3 Quick Steps For the Economy

Now the real economy is suffering from the virtual cessation of credit. Consumption and investment began to fall in the third quarter, and that trend has only intensified. As consumer demand has slipped, so, too, have commodity prices, with the prospect that the prices of finished goods and even services will drop as well—and that raises the specter of deflation. It is likely that this decline in demand will continue, for without credit, American households cannot consider buying a home, a car, or a major consumer durable. In fact, given how high their debts are in relation to their income, households are building precautionary savings and hoarding cash rather than spending.

The economic statistics are all going in the wrong direction. The consumer has an increasingly pessimistic view of the economy; the consumer confidence index is the lowest since records began in 1967. It is understandable that the consumer is on a buying strike when he is concerned about losing his job, his home, or his wealth. Housing prices are also continuing their decline because they remain overvalued relative to people's incomes or to rentals. Sales of new cars and trucks have plummeted to an annual rate of 10.5 million units in October—the lowest reading since the early 1980s and down by a third from the rate of just a couple of months earlier.

Job losses. The inevitable consequence of all of the above is that many firms are laying off people, whose wages represent their highest costs. The unemployment rate has jumped to 6.5 percent. The more inclusive measure of unemployment, which includes those forced to work part time rather than full time, has climbed to 11.8 percent. This reflects in part a sharp decline in the closely watched ISM manufacturing index, as well as new orders, a key leading indicator. The credit crunch is taking a growing bite out of all economic activity. It is doubtful that we can avoid a recession that will very likely be deeper than the 1990-1991 or the 2001 downturns.

What can be done? It's essential to keep the broad supply of money growing. The financial authorities must find a way to do that in the face of a rapidly deleveraging financial and banking system that is pushing down the money multiplier at an even greater rate than the Fed is boosting the monetary base, as recently described by the economist John Makin. The Fed is absolutely right to offer virtually unlimited money to commercial banks. We must avoid a drop in the money supply such as the one that occurred between 1929 and 1932 and accelerated the transition from recession to prolonged depression. But monetary policy alone won't get us out of this hole. It's essential, but it cannot have much immediate traction when there is so little lending. Three other steps must be taken with minimum delay.

First, we must have a large fiscal stimulus. The package should err on the side of being too large and should be at least $500 billion, in order to contain the deepening economic slump and to offset the sharp drop in income and spending from U.S. households and businesses. It must be structured to maximize the "bang for the buck." This means spending. In other words, tax cuts are not effective since most of them would be saved or depleted by spending on imports. Better to extend unemployment benefits along with food stamp payments because they will both be spent. Grants and loans should be made to hard-pressed state and local governments so they don't cut their spending for infrastructure or raise taxes: Many of them will be forced to do that because their constitutions call for balanced budgets (an unwise loss of flexibility in times of economic turmoil). The good news is that state- and city-level infrastructure programs that would support the economy are ready to be launched without delay. On the fiscal front, there is one counterintuitive exception to this stimulus thrust. Collapsing energy prices provide the chance to impose a significant tax on gasoline that should go into effect in 18 months. The proceeds should be devoted to the development of energy-efficient technologies.