Wednesday, October 15, 2008

From Fortune.com - How to rebuild AmericaThe era of small government is dead. We need a strong, skillful Washington again to start rebuilding America from the ground up.

(Fortune Magazine) -- It's certainly not morning in America.

Yet it doesn't have to be twilight either. America can pull through the current economic crisis with a dose of political maturity and a bit of luck. Success will mean the end of the Reagan era, of an ideology that has brought the country to its knees.

Ronald Reagan told us that government was the problem, and that low taxes and deregulation were the solutions. The result, even more than Americans recognize, is a government so shrunken in skill and mandate that our gravest problems - financial collapse, natural hazards like Hurricane Katrina, broken health care and education, unsustainable energy systems, and growing global instability - are left without a serious response.

Either we once again invest in our future, notably through an expanded public sector, or we will lose our future.

I presume that John McCain and Sarah Palin will lose the election. Never has a national ticket been less equipped intellectually, temperamentally, and practically to confront America's problems than this one. I also presume that Palin's winks to America will prove to be the equivalent of the Cheshire Cat's grin: the last expressions of an ideology disappearing from the scene.

Yet Barack Obama will soon find himself and our country in a labyrinth of difficulties requiring a new approach to public policy. The Reagan-era small-government ideology is defunct, and so too is the modest corrective that characterized Bill Clinton's "triangulation" with the right.

In the immediate future the greatest challenge is to stop what George Soros has called the "wrecking ball" of unregulated finance, the consequence of turning the economy's keys over to Wall Street.

Vast sums of money, untethered from the traditional capital-adequacy standards of commercial banks, inflated a gargantuan housing bubble that has now burst. The outflow has been violent in the other direction, as short-term funds from pensions, money markets, and foreign lenders have suddenly fled to safe havens. The housing market and consumer credit are in collapse. Wall Street's shadow banks have closed down. Money market funds are so spooked after Lehman's bankruptcy that they won't buy AAA commercial paper.

When AAA isn't good enough, we know that panic and fear have taken over.

The immediate need is to save the financial system through ample liquidity from the Federal Reserve, government backing of the commercial-paper market, and banking sector recapitalization, mainly by private money but also from public funds as needed.

Giving homeowners relief from foreclosures will be an important social policy and a way to return mortgage-backed securities to a partial-repayment basis. Unfortunately, the Paulson-Bernanke $700 billion bailout, aimed at buying mortgage-backed securities from the banks, addresses none of these issues, as the world's financial markets realized the moment the legislation was passed. The new President will have to modify the plan starting on Jan. 20 so that the vast sums voted by Congress will contribute more directly to banking recapitalization and the timely restructuring of existing mortgages.

Stopping the wrecking ball with these measures will take a while, probably at least through 2010 or 2011. These steps will prevent an economic collapse similar to the Great Depression or even to that of Asia in 1997, when several economies shrank by 10% or more.

By keeping credit markets open for business, the government can prevent an outright collapse, a depression, but that will not stop a recession in the U.S., centered on a steep fall in housing construction and consumer spending. The U.S. economy is likely to shrink by a few percent of GDP in 2009, and unemployment is likely to rise by a few percentage points. All of this will hurt badly.

Yet the greater challenge is not simply to stop a collapse, and certainly not to resurrect the housing bubble, an impossible and misguided goal that is still widely espoused through one scheme or another to get mortgages flowing again.

The deeper problems come back to Reaganomics. By next year we will find not only a shuttered housing market and weakened banking system but also a budget deficit exceeding $500 billion and perhaps as high as $750 billion or more, including charges for the financial bailout. The larger figure would amount to 5% of GDP, the highest proportion since the Reagan years. America will have gone through a decade of minimal household saving (made possible, of course, by the defunct easy access to mortgage financing and consumer credit) and will have borrowed, cumulatively, around $4 trillion from abroad since 1998, mainly from Asia. And we haven't even begun to address the challenges of climate change, broken infrastructure, health care, and schools.

For these reasons, we need to begin the transition back to national saving, both by government and by households. Now that easy financing has dried up, consumer spending will weaken dramatically, aggravating the pain in the short run.

For households, this can and should be the transition to positive saving and rebuilding net financial assets. Housing construction will remain low for several years, as will purchases of consumer durables like automobiles and home furnishings. The dollar should weaken, which will direct some of the resulting excess productive capacity toward exports, thereby reducing and eventually eliminating our heavy dependency on foreign saving. As a rich country, the U.S. should be a capital lender to the world, not a net borrower.

Some of the excess capacity, however, should be filled not by exports but by increased public and private investment at home. America needs an upgraded infrastructure to stay safe and secure. Yet we've neglected infrastructure for decades. Federal investment in nonmilitary major physical capital has been running a meager 0.2% to 0.3% of GDP in recent years. The results of chronic underinvestment are degraded roads and bridges (ones that actually go somewhere), lagging broadband access in parts of the country, vulnerability to natural hazards, and a dangerously decrepit power grid that is susceptible to disruptions and unequipped to support a modernized energy system.

In fact, the entire U.S. energy system needs an overhaul, both to ensure energy access and national security and to begin the transition to a low-carbon-emission economy to curb rapidly accelerating climate change. Such a massive multitrillion-dollar overhaul will inherently require partnerships between the public and private sectors, the kind of relationship deliberately shunned by the free-market reveries of Reaganomics. The goals of the partnerships should include:

*The development of mass-market battery-powered autos (hybrid or plug-in) that achieve at least 100 mpg of gasoline on new fleets by the year 2015.
*An efficient power grid that can carry renewable energy - solar from the Mojave Desert and wind from the Great Plains - to the population centers of the U.S.
*A utility industry that can reduce 80% of emissions per kilowatt on newly built power plants by 2016, either by recruiting noncarbon sources (wind, solar, nuclear) or by capturing and disposing of the carbon dioxide.
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These goals will require hundreds of billions of dollars of public financing for research, development, early demonstration, and the rollout of new technologies, which in turn will leverage trillions of dollars of private capital during the next 20 years.

Now here's the rub, the one that has not even begun to sink in. None of this can be accomplished with the fiscal straitjacket that has been in place since Reagan's first tax cuts in the early 1980s. The mantra of small government and money in the pockets of ordinary Americans has been with us for nearly 30 years now, right through the Clinton era as well. Budgetary revenues have been capped at around 18% of GDP even as the population has aged, health-care costs have soared, and needs from energy to education have been left unattended.

Reaganomics began with wrong diagnosis and a great lie. (In these waning days it depends on even more absurd justifications.) The wrong diagnosis was the belief that the stagflation in the 1970s was caused by too much government, when in fact it was caused by the breakdown of the global fixed-exchange-rate system in the early '70s and by a dramatic tightening of global oil supplies, which led to OPEC's market power. Stagflation was eventually overcome, at high cost, by the combination of Paul Volcker's tight-money policy, investment in energy efficiency, and the development of alternative energy supplies - not by Reagan-era tax cuts. The great lie was to blame the stagflation era's spiraling costs on the infamous "welfare queens" allegedly taking the hard-earned money of America's workers.

This narrative played into the fantasies of a free-market, go-it-alone America, and for some it still does. The absurdities today are that the budget deficit, now at $450 billion and rising, is somehow to be eliminated, according to McCain and Palin, by boldly cutting $18 billion in earmarks and other unidentified waste, fraud, and abuse. That won't get us very far. Such small-government platitudes are especially discordant at a moment when the government is plowing in $700 billion to bail out the financial system.

The true fiscal story is far more dramatic and interesting than the Reaganomics daydreams. Government outlays amount to roughly 21% of GDP, but nearly 17% of GDP is accounted for by a very few areas: the military (4.2% of GDP), health and veterans' affairs (5.4%), retirement and disability, including Social Security (5.4%), and net interest payments (1.7%). Four percent of GDP must now finance all of the following areas: infrastructure, education, housing, nutrition, antipoverty, energy, environment, international affairs, science and technology (including space), agriculture, judiciary, and general administration of government! Of course, this is absurd. It is the end stage of a failed ideology that says that these areas should be left to the private sector. In fact, everyone is awaiting serious government as a partner for business and society.

We can't even fund our current minimalist government out of current taxes, and yet we will have to expand government spending by several percent of GDP to face our cascading problems. Today's budget deficit of 3% of GDP will expand to around 5%, but on top of that will be another 3% or so for all the critical needs we will face. From the perspective of five to ten years, even an additional 3% may be too low in view of the vast unfunded liabilities represented by rising costs of health care for an aging society. The idea that our fiscal mess can be addressed with the current tax system is absurd. The McCain-Palin idea of adding still more tax cuts for the rich on top of everything is surreal.

Some fiscal steps are clear. Around 2% of GDP can be recouped by ending the Iraq occupation (costing roughly $140 billion per year in direct outlays) and by cutting some expensive, unnecessary weapons systems. Another 1% of GDP can be recouped by ending the Bush tax cuts for the wealthy, as Obama has suggested. Yet even those steps will leave us with vast and growing needs. We should probably be aiming realistically for outlays and revenues close to 24% of GDP (up by three percentage points in outlays and six percentage points in revenues), compared with the current federal outlays of 21% of GDP.

Where will this money come from? The income tax is pretty much exhausted as an effective source, except to recoup a bit more at the high end, and corporate income taxes are of limited potential in a global world economy where they can be so easily avoided. One good but partial option will be carbon taxation, which might realistically collect 1% of GDP (roughly $25 per ton on six billion tons of emission). The fiscal gap will remain.

Like every other high-income country, the U.S. will finally need a national value-added tax or sales tax of some sort, perhaps starting at a 5% rate (to collect initially around 3% to 5% of GDP). The VAT has proved to be a smart tax, by focusing taxation on consumption rather than on saving and investment. Admittedly, we are nowhere near a public consensus on such issues. Nobody has even bruited such a possibility. Both candidates are promising tax cuts: Obama moderately for the middle class, and McCain recklessly for the rich and for corporations as well.

Yet reality will begin to dawn. Reaganomics is over - even the moderate, triangulating version of the Clinton years. It's time to embrace government again as part of the solution rather than as the source of the problem. And it's time to start paying for government again. Our future, and surely our children's, will depend on it.

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