Repairing a Damaged Economy
Make no small plans. They have no magic to stir men’s blood.
When Barack Obama takes office as America’s forty-fourth president, he will face an acute, three-pronged economic challenge. The financial system will be in crisis to a greater degree than at any time since 1933. America’s international imbalances will be on a worsening downward slide. And the economy will be in a deepening recession supercharged by falling consumer purchasing power, declining housing values, and cascading business losses.
In addition, he faces four chronic problems that recession will only intensify. The recession will exacerbate a thirty-year trend of increasing inequality and insecurity. The crisis in energy and climate change will be deepening; the unreliability and cost of health care will be relentlessly worsening. The decay of America’s public spaces and facilities will persist. All of this will require a more activist use of government than we’ve seen in at least four decades.
As we saw in chapter 3, real obstacles to change are compounded by attitudinal ones. Assuming that he is not disabled by an undertow of dubious counsel, what exactly should Obama do? He will have no shortage of advice, much of it contradictory, and the risk will be either to aim too low or to run off in several directions at once before having a clear strategic plan.
At every step, he needs to restore confidence—not just with inspiring words or grand aspirations, but by demonstrating that help is on the way. He also needs to transform prevailing ideological assumptions, so that the practical help attracts wide support and builds public approval for even bolder measures using activist government that will take longer to enact—and to reclaim support for the more fundamental progressive idea that government plays a constructive and necessary role.
In Roosevelt’s famous First Hundred Days, FDR launched dozens of initiatives. Within just over three months, fifteen pieces of landmark legislation had passed Congress and remade the relationship between economy and government.
Obama does not need to match that record. But at the outset of his first term, he does need to address the economic emergency on three tracks. Longer-term reforms such as universal health insurance can come a little later.
First, Treasury Secretary Paulson’s policy of ad hoc financial bailouts needs to be turned into a more systematic program, with explicit principles of prudential regulation. The recapitalization of America’s damaged financial system must continue, perhaps at an expanded scale. But it needs to be part of a coherent strategy for restoring a sound financial system—one that the Bush administration has been incapable of creating. Second, since the housing collapse is so central both to the damaged condition of America’s credit markets and to falling consumer demand, Obama needs to work with Congress on a much more robust housing and mortgage rescue program. The Frank-Dodd mortgage refinancing law and Fannie Mae–Freddie Mac guarantee enacted in late July was not a bad start, but it is not enough to do the job. And third, we will need a dramatic expansion of public spending, well into the hundreds of billions of dollars, as classic anti-depression medicine.
Begin with Low-Hanging Fruit
Obama’s earliest measures should be devoted to delivering practical help to individuals, families, and communities. That will both relieve economic suffering and establish him as a leader, as well as moderate the recession. By spring 2009, we will need an immediate recovery package in the range of $200 to $300 billion, and not primarily in the form of tax cuts. That money will be needed to extend unemployment benefits; deliver money to states and localities whose falling revenues cause them to cut services in a recession; and provide the first installment on a long-term effort to rebuild public infrastructure, with an emphasis on both deferred basic maintenance and efficient renewable energy. Such public outlays can also speed development of technologies that will improve America’s competitiveness and provide such twenty-first-century basics as universal broadband service.
The public works funds could be combined with an increase in job training subsidies to reduce bottlenecks in the supply of skilled workers. For example, retrofitting homes and offices for energy efficiency, building on pilot programs already operating in some small cities, could be a quick source both of good jobs and local economic stimulus. This would also yield savings on America’s energy bill—which would reduce our trade imbalance and put more money in consumers’ pockets.
As of early August, when this book was going to press, Obama has offered three versions of this kind of public outlay, each getting bolder as the crisis has deepened. In a speech last April, he included:
A National Infrastructure Reinvestment Bank that will invest $60 billion over ten years and generate millions of new jobs. We can’t keep standing by while our roads and bridges and airports crumble and decay. We can’t keep running our economy on debt. For our economy, our safety, and our workers, we have to rebuild America. And we need to invest in green technology. We can’t keep sending billions of dollars to foreign nations because of our addiction to oil. We should be investing in American companies that invest in American-manufactured solar panels and windmills, and in clean coal technology. That’s why I’ve proposed investing $150 billion over the next ten years in the green energy sector.
This is exactly what’s needed, but the scale should be bigger. Later he proposed a second stimulus package of $50 billion, of which $30 billion was to be tax cuts. That was far too feeble.
Then, on July 31, after his economic summit meeting and the Labor Department’s announcement of higher unemployment, came stronger medicine. Obama proposed $25 billion for a “State Growth Fund to prevent state and local cuts in health, education and housing assistance or counterproductive increases in property taxes, tolls or fees.” The fund would also fund home heating and weatherization assistance. Second, he proposed another $25 billion for a Jobs and Growth Fund to replenish the highway trust fund, prevent cutbacks in road and bridge maintenance, and fund new fast-tracked projects to repair schools. All of this, he said, would “save more than 1 million jobs in danger of being cut.”
This proposal was a welcome down payment on an idea that progressives have been proposing for three decades—a “ready-to-go” program of standby anti-recession investment in public infrastructure. The idea is that localities can qualify in advance for preapproved projects, which can then be launched on relatively short notice. When recession strikes, the federal govern¬ment would release the funds, with the money divided among localities according to a formula. With the economy in serious trouble and a $1.6 trillion infrastructure backlog, this program is probably necessary for several years, and should be continued as an ongoing standby measure.
In the first phase, federal public works outlay could begin delivering badly needed public funds and decent jobs within as little as ninety days—money to repair and refurbish roads, bridges, mass transit, parks, schools, and public buildings, or to prevent cuts in state and local budgets. Gearing up a planning system for a more expansive second phase should take about six months. During the Depression, Roosevelt got money flowing in a matter of weeks. Later, the Public Works Administration not only delivered tangible public improvements and good jobs but also created a local planning system in which proposed projects were discussed and debated by citizens, who played a role in setting local priorities.
Why begin here? Three big reasons. First, this approach would deliver tangible, visible help, and quickly. Second, it would be politically irresistible—for the very reason that conservative opponents of public outlay love to hate: It would have elements of what is disparaged as pork-barrel spending. Every congressional district would get its share (would you like to be the congressman who voted against such a measure in a serious recession?). Harder-hit regions of the country would qualify for extra aid.
Third, an economic downturn supercharged by a credit contraction is a different creature from an ordinary business-cycle recession. About 16 percent of America’s homes have mortgages worth more than the value of the house. As economic activity slows, business defaults are rising. Loans that would be considered perfectly sound in normal times are being turned down or charged higher interest costs, because panicky banks have suddenly turned risk-averse. When businesses and consumers have trouble getting credit, economic activity slows and reces¬sion becomes a self-fulfilling prophecy. We saw this first in the subprime collapse, which gradually spread to the entire banking sector, and then to the rest of the economy. As a consequence, public spending needs to do heavier lifting than usual to counter¬act the depressive effect of a credit crunch.
In the short run, part of this program of public works would be deficit-financed, as Obama recognized in moving beyond an earlier and ill-advised promise last spring that all his new spending programs would be offset by cuts elsewhere. It is a matter of basic macroeconomics that new outlays that are offset by other budget cuts or tax increases provide no net stimulus. After Obama announced his emergency anti-recession program on July 31, he gave an interview to NPR’s usually intelligent Michele Norris. Norris, in a flawless rendition of the conventional wisdom, asked in a slightly horrified tone, “This morning you announced a new emergency economic plan. It includes a $50 billion package. Can you promise to pay for all that without increasing our debt? Where will this money come from?”
Obama explained, “When it comes to a stimulus package, typically you are not looking at offsets, because what you are trying to do is to prevent the economy from going into a further tailspin.”
But Norris persisted with the usual story: “But with the deficit as high as it is right now, is it responsible to propose something that is likely to increase deficit spending?”
Obama didn’t flinch: “Well, Michele,” he said, “understand that if we continue on the trends we’re on right now, where unemployment keeps on going up—I’m in Florida, where they are in recession for the first time in 16 years—if you continue to see an economic slide, that is going to cost far more in terms of tax revenues, because businesses aren’t selling, taxes aren’t being collected. And what we’re going to end up with is a much worse situation when it comes to our deficit.”
This exchange occurred during a week when McCain was closing the polling gap with Obama and Democrats were expressing alarm that Obama had not yet made the sale with enough white working-class voters despite worsening economic conditions that should play to Democratic advantage. By explaining the stakes and offering tangible help, Obama positioned himself to be an effective president—as well as increasing the odds that he would reach the White House at all.
In the financial collapse of the Great Depression, Roosevelt turned to previously unknown peacetime deficit spending of around 4 to 6 percent of GDP. It turned out that this level of pump priming was necessary but not sufficient to fully restore prosperity. On the eve of the wartime mobilization, unemployment had been cut only in half, from a peak of 25 percent to about 12 percent. The economy kept slipping back into reces¬sions. Full recovery came only with the even greater deficit-financed government spending of World War II, which peaked at 30 percent of GDP.
We are not in another Great Depression, and we don’t need a recovery program on the scale of World War II. But we will need increased deficits, at least for a year or two until we are on the road to recovery. Even if we did nothing, the recession itself would reduce economic activity, hence tax receipts, and only an economic idiot (or perhaps the International Monetary Fund) counsels fiscal austerity in a deep recession.
A temporary increase in deficit spending might offend Democratic budgetary conservatives who have embraced pay-as-you-go budget rules both on grounds of fiscal prudence and as a defensive strategy against further Republican tax cutting. Under these so-called pay-go rules, all new outlays and all new tax cuts need to be “paid for,” either by other program cuts or other tax increases. For example, in the first stimulus package, a rather meager $168 billion affair passed by Congress last February, conservative Blue Dog Democrats joined far-right Republicans in blocking a more expansive measure because they didn’t support increasing the deficit. But as Obama explained so cogently, the very definition of a fiscal stimulus is a temporary increase in deficit spending.
At the same time, not all stimulus programs are fiscal. For the longer term, there is a good argument that raising taxes on the very wealthy and spending the money on old-fashioned public works or investments in energy independence, science and technology, or college aid would have a net stimulative effect, even if the deficit impact were neutral. The reason is that every penny would be spent, whereas the nontaxed incomes of the very wealthy might be saved, moved abroad, or invested in nonpro¬ductive uses such as diamonds, gold, or pre-Columbian art.
Legislatively, I am assuming that while an emergency public works program was advancing on one track, a program to repeal the Bush tax cuts would be moving on another. There might or might not be an exact rendezvous. But pay-as-you-go budgeting was a tactic for another era, one in which Republican tax giveaways needed to be restrained, and one in which the economy was not in deepening recession. Fiscally, as FDR belatedly recognized, budget rules that make sense for normal times do not apply in an economic emergency. Over the entire business cycle, fairly moderate deficits of, say, 2 percent of GDP are sensible. But in a severe recession, greater deficit spending makes sense; and in no event should a public works program be held hostage to a balanced budget, much less to long-term reform of social insurance.
Beyond an immediate and more expansive program to increase jobs and fiscal relief for communities, the new administration will need to move on multiple fronts. Here again, the most important principle is first to do what needs to be done to stop the bleeding while building toward more expansive successes in the future.
The Special Case of Housing
By July 2008, there were 272,171 foreclosures recorded, a 55-percent increase from a year earlier. Homeowners were losing trillions of dollars of home equity, the principal form of their net worth. During the boom years, as incomes lagged behind inflation but housing values surpassed it, homeowners got into the habit of borrowing against their homes. By spring 2008, more than half of the value of America’s homes was not equity but debt, up from just 20 percent debt in the 1960s; it was the worst debt-to-equity ratio since World War II. Plummeting housing values contributed to the downward spiral of reduced consumer spending and shrunken economic activity generally.
The Frank-Dodd housing bill, enacted and signed (with no ceremony) by a reluctant President Bush in late July, included provisions enabling people stuck with subprime loans at astronomical interest rates to get refinancing at more modest interest costs, with the loans guaranteed by FHA. But there will be a great deal of litigation on whether a holder of the loan is obligated to accept the refinancing. The Congressional Budget Office estimates that only about 400,000 homes will be refi¬nanced over the next three years thanks to the bill. Yet 2 to 3 million homeowners are expected to default on their mortgages in 2008 alone.
CBO also calculated that the banks are likely to off-load the riskiest loans onto FHA, and that 35 percent of these lower-interest-rate mortgages will eventually default, at taxpayer expense. In the end, the rescue program could do more to help banks than homeowners, according to CBO. In fairness, the whole point of the bill was to refinance the mortgages at great risk of foreclosure. The problem is that the bill, by itself, solves only a fraction of the problem.
A more expansive provision of the Democrats’ bill would have included upward of $10 billion to enable local governments and nonprofit agencies to buy foreclosed-upon houses and either return them to the rental housing supply or sell them with low-interest-rate mortgages to moderate-income buyers. The Bush administration and fiscally conservative Blue Dog Democrats in the House blocked this provision as adding to the deficit. (What are they waiting for—a full-blown depression?)
The next version of the housing and mortgage rescue program will need to be far bolder. Only presidential leadership can accomplish that. Once again, the New Deal offers a precedent.
Before the Roosevelt era, virtually all mortgages were short-term loans of five years of less, typically interest-only, with the principal due and payable at the end. If homeowners could not roll over the loan, they were out of luck. As foreclosures skyrock¬eted in the early 1930s, the New Deal invented the modern long-term, self-amortizing mortgage. The government offered to insure such mortgages so that lenders would accept them, devising the Federal National Mortgage Administration (FNMA) to create a “secondary market” to purchase mortgages from lenders, turn them into government bonds, and replenish the bank’s money so that the banker could make more loans.
As foreclosures kept rising because of the general economic conditions, Roosevelt and Congress also created the Home Owners Loan Corporation, which made low-interest direct loans at the government’s own borrowing rate. Eventually, HOLC refinanced one American home in five, saving innumerable families from foreclosure, reviving a normal market in real estate, and tempering the free fall in housing prices. Because there was no corrup¬tion and loan standards were maintained, when HOLC closed its doors in 1952, it returned a modest profit to the Treasury.
There is surely a lesson here—which could usefully be the subject of another Obama teachable moment. When people who believe in government operate it competently, the public sector can often outperform the private, particularly when the purpose is partly social. Under the New Deal schema of financial regulation, which suffered its first serious assaults only in the late 1970s, there were no major banking scandals or losses. FNMA performed beautifully, and mortgage credit was plentiful. The rate of homeownership rose from 44 percent in 1940 to 64 percent by the mid-1960s. Only after FNMA was privatized as Fannie Mae, and its executives began paying themselves multimillion-dollar salaries and taking exotic financial risks, did the institution get into big trouble.
The July 2008 housing legislation, though useful, will prove far too weak to halt the epidemic of foreclosures and the collapse in real estate values. Before this housing collapse is over, government will need something like a Home Owners Loan Corporation with the power to refinance mortgages when the private market fails. The agency should have a separate window to underwrite efforts by local government to get foreclosed houses reoccupied so that they don’t drag down entire neighborhoods. This strategy could be part of a long-overdue need to subsidize affordable housing. This or something like it will need to be enacted in Obama’s first hundred days. As congressmen and senators hear from constituents about collapsing housing values, dwindling real estate tax receipts, and devastated homebuilding firms, this bill should be among Obama’s easier legislative challenges.
In recent years, the private housing market has seen the coexistence of feast and famine. Part of it was a bubble economy that produced windfall gains for some and ultimately invited a crash. Elsewhere, as rents followed prices upward and conservative administrations withdrew subsidies for affordable housing, tens of millions of people were paying more than a third of their incomes for shelter. Many more were doubling up or enduring two-hour commutes to work from distant small towns where prices were still relatively low.
The housing crisis creates an opportunity for government to connect millions of foreclosed-upon houses with millions of aspiring homeowners and renters seeking affordable shelter. The missing ingredient is subsidized mortgages and creative community lenders. A bold program along these lines would brake the slide in housing prices by subsidizing the purchasing power of new occupants.
One of the many perverse things about the subprime industry was that it advertised itself as the friend of moderate-income homeowners. But by offering them bait-and-switch loans with teaser rates that soon reset to interest rates that might make the Mafia blush, these lenders robbed people of their dreams. If we want to help people of modest means acquire homes, the proven way is not to charge exorbitant rates but to use subsidized mortgages with below-market rates, coupled with counseling. There are plenty of proven models, such as the fine work of Shorebank of Chicago, near Obama’s old neighborhood, or Neighborhood Housing Services, both of which help moderate-income Americans realize secure homeownership. All that’s lacking is adequate federal subsidy.
For the more complex reform projects of the new administration—restoring a secure financial system; revising trade priori¬ties; expanding the supply of good jobs; devising a path to secure renewable energy; moving toward universal health insurance—it makes sense for the new administration to take some months to plan, and then to build support in the country. Task forces in each area could tender reports while the emergency business of stopping a slide toward depression proceeds.