The Treasury will use the first $250 billion tranche of the TARP fund to purchase preferred shares in commercial banks and thrifts. The institutions will be permitted to count this investment as part of their regulatory Tier 1 capital, measurably adding to the $1.35 trillion in such capital that existed at the end of June according to the FDIC. Nine large institutions have already agreed to the Treasury's offer of capital; their stocks have firmed and their borrowing costs have declined.

Equally important are the plans to purchase distressed mortgage loans and securities through reverse auctions. The auctions will establish market prices, which haven't been available since trading in these assets collapsed. The Treasury will be the buyer in these auctions, taking bids from the institutions that own the assets. The lowest bids will set market prices, so that institutions, and just as importantly potential private investors, can determine how much capital the institutions need. With announced write-downs on mortgage assets approaching $600 billion, it may be that most institutions have already marked down the value of their holdings appropriately. Six hundred billion dollars in losses equates to some six million mortgage loans going through foreclosure, with the mortgage owner losing half the value of loan in the process. Things may well turn out worse than this scenario suggests; we won't know until a price for these mortgage assets has been established. The reverse auctions work well at least in theory, and that theory is strong enough to make it worth trying in practice.

Forestalling foreclosure

Policymakers are trying a number of different approaches to modifying mortgage loans in an effort to keep homeowners out of foreclosure. The Hope Now consortium of mortgage owners, lenders and servicers has been helpful in modifying loans through interest-rate reductions, freezes and term extensions. The FDIC is helping those who borrowed from banks and thrifts that have been taken over and put into receivership, such as IndyMac. Hope for Homeowners, a program established this past summer that allows mortgage owners to help distressed borrowers, may also prove successful. Under that program, mortgage owners can move borrowers into FHA insured loans if they cut the mortgage principal to 90% of the home's appraised value, and pay the FHA a 5% insurance premium.

The TARP fund could help advance the Hope for Homeowners plan if it conducts auctions for second mortgages. Second-lien holders are a significant impediment to this program, because they must subordinate their interests before a refinancing can take place. Few are willing to do this for free, but paying them off could be well worth the effort. Second-lien holders could receive a couple pennies on the dollar for their mortgages via a TARP auction, on condition they do not block modifications to the loan. If the Treasury purchased whole mortgage loans through the TARP auctions, then these loans too could by modified.

These are laudable efforts, but they are being overwhelmed by the size of the foreclosure problem. According to data from credit bureau Equifax, first-mortgage loan defaults–the first step in the foreclosure process–are running at a 3 million annualized pace. In a good year, annual defaults are well below 1 million. Many more are coming; there are now an estimated 12 million homeowners whose mortgage debt exceeds the value of their home. While negative equity alone needn't result in a default, negative equity combined with surging unemployment often does. With house prices expected to fall at least another 10% and unemployment expected to rise to 8% over the coming year, defaults and foreclosures in 2009 threaten to dwarf anything experienced so far.

A much more substantial mortgage writedown plan will thus be needed by early next year. There are many good ideas to consider: FDIC Chairman Sheila Bair's Homeownership Preservation Loan plan; Harvard Professor Martin Feldstein's plan for low interest rate loans from the government to stressed homeowners; and my own Home Appreciation Mortgage plan. It is time to think bigger and more comprehensively about how to keep households in their homes and out of foreclosure. Temporarily changing the bankruptcy laws to allow for first-mortgage cramdowns in a Chapter 13 filing on loans originated during the housing bubble would also be helpful. The argument that such a change would substantially raise future mortgage costs feels specious.

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In framing macroeconomic policy, policymakers need to be mindful of the fact that the US economy is presently in the grips of its worst asset-price deflation and financial market de-leveraging in the post-war period. They also need to be sensitive to the fact that rising home foreclosures and the emerging problems in the hedge funds makes it unlikely that asset price deflation or financial market de-leveraging will end anytime soon.

Over the past year, US asset prices including homes, equities, and bonds have fallen by more than 20 percent. This has had the effect of reducing US household wealth by the equivalent of over 80 percentage points of US GDP with obvious consequences for consumer spending. At the same time, bank credit is now declining at the fastest rate in the past sixty years, while the all important securitization market is presently in a state of virtual paralysis.

Recent economic data suggests that, prior to the October financial market meltdown, the economy was already very weak. In light of the October equity market crash and credit market dislocation, one has to expect substantially negative economic growth over the next two quarters. This heightens the risk of exacerbating adverse feedback loops between the economy, the asset markets, and the credit markets.

With monetary policy rendered largely impotent by the present financial market travails, the case for early, substantive, and well-targeted fiscal policy stimulus would appear to be overwhelming. The argument that this might compromise the longer run US budget position overlooks how very much worse the US budget position would be in the event of an even deeper recession than that already in train.

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Another stimulus package is needed for the reasons Jared suggests. And I agree that it needs to provide some infrastructure spending or help for state and local governments. The stimulus needs to be temporary and should focus on projects that are already underway or can be completed within a relatively short period. If interest rates are pushed up, so much the better in terms of keeping foreign capital here. I would combine this stimulus with an effort to tackle entitlements. Use the crisis as a rationale. The government can bail out the banks and the economy but who bails out the government? The time for Social Security reform is now. The benefit or tax adjustments that need to be made should be legislated as soon as possible but phased in slowly. This will increase confidence in government and make short-run deficits less worrisome once we have taken steps to rein in long-term obligations. Bottom line: short-run stimulus, long-term restraint are in order.

It’s essential that we undertake a stimulus package to address the demand shortfall in the “real” economy (as opposed to the financial markets, which seem terribly unreal these days).

The massive interventions to offset the financial crisis are targeted at the supply-side of the economy from the perspective of credit markets. Now we need to target the demand side. Think of it like this: the Fed and Treasury are in the process of applying angioplasty to clean the sludge out of the economy’s veins. Once that works (fingers crossed!), we’ve got to get the heart beating.

Absent a fiscal stimulus, Goldman Sachs forecasts real GDP to be flat or falling for the next few quarters, and for unemployment to be 8% by the end of next year. Other forecasters consider that pretty optimistic.

The magnitude will need to be in the 1-2% of GDP range ($150-300 billion). The composition should focus on fiscal relief to states, infrastructure investment targeted at projects that are ongoing but starved for capital, and extending unemployment insurance benefits. In this last round of stimulus we emphasized checks to households. That’s fine, but we ignored these other needs. This time, we’ll get a bigger bang for our stimulative buck if we focus on the direct spending ideas just noted.

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