Policymaking

Among the worst examples of policymaking in response to a financial crisis is Japan, which is working on its third lost decade. The response to the collapse of the country’s real estate boom in the early 1990s was lots of deficit-financed government spending on roads and bridges to nowhere that nobody needed. When such Keynesian stimulus failed to work, the Bank of Japan joined in with zero interest rates and quantitative easing. The broken banking system was never properly fixed.

European leaders seem to be going down the same road. They repeatedly meet in response to the latest flare-up in their financial crisis, and agree that something must be done. The specifics are always vague, and the implicit assumption seems to be that if all else fails, the ECB will have no choice but to load up on the debt of debt-challenged euro zone governments.

This morning’s FT reports that the leaked draft of the communique of the latest meeting of the G20 boldly declares: “The euro area member states…will take all necessary policy measures to safeguard the integrity and stability of the euro area, including the functioning of financial markets and breaking the feedback loop between sovereigns and banks.” So don’t worry: They will do something.

Meanwhile, here in the US, Fed officials will start their two-day meeting of the FOMC today. They are widely expected to do something too. They might extend Operating Twist, though they are running out of short-term Treasuries. They might do QE3, though QE2 and Operation Twist didn’t really work. Indeed, in yesterday’s WSJ, Jon Hilsenrath reports that “Fed officials have been frustrated in the past year that low interest rate policies haven't reached enough Americans to spur stronger growth, the way economics textbooks say low rates should.” Could it be that they are starting to realize that monetary policy can’t fix all of our problems?

The Fed can’t do much about the “credit divide.” Fed Chairman Ben Bernanke has already warned that monetary policy can’t offset the coming “fiscal cliff.” So what is to be done? Simpson-Bowles! This deficit reduction plan provides a supply-side solution to our economic woes by slashing margin tax rates and corporate tax rates. It does so by eliminating $1 trillion of tax loopholes, which greatly simplifies the tax code. It should generate enough revenues to meaningfully reduce the federal deficit. It could happen after November 6.

Today's Morning Briefing: Then and Now. (1) Policy paralysis or policy pandering? (2) Punch losing its punch. (3) How to avoid a lost decade. (4) “Austerians” weren’t popular during Latin and Asian debt crises either. (5) Partnering with the markets to resolve a crisis. (6) Brady Bonds, RTC, SAP, and TLGP. (7) How Sheila Bair saved the day. (8) Europeans could lose a decade. (9) Reality bites the Fed. (10) The US could leap over “credit divide” and “fiscal cliff” with Simpson-Bowles. (More for subscribers.)