Most financial markets around the world have fallen since the start of the year, with all of them plunging in unison yesterday. Today, the Federal Reserve was forced to cut its key federal funds rate by three quarters of a percentage point, to 3.5 percent, to calm global stock markets, as investors adjusted anew to the long-term structural weaknesses in the U.S. economy, particularly in consumer spending and in the housing and mortgage markets.
What sparked Monday’s stock market sell off, however, was investors’ lack of confidence in President Bush’s grasp of the depth of the problem. His proposed $145 billion economic stimulus package is not targeted enough to get the biggest bang for the buck from the sizeable spending increase he proposed, and it does not include an answer to the threat of sharply lower house prices.
First the macroeconomic backdrop. Since the beginning of the current business cycle in early 2001, family incomes in the United States have not risen, yet the costs for important consumer items such as housing, health care, transportation, energy, and food all climbed at often breathtaking speeds. To afford these necessities, families piled on record amounts of debt relative to their income—at a rate more than four times faster than that in the 1990s.
Families, though, were not the only ones going deeper into debt. The federal government ran up large budget deficits due to massive tax cuts for the rich and a spending spree for an ill-designed Medicare prescription drug benefit and two wars in Afghanistan and Iraq. Since March 2001, foreign investors financed close to 80 percent of the federal budget deficit.
More importantly, these large capital inflows financed a massive U.S. trade deficit that still remains at an unsustainable 5 percent of gross domestic product. To finance this deficit, the U.S. economy borrowed heavily overseas, selling everything to foreign investors, including home mortgages.
The result: a vicious cycle of debt, with foreign investors fuelling a housing market boom that required households to borrow money that foreigners were willing to borrow.
This process is now going into reverse. Stock market investors are selling off shares tied however tenuously to the U.S. housing market, thus fuelling the financial markets downturn. This sell off is also increasing worries about a broader credit crunch that could lead to further deterioration in the U.S. housing market.
The largest drawback of the debt boom was that it let U.S. policymakers get away with not addressing the country’s underlying economic problems. The fundamental weaknesses of the U.S. economy—a weak labor market, large budget deficits, and massive trade deficits, and an unsustainable housing boom—were masked by record amounts of debt, allowing the federal government to continuously ignore these problems.
Yesterday’s global stock market plunge came after President Bush once again ignored sound economic policy in his $145 billion economic stimulus package. Markets are not putting their trust in a president who has ignored the country’s economic weaknesses for his entire tenure—and then unveils a temporary tax cut that fully or partially excludes an estimated 65 million taxpayers who would be the most likely to spend the money to help our ailing economy and which still fails to address the fundamental threat the sharply deteriorating housing market poses for the economy.
What our country needs instead is some display of economic competence from the Bush administration and conservatives in Congress. What’s needed right now is a well-crafted economic stimulus package that is targeted toward lower- and moderate-income families to increase spending most efficiently and that includes support measures to strengthen the troubled housing and mortgage market. Progressives in Congress have put forth these proposals. A bipartisan effort to quickly enact these reforms and swiftly see President Bush sign them is perhaps the most immediate step our government can take to calm investors at home and abroad.
Christian E. Weller is an Associate Professor in the Department of Public Policy and Public Affairs, University of Massachusetts Boston, and a Senior Fellow at the Center for American Progress.