Instead of opening 2008 with the traditional boom, equity markets plunged, with many “economy” stocks leading the way down. A few wayward economic statistics kept the bears from going into hibernation while fears of a yet-to-appear recession continued to grip investors. Not to be outdone, many big-name Wall Street brokerage firms jumped on the recession bandwagon, adding a little gasoline to the bears’ bonfire. And since a new year brings with it a raft of portfolio rebalancing, the downtrend was accelerated as money managers sold winning stocks and bought losing bonds.
No wonder the equity markets weakened.
Most of the talking heads on the financial news channels have turned to the Federal Reserve as the “savior” of last resort. Even though the Fed’s discount-rate policy helped alleviate a serious credit crisis last quarter, market mavens want more — in the form of additional cuts to the fed funds rate.
The idea is that a lower fed funds rate will free the economy from weakness by encouraging borrowing and spending. But the pundits seem to forget just what led the U.S. out of its most recent downturn, the Y2K-induced mini-recession of 2001. President Bush and his advisors saw the need for immediate fiscal stimulus, and they pushed through a tax-cut package that at least neutralized the downturn. Unfortunately, since there were not enough incentives built into that tax cut, financial markets were unimpressed and the bear market extended into 2002.
But fiscal policy was the dealmaker again in 2003. As part of a follow-on stimulus package, President Bush instituted major incentive-based tax-rate cuts to incomes, capital gains, and dividends. The expectation of that tax cut triggered a sharp market rally in the second quarter of 2003, a rally that continued into the third quarter of 2007.
The economy is, once again, ripe for another round of fiscal stimulus. The ramifications of the housing crisis, in addition to high oil and commodity prices, are deflating the economic expansion. Lower interest rates are not going to turn the economy around; only immediate fiscal action — in the form of a significant tax-rate reduction — can do the job.
The Fed heads can talk all they want about half-point interest-rate cuts, but only an immediate spark to economic activity through tax-rate reductions that introduce new fiscal incentives can provide the basis for greater optimism.
President Bush, in his final State of the Union message, can make it three in a row by proposing a meaningful stimulus package. It could make the difference between a prolonged downturn and a continued expansion.