The first thing we do, let's kill all the spokesmen. Not really; but officials at both the White House and the Federal Reserve have been making things worse. On one side, we have Ari Fleischer et al. doing their best to spread panic, in the belief that fear sells tax cuts. On the other side, we have Fed officials offering upbeat assessments that, far from building confidence, only add to the sickening sense that the central bank doesn't get it.
Monday's plunge in the markets was driven in part by more bad corporate news. But it also reflected the market's judgment about how the economy is doing. And despite the partial recovery Tuesday, the case for really dramatic interest rate cuts has gotten considerably stronger.
Right now we are in a race between the natural forces of recovery and the self-reinforcing forces of contraction. The manufacturing slump that began last year was mainly an inventory cycle: Companies produced too much and then cut back their production in an effort to get rid of the excess. If that were the whole story, the economy would soon bounce back of its own accord.
But it isn't the whole story: The manufacturing slump, falling stock prices and a general climate of nervousness are undermining both consumer and business confidence.
The Fed's position has been that the natural rebound once excess inventories are worked off will outrun the decline in confidence and that confidence, too, will rebound once there is a clear improvement in economic indicators. Under that scenario, the Fed wouldn't want to cut interest rates too much; cutting rates drastically in the face of merely temporary weakness would risk fueling a future inflationary boom.
But what if declining confidence wins the race? Then the decline in confidence would feed on itself. The odds are that the Fed would eventually succeed in turning things around; but a lot of damage would have been done in the meantime. And there's the small but scary possibility of a Japanese-style trap, in which even cutting rates all the way to zero turns out not to be enough.
Even a few weeks ago the Fed's sunny scenario seemed fairly plausible. But since then a drumbeat of bad news has changed the odds. Numbers on employment have held up pretty well so far, but surely they are a lagging indicator. Given the evidence that consumer spending is starting to fall and the anecdotal evidence of canceled or postponed business investment, it's hard to avoid the sense that contractionary forces are pulling ahead in the race. And the decline in the markets both reflects growing pessimism and strengthens the case for that pessimism.
I've done a very rough calculation on what Monday's fall in stocks might do to consumer spending. This is real fuzzy math, but it suggests that one day's stock decline might well depress consumer spending more than a whole year of the new, accelerated version of the Bush tax cut would increase it. Which brings us to the question of policy.
It goes without saying that the Fed must cut interest rates next week. And too small a cut will be almost as bad as no cut at all. If confidence is not to plunge, business needs a big rate cut, one that shows that the Fed understands the gravity of the situation.
What about tax cuts? George W. Bush continues to sell his plan as a recession-fighting measure, but his plan is almost perfectly designed not to serve that function. Or as a headline in the Wall Street Journal put it, Tax-Cut Talk Is Big; Relief Would Be Small. In order to keep down the headline cost of their plan, Bush's economists delayed most of the big tax breaks until late in the decade. And they cannot do much to accelerate those breaks without making it obvious to everyone that they are planning to raid Medicare and Social Security.
On Monday, former Treasury Secretary Robert Rubin suggested a smaller, "front-loaded" tax cut that would cost far less but would put much more money into consumers' pockets in the near term. This could help a bit more. But the ball is mainly in the Fed's court.
There are times when policymakers should be judicious, when they should resist being rushed by events. This is not one of those times.
Paul Krugman is an economist and a New York Times columnist.
New York Times News Service