WHAT STIMULUS PLAN WILL WORK?

The U.S. Gross Domestic Product contracted at a 0.3% annualized rate in the third quarter, as consumer spending declined at the fastest rate in 28 years, the Commerce Department estimated Thursday. This is making an additional stimulus package even more urgent. The House of Representatives is now holding hearings on it, evaluating what economists and others are recommending.

Harvard economist Martin Feldstein wants government to stop the foreclosure hemorrhage by replacing 20 percent of mortgage debt with low interest government debt for the 12 million homeowners who have negative equity in their homes. The government’s debt would take precedence and so be paid off first in the event of any payoff.

“The president-elect should focus on developing a mechanism for identifying and funding spending initiatives that can occur quickly and that would otherwise not be done”, said Feldstein in a recent Washington Post editorial. “The increased government spending should include not only money for infrastructure such as bridges and roads but also for a wide range of equipment. Rebuilding some of the military capacity that has been depleted by the wars in Iraq and Afghanistan could be done relatively quickly and should be part of the overall package.”

An even more radical solution proposed at a recent 2-day Berkeley, California symposium on the mortgage meltdown by Glenn Hubbard and Christopher Mayer of the Columbia Business School is for the government to buy down interest rates. Under this plan, the government would take action to return mortgage rates to what they would otherwise be if the mortgage market were functioning normally (about 160 basis points above the 10-year Treasury rate). This means that 30-year fixed conforming rates should be around 5.5 percent, rather than the current 6.25 percent.

“The principal benefit of our plan is to reduce mortgage rates by nearly one percent, holding up house prices by 10 to 17 percent around the country relative to how much house prices would fall if the mortgage market remains dysfunctional,” says Hubbard and Mayer. “Lower mortgage rates would allow many homeowners to refinance their mortgages at more normal spreads and to improve affordability for potential new home buyers.”

The House stimulus package will probably include something for everyone. It is projected to cost about $300 billion, which corresponds to the drop in consumer spending over the past year. It is likely to include many of the same provisions that comprised a $61 billion stimulus measure that last month passed the House but died in the Senate, according to the Washington Post, including new money for roads and bridges, aid to cash-strapped state governments and extra funds for food stamps and unemployment insurance.

The decline in real (after inflation) gross domestic product was the largest since the end of the last recession in late 2001. The economy grew at a 2.8 percent pace in the second quarter. Final sales to domestic purchasers fell 1.8 percent, the largest decline in 17 years. Consumer spending dropped 3.1 percent, the first decline in 17 years and the biggest drop in 28 years, while business investment fell 1 percent. Investments in homes fell for the 11th straight quarter.

After getting a big boost from tax rebates in the second quarter, inflation-adjusted after-tax incomes fell 8.7 percent, the largest quarterly decline since U.S. record-keeping began in 1947. Though incomes fell much more in the Great Depression, when annual records were kept.

"The capitulation of the consumer is the primary catalyst behind what is clearly the first consumer-driven recession in three decades," wrote one economist about the GDP contraction. "Just about all sectors of the economy are in the process of a serious contraction." So it looks like anything that gives a boost to consumer spending could shorten this recession.

© Harlan Green 2008