Lessons From the Selloff

The selloff will help if it breaks down economic policy-making myths.

Well, it’s finally sinking in. Yesterday’s global stock selloff is best understood as the recognition by investors that the financial panic is world-wide, and moreover that it almost certainly means a global recession. As bad as the carnage is and will be, this isn’t the end of days. It might even be clarifying if it causes economic policy makers to abandon some of the illusions that have guided them for the past 14 months.

[Lessons From the Selloff] AP

NYSE floor traders, Oct. 6, 2008.

One such myth is that the Treasury’s bank asset-purchase plan that passed Congress last week is somehow a financial silver bullet. It is merely a single tool, and in any case it can’t do much about the panic now afflicting banks across Europe. It also can’t rescue the property markets in Dubai, or the flight from emerging market stocks that also marked yesterday’s news. Europe in particular is going to have to fill the capital hole in its banks with its own rescue effort.

The rout might well have been worse if Congress hadn’t passed the plan, which signaled that the U.S. political system wouldn’t let the banking system crash. A problem now is that Treasury Secretary Hank Paulson still hasn’t shown he knows how to use his new tool, and his appointment of a 35-year-old former Goldman Sachs employee as the auction czar doesn’t call to mind Paul Volcker arriving at the Fed in 1979. With no disrespect to Neel Kashkari, who is Mr. Paulson’s choice, a financial panic is a bad time to be introduced to global markets. At a minimum, Treasury should have done better than leak his name to the newspapers. This is the kind of roll out that needs to be better than seat-of-the-pants — and continues the problem of weak execution at Treasury.

Another myth is that exports to the rest of the world would somehow rescue the U.S. economy. This was the idea behind the devaluationists — in Washington and at Harvard — who pushed a weak dollar to promote exports to counter the U.S. housing slump. So much for that one. Yesterday’s selloff was worse in Europe and Latin America than it was on the U.S. Trying to steal “demand” from the rest of the world was short-sighted in the way that beggar-thy-neighbor tactics always are. And with Europe and Japan already in recession, and China slowing down, the export contribution to U.S. GDP is likely to fall sharply.

A third mistaken idea is that Federal Reserve rate-cutting would save the day. This is the poor sister of the weak-dollar lobby, popular on Wall Street and at Chairman Ben Bernanke’s Fed. Despite a year of falling rates, the financial panic is worse than ever and now the real economy is getting hit. The Fed’s rate cutting led to dollar flight that produced a commodity spike and oil as high as $147 a barrel. That only made a recession more likely as it sapped consumer discretionary income around the U.S. and worried families and business alike.

The good news is that some in the Fed now seem to realize this, and the Open Market Committee has stopped its pell-mell flight to a 0% fed funds rate. Instead, the Fed is using its discount window to provide liquidity to banks seeking safety, including yesterday’s addition of $600 billion to its Term Auction Facility, growing to $900 billion by November. That’s a striking amount of money, but it is the right way for a central bank to manage a panic.

Another useful step — contained in last week’s rescue — allows the Fed to start paying interest on reserve balances held at the central bank. This removes an implicit tax on banks and serves to put a floor under the fed-funds rate, because no one will lend overnight money at less than they can get by holding it on deposit at the Fed. This is another tool to begin the major and essential task of rebuilding the banking system.

Meanwhile, in other good news, the dollar has strengthened and commodity prices have fallen markedly from their record peaks in July. Much of this is a reaction to a potential recession, especially oil’s fall below $90, because the Fed’s monetary policy is still far from tight. But the dollar’s relative strength means Chairman Bernanke can afford to worry less about a run on the greenback and thus has more room to maneuver. As commodity prices fall back to Earth, consumers will pay less for gas and groceries and that should also help the economy in the months ahead.

The fourth illusion to burst is that temporary Keynesian “fiscal stimulus” would make all the difference. The Bush Administration and Congressional Democrats teamed up for that mistake in January, promising that $165 billion in tax rebates and spending would spare us from recession. Just a month ago, President Bush was still promoting these rebate checks as a blessing.

However, rebates merely took money from one part of the economy and redistributed it to others who either saved or spent it. Neither one changed incentives to invest or take risks. The result was a short-term fillip to statistical GDP but no surge in real growth. Mr. Bush should have learned this lesson from the failure of the rebates that were part of his tax cut of 2001. He listened to his political advisers instead of to the economists who gave him better advice in 2003. Because they were immediate, marginal and permanent, the 2003 tax cuts did help ignite a recovery. The world economy could use a similar U.S. tax-cut boost now to reduce the depth of recession and speed on recovery.

This is where our two Presidential candidates could help, if they have a mind to. The response by both Barack Obama and John McCain to the financial panic has done neither man credit. Both have been tactical and political in the most self-interested sense. Mr. Obama may get away with it given his lead in the polls, but Mr. McCain could use this moment to show some leadership.

Senator McCain could use tonight’s debate to map out an economic argument for the final month of the campaign. He would explain to voters how we got here, and that he has a plan to calm the panic, rebuild the banking system and revive the economy. He could start by saying his economic plan was designed before this crisis, but given the panic he has scrapped it and is proposing a major and immediate across-the-board tax cut.

It ill serves voters if the two men running for the Presidency of the United States offer little more than campaign boilerplate amid a crisis of this magnitude. The whole world is focused on these sobering events. The time is now for the country’s next President to match the moment.

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