Obama Is Wrong. Radical Tax Cutting IS The Answer.

Barack Obama has been very consistent about several elements of his storyline. It has three basic parts: First, the financial system just needs a little confidence. Second, the economy just needs a huge dose of spending on left-wing priorities. Third, and key to the point here, tax cuts don’t work.

Obama always frames the point about taxes in a political context, something like: “the last eight years have proven that tax cuts are bad for the economy.” So by taking him at his word, I’m at risk of misreading statements that may be meant only to shift blame for the difficult economy onto the Republicans. But here goes, anyway.

The great and abiding fear of Obama and his advisers, is a deflationary spiral, in which wages and prices fall, and people who owe money find it harder and harder to get by. (Debt-service generally consists of periodic payments of fixed size, so if the real value of the payments increases as overall prices fall, then debtors start defaulting more.)

And history suggests when you get a deflationary spiral, you can’t get out of it, and it sticks around for years. What history? The Great Depression, and the “lost decade” in Japan. (Shockingly, Obama even mentioned the lost decade in his press conference the other night. Aren’t Presidents supposed to avoid talking about worst-case scenarios?)

Unfortunately, there are several big problems with Obama’s approach.

First, he really doesn’t know what he wants to do about the problem, other than spend nearly a trillion borrowed dollars to increase funding for a vast array of government programs, many of which are priorities of the political left wing.

Second, the President is profoundly misreading the mood of the country. The other night on national television, he repeated almost literally the conventional wisdom that the economy suffers when people save more money. (Confusingly, he also warned us that the era of debt-financed consumption and investment is over.)

The President’s people are hoping against hope that a big pulse of spending will keep us from tipping over the edge into full-blown deflation. There is a deep error baked into this, which is this: the deflation is already here. We shouldn’t be pursuing counter-cyclical macro-policy at this point. Rather, we should be looking for ways to keep individuals from hitting the wall, where they face the choice of making their mortgage or credit-card payments, and buying food.

Americans figured out months ago that they should be paying down their debt. There’s almost a sixth sense for when job losses will increase, and salaries and wages will fall even for those who don’t lose their jobs. This “paradox of thrift” absolutely will result in a weaker economy, but the Administration needs to face the fact that there’s nothing they can do about this.

Instead, they need to figure out how to support the people who are desperately scrambling to pay down their debts. This is a way to directly avoid the deflationary spiral.

The standard argument against cutting taxes in a recession is that people who receive extra money will tend to save it and pay down debt, whereas countercyclical economic dogma says that you have to spend more, rather than save. That’s what Obama is talking about when he says that tax cuts aren’t the answer.

But tax cuts actually are the answer. The economic weakness is a forgone conclusion, because it results from de-leveraging. You can’t put that genie back in the bottle.

The most radical, and effective, thing we could do for the economy right now is this: Stop collecting all forms of Federal business, income and payroll tax. EVERY PENNY OF IT. RIGHT NOW.

Gasp! Yes, I said it, and I meant it. Go on an absolute, 100% Federal tax holiday. That’s a real shot in the arm that would suddenly inflate the economy by a solid $1.5 trillion or more per year.

Are you worried about the resulting fiscal deficits? Don’t be. There is a huge amount of demand for debt from global investors, and the credit crunch has blown a huge hole in private debt formation. That leaves a lot of room for the government to borrow more.

It’s absolutely NOT the case that my radical tax holiday would cause GDP to shoot higher. People absolutely WILL save a very big chunk of the money and pay their debts down. But that’s going to give them the ability to weather the coming deflationary cycle, and do wonders for their confidence. A few years from now, we’ll all be in a position to start growing again, from a lower base.

But we’ll have avoided the most socially corrosive and damaging effects of deflation. We’ll avert many of the personal and business bankruptcies that would have occurred, and we’ll put a floor under the unemployment rate. We won’t return to strong growth soon, but that wasn’t going to happen anyway.