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The question posed in an economics course circa 2007:
What policies (monetary, fiscal or a combination of these) would you recommend for the current state of the U.S. economy?

Here is the response I wrote, unedited from the original submission.

Currently, the US is undergoing a cyclical contraction that is to be fully expected given the state of the world economy. After several years of robust growth, the global economic boom is producing increased prices for a variety of basic materials, especially due to significant demand from China and India. Further, a significant and growing trade deficit implies that demand for US good and services is declining. Our own domestic growth pattern suggests that a period of contraction is necessary in order to prevent significant inflation, especially after posting three years of growth despite several events (starting with the terrorist attacks in September 2001) that would suggest a change in expectations of business owners toward slower or non-existent growth.

An overheated housing market has caused people to ``cash out'' on home equity loans and lines of credit, pushing debt levels higher without any underlying support for such debt. This extra money is likely a significant reason for continued consumer demand in the face of economic uncertainty. With the Federal Reserve tightening the money supply, via a series of seventeen consecutive increases in the prime lending rate, adjustable rate mortgage holders are likely to start scaling back consumption to meet debt service requirements, or otherwise convert to a fixed rate mortgage. New construction starts and existing home sales have shown signs of slowing down in the last few months, and this trend will most likely continue in the coming months.

Due to the increased costs of various commodities (as measured by the CPI-U), consumers are likely to scale back consumption in response to lower disposable income. While there has been some moderation in fuel prices recently, the price of gasoline has caused some people to put off purchases of big-ticket items or cancel such purchasing plans altogether. Of course, high fuel prices is not all bad news: windfall profits for oil refining companies like ExxonMobil and BP have been recorded, though perhaps BP took a bit too much profit, as the CFTC is now investigating BP's oil trading practices. Those who invested in refining companies probably complain less about high gas prices. The air travel industry has been taking steps to bolster demand, often without success, as the cost of fuel, higher health care costs and wage demands contribute to larger expenses.

The continued trend of American consumers to engage in dissaving is also a factor likely to induce lax demand. Over the past several years, low interest rates have induced people to spend well beyond their means; while the original intent of low rates was to bolster slackening demand in the face of the late 2000 slowdown, perhaps the Federal Reserve was too slow in reversing the drastic rate decreases. Now that many people are burdened with significant debt, servicing that debt is a higher priority, especially given the new bankruptcy laws. The most likely result of this will be a marked decrease in consumer spending over the next few years, producing a stable or slightly declining GDP. This may in turn induce businesses to have lower expectations, scale back production, and thus lead to rising unemployment. Continued uncertainty in the global economy, especially with political instability in Iran and North Korea, will further contribute to lower expectations.

Our first recommendation is to encourage saving over spending, or in the case of people who are saddled with debt, debt repayment over spending. The intent is to prevent bankruptcies from becoming endemic, and to produce a more controlled decline in consumer spending rather than a drastic falloff. (There is no sense in avoiding the inevitable: consumer spending is going to decline in the coming quarters.) With the recent rise in interest rates, savings vehicles such as certificates of deposit, money market accounts and even passbook savings accounts should start to offer a more compelling rate of return; coupled with the results of higher borrowing costs (and often existing debt servicing costs), hopefully some level of debt reduction will occur naturally. The recently passed Pension Protection Act of 2006 is likely to further add to savings incentives. While these measures are laudable, more can be done. By offering tax incentives for people who eliminate their credit card debt, people are far more likely to focus on debt repayment. For those people who already have paid off or do not carry discretionary (i.e., non-mortgage) debt, a tax break in the form of an exclusion of taxation on interest earnings would probably have the desired effect.

The point of increasing savings is not to do so at the entire detriment of spending. After all, any large-scale reduction in consumer spending will have a dramatic effect on GDP due to the circular flow: as consumers pull back on discretionary spending, firms will scale back production, lay off excess workers who in turn further scale back their own spending, unemployment insurance costs will increase as the number of initial claims rises faster than the re-hiring of idle workers, and finally firms may continue to lay off (or consumers will continue to scale back due to lower pay) as a result of higher unemployment insurance costs. Clearly, avoiding an avalanche in consumer spending is a priority. However, enforcing some level of financial responsibility among the populous is a good idea to avoid bankruptcies. Newer bankruptcy laws have already started to have an ill side effect, with a large number of involuntary bankruptcies occurring due to the increased rate of repayment on existing debt.

Our second recommendation is to offer incentives for firms to export goods and services. As a net importer, our current trade deficit has been a constant political flash point. Concurrently, many special interest groups have been fighting against trade liberalization, which is a path to simpler exportation procedures. While the current WTO talks (Doha Round) has resulted in a stalemate on some such issues as agricultural subsidies, recent advances will hopefully lead to greater exportation activity. (CAFTA is a good example of such a measure.) The hope is that an increase net exports (which is currently a very large negative number) will offset any decrease in consumer spending, dampening or reversing any potential decrease in GDP. Offering streamlined export controls and tax incentives to export to countries from which we import a great deal should have the desired effect. Contrary to current popular belief, a weaker dollar does not appear to be producing increased exports. Focused tax rebates can be used to shore up the current trade deficit if applied properly.

A third recommendation is to continue the reduction of welfare benefits as well as reform of welfare administration. Much attention has been given to the ``working poor,'' people who are employed full time (or have more than one part-time job and work more than 40 hours per week) but do not earn a sufficient ``living wage,'' but less attention has been given to people who have joined the ranks of discouraged workers or people who refuse to work because of lax welfare administration. While there has been much progress since former President Clinton first re-introduced the issue of welfare reform in 1996, the sheer size of such transfer payments represents a significant waste of funding that could be used to address pressing issues such as energy independence research, health care reform and tax rebates for programs we have mentioned.

Our final recommendation is the reform of tax credits in research and development. The last time Congress considered this topic appears to be in 1981, when the Research & Development tax credit was created. The Federal Reserve Bank of San Francisco recently released an economic letter regarding this issue, in which economist Dan Wilson cites that ``[w]henever different jurisdictions separately choose tax policies that may benefit their own jurisdiction at the expense of others, there is the potential for tax competition.'' The current R&D tax credit framework is hopelessly outdated and full of loopholes that lead to wasteful spending of taxpayer dollars on pork barrel projects with little or no economic usefulness. There has been more interest in alternative energy sources in the past year, largely due to high fossil fuel prices. Instead, R&D tax credits should be issued for pioneering work in new sources of energy or the improvement of existing sources such as solar and wind power. Little incentive exists for this type of work to take place, especially in light of the windfall profits at fossil fuel refiners previously mentioned. Tax credits would likely induce such work, and help to reduce our trade deficit in the future as our importation of fossil fuel is reduced.

In summary, a combination of both fiscal (tax credits, transfer payments) and monetary (interest rates, monetary base) policies - as well as reform of existing policies - is needed in order to correct the current state of the economy. What is not covered by fiscal or monetary policy is expectation management: citizens should not view a controlled recession as a bad event, but instead as a necessary state of a normal global economy. Since expectations are a key part of the economic cycle, managing expectations properly is no less important that proper administration of tangible policies.

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