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The Recovery That Won't Stop Stalling


As summers go, this one has been no picnic for President George W. Bush and his economic advisers. The economy, which sagged through much of 2001, was supposed to be sizzling by now. The stock market, which last spring looked ready to bounce back, took a gut-wrenching tumble in June and July. Business investment has stalled. And consumers--long the mainstay of the economy--may be flagging as slowing wage growth and the destruction of trillions in stock market wealth take a toll.

As the recovery wilts in the summer heat, worried investors and voters are looking to Washington for help. But politicians in both parties appear reluctant to tackle head on what now appears to be a more shaky recovery than anyone was expecting just a few months ago. The Administration seems bent on doing little more than tinkering. The centerpiece: offering bite-size tax cuts aimed at propping up the stock market and boosting long-term investment. Meantime, deficit-shy Democrats have offered few ideas of their own. The result is political inertia at an increasingly fragile phase of the recovery.

While Washington seems hesitant to take bold stimulative steps, there are rising calls from Wall Street for more aggressive action. Among the demands: another round of interest rate cuts, combined with stepped-up tax cuts and spending increases to prevent the economy from slipping into a double-dip recession. Says James W. Paulsen, chief investment officer at Wells Capital Management: "The problem with the economy is a lack of sufficient demand. Any fiscal stimulus is welcome."

So far, Americans have heard mostly pep talks from Cheerleader-in-Chief Bush and Alan Greenspan. But the Federal Reserve chairman did concede on Aug. 13 that economic risks have risen. Outside the Beltway, moreover, pessimism is growing. Excluding gasoline and cars, retail sales were flat in July. And the situation has grown worse, with chain stores reporting an outright drop in sales during the first two weeks of August, according to the Bank of Tokyo-Mitsubishi Ltd. (MBK).

Business purchases of computers and other equipment are also tailing off. Faced with a barrage of criticism from shareholders and lawmakers, corporate chieftains are focusing on cleaning up balance sheets rather than building business. Consulting firm G7 Group Inc. said on Aug. 20 that its business spending index--which predicts capital outlays--has fallen sharply so far this quarter.

Even the red-hot housing market is cooling off. The National Association of Home Builders reported on Aug. 15 that its housing-market index fell in August to its lowest level this year. In response to all this gloom, consultant Macroeconomic Advisers LLC has lowered its growth forecast for the rest of this year to 2.5%, from 3.4%. And pessimistic prognosticators fear the economy will double dip back into recession, though they remain a distinct minority.

The prevailing view in Washington? The White House, the Fed, and many in Congress still believe that the economy will right itself. That's in sharp contrast to a year ago, when a fiscal and a monetary jolt enjoyed broad support.

There is another reason for the reluctance to act. Policymakers have less room to maneuver now. With interest rates at 40-year lows and budget deficits roaring back, they feel they have already done a lot to boost growth, and they worry about the long-term consequences of doing more. Says Representative Rob Portman (R-Ohio): "The issue is the deficit and how much [a tax cut] will cost."

Short-term rates are at 1.75%, and the Fed wants to conserve what little ammunition it has left in case the economy dramatically downshifts later. Says Chicago Fed President Michael H. Moskow: "The road to recovery is turning out to be bumpy. [But] the Fed cannot--and should not--try to smooth out every bump."

But those bumps are exactly what have voters nervous. With one eye peeled for pink slips and the other looking for more dismal 401(k) statements, Americans are increasingly uneasy and may well take it out on politicians in November. And Bush is starting to feel some heat. A July 29 ABC/Washington Post poll reported that the number of those surveyed who back the President's handling of the economy had dropped to 57%, down from 72% last November.

No doubt those numbers had something to do with Bush's hint on Aug. 16, just a few days after his Waco economic summit, that he'll soon unveil a new economic strategy.

Unlike his 2001 tax cut, which sought to boost consumption, and the early 2002 tax reduction, which tried to jump-start investment, this go-round promises to be much less stimulative in the short run. Rather, it would shift tax policy to encourage long-term savings. Says White House Council of Economic Advisers Chairman R. Glenn Hubbard: "The point is to pick policies that are pro-growth and promote the fundamentals of long-term investing."

Among the ideas Bush is mulling: allowing investors to write off more stock market losses against their taxes, making it easier to contribute to and withdraw from tax-advantaged savings accounts such as 401(k)s and Individual Retirement Accounts, and reducing taxes on corporate dividends.

Critics argue that such proposals would be little more than a giveaway to investors. Says Brookings Institution economist William G. Gale: "If we agree that the stock market was overvalued and has now adjusted, what is the purpose of trying to manipulate the market through fiscal policy?" Even conservatives who like the Bush plan as long-term tax policy worry about its timing. Says Cato Institute Chairman William A. Niskanen: "If they try to hurry up [the plan], they're likely to do something silly."

One possible idea--to let investors use up to $20,000 of stock market losses to reduce taxes on other income--would be aimed largely at those clobbered by the bear market. Some critics complain that any such bailout would aggravate the market's decline by encouraging investors to dump even more losers. And the plan does nothing to help the vast bulk of investors whose IRAs or 401(k)s took a hit because no taxes are paid on trading inside those accounts.

Another possible Bush initiative, lowering the existing 20% tax on capital gains, has broad GOP and business support, but Democrats deride it as welfare for the rich. Without Dem backing, a cap-gains cut is unlikely to pass.

The most far-reaching of Bush's likely proposals would trim taxes on corporate dividends. Today, investors must pay tax on dividends, but businesses are not allowed to deduct the cost of paying them. As a result, about $350 billion in dividends is taxed twice.

Bush is likely to propose letting individual investors exclude from taxable income perhaps up to $1,000 a year in dividend checks. For decades, economists have argued that ending double taxation is an important step toward reforming the U.S. tax system. It is unlikely that Bush will want to go that far, which could cost in excess of $40 billion a year. But adopting the partial exemption, for about $4 billion a year, would be a step in that direction. Cutting taxes on dividends could also boost stock prices, since today's market values reflect the extra cost of the tax.

Democrats, eager to capitalize on what they see as Bush's unfocused economic management, are already blasting his tax plan. Representative Robert T. Matsui (D-Calif.) says Bush's ideas "are probably the least productive way to go." Instead, Democrats would rather spend the money on their own agenda.

But their proposals are also modest. They would allow jobless workers to get an additional 13 weeks of unemployment benefits, increase the $5.15-an-hour minimum wage by up to $1.50, and tinker with the pension system.

A few Senate Democrats, including Majority Leader Tom Daschle (D-S.D.), have toyed with the idea of accelerating personal tax-rate cuts scheduled to take effect in 2004 to give the struggling economy an immediate booster shot. To avoid even bigger deficits, they'd freeze other parts of the 2001 tax cut rather than let them take effect in 2006 and beyond. But because the scheduled '04 tax cut trims only a modest one percentage point off individual rates, speeding it up would add just $7 billion in new stimulus to the $10 trillion economy.

Deficit fears are keeping Democrats from embracing major new spending. This year, the deficit is expected to top $160 billion, and most analysts expect it will hit $200 billion in 2003. Bush is already blasting Congress for spending too much.

As a result, Democrats, who once could be expected to propose big new spending initiatives on such infrastructure projects as roads and bridges in response to the slowdown, have remained relatively quiet. The federal government is already spending roughly $27 billion a year on highways. And while Congress and the White House are battling over the fate of an extra few billion, there is little chance that lawmakers will try to add much more.

Congress will almost certainly boost spending for defense and homeland security. It will soon approve about $355 billion in military spending for the fiscal year beginning in October--some $30 billion more than the Pentagon will spend this year. That will help, but if the economy continues to sputter, Washington may wind up wishing it had taken out a much bigger insurance policy against the slump that won't go away. By Howard Gleckman and Rich Miller, with Amy Borrus, in Washington


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