WEALTH OF NATIONS

Why Obama Must Be Radical

Rather than splitting the difference between Democrats and Republicans, Obama needs to be bolder than both.

by Clive Crook

One of the things the country likes best about its new president is his taste for consensus. Barack Obama campaigned as a moderate, open to the views of people who disagree with him. His appointments seem to reflect the same attitude: He has chosen mostly centrists, including many veterans of the Clinton administration, with other viewpoints represented too. In planning his fiscal stimulus, Obama made a point of reaching out to Republicans in Congress. This attitude is widely admired, but one must ask whether Obama's preference for moderation, accommodation, and consensus is what these times require.

The economy's plight is extreme. Bold and unusual remedies are needed. This necessary radicalism, if you want to call it that, is not straightforwardly partisan, to be sure. This is not a matter of listening to one particular faction and ignoring everybody else. But at the same time, you cannot get to the right policy merely by trending to the middle and splitting differences between Democrats and Republicans.

Obama will have to be radical, first, in his approach to the shattered banking system. Despite the vast sums already committed to the effort to rescue banks and other financial institutions, the system is still broken. Lending has not recovered and confidence in the system's integrity is nowhere near restored. Without a well-functioning financial system to provide credit, business investment and consumer spending will stay suppressed, and the economy will revive only slowly, if at all. The first few hundred billion dollars of the Bush administration's Troubled Asset Relief Program were surely not wasted -- they contained the immediate crisis, despite the muddle and the changes of thinking -- but they were insufficient to fix the problem. Spending the second part of TARP in the same fashion, however, is likely to fail as well.

The Obama administration must grit its teeth and look afresh at the problem. The crux of the issue is the reluctance of the banks and the authorities to recognize the full extent of impaired assets. The hope was that asset values had undershot and, given time, would recover -- the perceived task was to hang on, patch and mend, and avoid an outright system-wide collapse in the meantime. Once, you could argue that this approach was worth a try. Now it is time to try something else.

The government must coldly examine the banks' assets and urgently come to a new reckoning. There is more than one way to proceed, but the key thing is that banks must be forced to write down their toxic assets -- not to "fair value," whatever that means, but all the way to what they are now worth in the market. This will make many banks insolvent. The best course then is to nationalize them. Even the ones that stay solvent will likely need the government to supply further new capital in exchange for equity.

The income tax raises comparatively little revenue despite comparatively high rates, a textbook case of bad tax design.

All told, this could be enormously expensive -- another trillion dollars and up -- but at least taxpayers will have paid no more for their resulting ownership of the banks than the institutions are worth. The principal losers will be the banks' previous owners, which is right. This unequivocating clear-out of the banks' balance sheets would create the basis for new lending and a stronger economic recovery.

The Left of the Democratic Party is all for nationalizing the banks (and not just the banks), but it has trouble with the next part of the radical remedy: tax cuts. Many Democrats are opposed to any and all tax cuts, just as many Republicans have suddenly decided that they oppose any and all increases in public spending. This partisan simple-mindedness threatens to delay the new administration's fiscal stimulus, and the economy cannot afford for it to be delayed.

It is most likely true that the first $1 billion of extra public spending on infrastructure will do more to raise demand and employment than the first $1 billion of tax cuts (although Obama's advisers are not entirely certain of the point). But even if you accept that view, the principle of diminishing returns applies: Once you have already commissioned the best infrastructure projects, made unemployment assistance more generous, and spent a lot of money in other intelligent demand-boosting ways, the case for using tax cuts for any additional stimulus gets stronger.

In a package of the size now contemplated -- more than $800 billion over two years -- there is plenty of room for both. And the right kind of tax cuts kick in quickly, faster than spending on infrastructure. The outlook for demand in 2009 and beyond is so poor that a bigger plan is warranted. That makes the case for including some tax cuts stronger still. Rather than splitting the difference between Democrats and Republicans, Obama needs to be bolder than both.

The same is true of the third part of the radical treatment that the economy requires: a plan for fiscal consolidation after this crisis has passed. For the moment, the U.S. government is a creditworthy borrower. In the aggregate, public debt in relation to national income is low by international standards, and foreign investors see lending to the Treasury as a safe investment in troubled times. At some point, though, that will change.

The necessary fiscal response to the economic emergency will cause budget deficits and the public debt to surge. This is part of the cure. It has to be tolerated. To get public borrowing back on a sustainable path, however, and to minimize the risk of a sudden flight from U.S. assets in the meantime, the Obama administration needs to commit itself now to medium-term fiscal restraint. It needs a plan to cut spending and raise taxes once the economy is back on its feet.

As soon as any such plan is suggested, both sides will lodge the usual partisan robo-protests. Democrats will want to raise taxes and leave spending unaddressed. Republicans will want to rely on spending cuts alone. As before, the right policy is bolder than either party advocates: not "split the difference" but "all of the above."

If the administration does the right thing, even many Democrats may complain about the higher taxes. The reason is that the federal income tax -- let alone the part of it that falls on the truly rich -- cannot supply all the needed revenue. Hollowed out by exemptions and deductions since the last big reform in 1986, the income tax raises comparatively little revenue despite comparatively high rates, a textbook case of bad tax design. The idea that reversing the Bush administration's income-tax cuts for the highest-paid will suffice to balance the books is mere fantasy.

Either the base of the income tax will need to be broadened (which will shift more of its burden to the non-rich) or other taxes, falling on a much wider segment of the population, will have to rise. The gas tax is an obvious candidate, assuming that the Obama administration is going to get serious about climate change. Entirely new taxes will most likely be required in addition: an explicit or implicit carbon tax, for instance; perhaps a European-style value-added tax (a national sales tax).

Many Democrats reflexively favor higher taxes because they assume that the burden will fall mainly on the rich. The rich have too much money anyway, they feel, so taking more away makes sense twice over. It makes them less rich (building, in this regard, on the progress of the past year), and the government needs the money. But the costs of retrieving the fiscal situation, not to mention honoring Obama's other promises (including near-universal health care and "affordable college for all"), are going to be far too big for this thin slice of the country to bear.

Here is a confident prediction. By the end of Obama's first term, almost all of us will be paying substantially higher taxes -- or public borrowing will be close to exploding in our faces if it has not done so already.

You have to wonder whether such politically unorthodox radicalism -- a new and bigger bank bailout; a bigger fiscal stimulus than now contemplated; and a believable commitment to future fiscal restraint -- could ever be the product of pragmatism and consensus. At first sight, it does not look like the line of least resistance.

Martin Luther King said that a leader was not a searcher for consensus but a molder of consensus. Before Obama even tries to be a molder, he must decide what he thinks. If he then chooses to be bold, he will have to persuade not only Democrats and Republicans in Congress but, more important, the country at large.

Obama is self-evidently an extraordinary politician, with the makings of a fine president and all the political capital any new leader could ask. The country trusts him and expects great things. The challenge is enormous.