On September 18, in an article entitled “The Financial Sun Will Shine Again,” I made some suggestions about resolving our financial and economic crises. At that time the Dow Jones was at 11,019. Since then, the Dow has plunged to an intraday low of 7,774 — a decline of 29 percent in just two months. The situation has worsened significantly, and the way out of this mess has necessarily altered.
Global markets have fared even worse than U.S. markets as a worldwide economic slowdown has become a full-blown recession. Consumers, in the face of tougher times, have predictably withdrawn from discretionary spending — a development that only accelerates the economic downturn.Taking extraordinary actions, the federal government has acted successfully to help stem the financial-market meltdown, which mushroomed from a housing downturn to an unwillingness of financial firms to lend to one another. But the shock to the system has spread from Wall Street to Main Street, prompting the Beltway bureaucrats to formulate a cure for an extreme downturn in consumer confidence and spending.
In the immediate aftermath of the elections, President-Elect Obama quickly got behind one or more stimulus packages that lawmakers believe will get the consumer going again. So did House Speaker Nancy Pelosi and Senate majority leader Harry Reid, both of whom saw their power-bases increase on November 5. The post-election race was quickly on to do something about the economy, and yet financial markets continued to fall by 1 to 2 percent a day. With stimulus apparently on the way, why hasn’t the stock market locked into a rally?
For one, the Treasury’s vacillation on how best to use its $700 billion bailout facility has introduced more uncertainty to the markets. Just how will the government’s monstrous bailout package impact the economy? There are no certain answers. Stock market volatility suggests that Washington, D.C., is confused as to how to stop the economic downturn.
There’s also the reality of a steady stream of negative economic data. From jobs to retail sales, the numbers are not so good, and they are likely to get a lot worse if the stock market is a good indicator of future economic activity.
But there’s another critical reason why this stock market downturn is so lengthy and pronounced: To a significant extent, markets believe fiscal and monetary policy is headed in the wrong direction.
In the case of fiscal policy, there simply are no viable ideas on the table in Washington (at least Democratic Washington) about increasing consumer spending power. Consumer bailouts are instead being framed in a rebate conversation — in terms of one-time stimulus packages that have failed in the past to produce positive and long-lasting economic effects.
If you can remember back to 2001, President Bush’s first stimulus package was a demand-side program that did very little to spark an economic or stock market resurgence. It was only when his stimulus turned to the supply-side in 2003 — a package of tax cuts on dividends, capital gains, and incomes — that the stock market and economy started to roar once again.
Then there’s monetary policy. The Federal Reserve got creative in the midst of the financial meltdown by dealing directly with problem institutions. Observers approved of this “rifle” approach to solving specific liquidity problems. However, as the economy weakened across the credit crisis, monetary policy shifted back to a “shotgun” approach of interest-rate cuts, with the Fed lowering its target federal funds rate all the way down to 1 percent.
Lowering interest rates in the hopes of stimulating the economy is a dangerous, if not downright stupid, business. As one example, in the macro economy there are many savers who rely on income from investments — especially safe short-term investments — to maintain their standards of living. Yet as the Fed lowers interest rates across-the-board, income for these people collapses, leading them to curtail their spending. Monetary policy here produces the exact opposite outcome of what was intended. And with baby boomers making up an ever-larger percentage of the older population, falling interest income becomes an even greater economic risk.
One year ago, yields on money-market funds were in the 4 percent range; today they are around 1 percent, indicating a decline in income of about 75 percent from these investments. As for conservative investors who purchased U.S. Treasury securities, those yields have collapsed as well: A one-month U.S. Treasury bill is now yielding close to zero. If anyone wonders exactly why consumers are more cautious these days, this is a good place to start looking.
Additionally, as corporate earnings collapse, pulling dividends down, investors seeking income from high-yielding stocks will find themselves at the wrong end of dividend cuts and eliminations. And yet forecasters suggest the central bank will take the fed funds target to zero to help increase consumer confidence, all while this strategy contributes to falling consumer income.
Bailouts aside — since there appears to be no stopping that freight train — positive action can be taken. As for monetary policy, the Fed should put its shotgun away and concentrate on taking dead aim with its rifle. At the very least, it should take the funds rate no lower than the current 1 percent.
As for fiscal policy, economist Larry Kudlow and other prominent supply-siders have the right idea: Substantially cut the corporate income-tax rate. Such a policy will have a direct impact on aggregate demand as businesses pass this tax cut along to consumers in the form of lower prices. Additionally, a holiday from the payroll tax would do wonders for consumer confidence.
Without a major fiscal stimulus package that includes such bold steps, and without a dead-aim-only policy from the Federal Reserve, the new leaders of our country may not be able to put Humpty back together again.