The American economy is now very weak and could get substantially weaker. Current economic conditions call for lowering interest rates and for enacting a tax cut now that is conditioned on economic developments in 2008. More generally, fiscal policy should be considered in the future whenever there is a risk that an excessively easy monetary policy could cause an asset-price bubble.
So far, so good. Feldstein then goes on to say that interest rate cuts may not be sufficient to avert a recession:
Because of current credit market conditions, there is a risk that interest rate cuts will not be as effective in stimulating the economy as they were in the past. The current credit crunch reflects not only a lack of liquidity, but also a lack of confidence in the creditworthiness of counterparties and in the accuracy of asset prices. This problem is now being compounded by the banks' loss of capital as they recognize past losses, and by their need to use large amounts of the remaining capital to support existing off-balance-sheet credits that have to be shifted to their balance sheets. All of this implies that lower interest rates may not raise lending and economic activity to the same extent that they did in the past.
Again, no argument from me. I suspect that interest rate cuts will have a more dramatic impact on asset prices than the real economy. Here's where I part company with Mr. Feldstein:
What's really needed is a fiscal stimulus, enacted now and triggered to take effect if the economy deteriorates substantially in 2008. There are many possible forms of stimulus, including a uniform tax rebate per taxpayer or a percentage reduction in each taxpayer's liability. There are also a variety of possible triggering events. The most suitable of these would be a three-month cumulative decline in payroll employment. The fiscal stimulus would automatically end when employment began to rise or when it reached its pre-downturn level.
The history of temporary fiscal stimulus schemes such as this are not good. They do nothing for the long term health of the economy. A better idea would seem to be that when the economy starts to recover, the Fed should use monetary policy to limit the stimulative effects of the fiscal package. The US economy needs lower tax rates (especially corporate taxes) that are permanent, not some gimmick short term fix.