James K. Galbraith

In a war economy, the public obligation is to do what is necessary: to support the military effort, to protect and defend the home territory, to stabilize the economy itself, and, especially, to maintain the physical well-being, solidarity, and morale of the people. These may not be easy tasks in the months ahead.

We are facing an economic war--but not exactly a war economy. That means we get the dislocation without the usual growth. The impact of the September 11 attacks now includes a 14.4 percent drop in stock prices in the first week and collapse in sectors related to travel and leisure, notably airlines, hotels, and resorts. As these events cascade through the economy, they will weaken fragile household balance sheets and precipitate steep cuts in consumer spending. This, in turn, will deepen layoffs and depress economic activity. The ensuing recession could be severe.

This is not merely a shock to a healthy system, requiring only limited measures to restore confidence and stimulate spending. Since 1997 consumers have been financing consumption in excess of income. Those who had stock-market winnings borrowed against them. Those who did not borrowed anyway. But capital gains turned negative 16 months ago, and consumers are in no position to borrow more. What has happened since September 11 consolidates and accelerates a pullback that was already well under way.

Estimates last summer by my Levy Institute colleague Wynne Godley were that unemployment would have to rise to 7.4 percent just to bring household expenditures into line with income. Unemployment would rise as high as 9.0 percent, Godley estimated, if households returned to normal post-World War II saving levels. That was before the recent events.

There is thus no chance that events will right themselves in a few weeks or that we will be saved by productivity growth, as Federal Reserve Chairman Alan Greenspan professes to believe; nor will the economy be rescued by lower interest rates or the provisions of the recent tax act, most of which take effect after 2004. Rather, we are in for a crisis; the sooner this is recognized and acted upon, the better.

Normally in wartime, largescale support to the domestic economy is not needed, because of vast increases in military expenditure. But what we face so far is a veneer of military action over a worldwide diplomatic and police offensive. In a $10-trillion economy, the $40 billion already appropriated for the military and for relief is minor.

Including the airline bailout, further programs exceeding $100 billion may soon appear, including unemployment insurance, extended tax rebates, and payroll-tax relief. But all of this is not likely to be sufficient. Indeed, the concept of "stimulus" should be discarded in favor of the objective of economic stabilization--implying a sustained effort commensurate with the crisis as it unfolds.

Business and capital-gains tax cuts are useless here. Without profits, reduced taxes on profits have no effect. And without sales, investment is not likely even if the tax regime favors it. The logic and also the motives of those proposing such measures are to be suspected. All wars attract profiteers.

Personal tax cuts pose another problem, even if aimed properly at working households: They may not be sufficient if anxious consumers are in a mood to increase their reserves. Of the available tax-cutting options, temporary cuts in payroll taxes are the best, since they will immediately boost take-home pay. Shibboleths about the Social Security trust funds should not stand in the way of this simple and progressive measure. And if Social Security reserves contribute to relief of the present national crisis, then we have a solemn moral obligation not to use that contribution as an excuse to cut benefits later. To repair the long-term damage to federal finances, Congress should repeal the tax cuts scheduled to take effect after 2004. That will help bring down long-term interest rates.

The cautious men are in charge at the moment; their attitude can only bring disaster. There is no danger of overdoing fiscal policy anymore; inflation stimulated by excess demand is not even a remote threat. The initial program could easily be three times what has been so far proposed.

Increases in spending on public health, education, transportation, and other areas are absolutely needed and should be funded liberally. But a new program of revenue sharing is most readily implemented, least likely to be dissipated in saving or imports, and also the least partisan in concept. Direct purchases by state and local governments now comprise nearly 10 percent of gross domestic product; they have been rising rapidly in the past few years and will fall rapidly as revenues are curtailed. To prevent this and create new capacity for state and local action, including direct job creation and social aid, revenue sharing could be on the order of $300 billion this emergency year, with a phasedown as events warrant. This would give state and local governments new fiscal capacity that they can use at once to avert tax increases and even permit tax holidays for local property and sales taxes.

How about monetary issues? Federal Reserve policy has completely lost domestic effect. Cuts in interest rates on September 17 had no discernible impact on the largest one-week decline in stock prices since 1933 and also none on economic activity. In wartime the Federal Reserve plays very little role; it must simply bring down long-term bond rates and hold them down. But even then, wartime monetary policy runs into a contradiction: It is inconsistent with a stable dollar, openly traded.

Here, the analogy to World War II mobilization is also misleading. Before World War II, the United States was the world's creditor nation; it enjoyed energy self-sufficiency and did not run a large trade deficit. None of these conditions now hold. As a result, a high-order Keynesian response will have global financial repercussions. To finance a major military or domestic economic effort, or both, risks driving down the dollar on world capital markets.

Lower interest rates worldwide after September 11 have kept the dollar up. In the short run, the recession will cut imports and improve the trade account; oil and gas prices may well decline. But in a global slump falling exports will add to our miseries; moreover, oil supplies could be disrupted in a wider war. And imports will rise again if large-scale Keynesian policies take hold.

Any of these scenarios could gravely destabilize the dollar. The natural reaction of the Federal Reserve would then be to raise interest rates, deepening the slump. Indeed, the Fed's opposition to economic-stabilization efforts now may rest more on unacknowledged dollar fears than on anything else.

What is to be done about this risk? The old reality in global finance is that debtors cannot run wars--or economic-recovery programs--without the organized assistance of their friends and allies. This, in turn, requires our commitment to a more stable and successful global financial system afterward.

The further reality is that the United States needs the sustained support of the world community for diplomatic, intelligence, and military purposes. This cannot be assumed to come for free--especially not from countries that have not benefited at all from the modern global order. A new and more just and stable global financial order will therefore have to emerge from the present crisis or we will eventually become mired indefinitely in fruitless and unending military struggles, with fewer and fewer reliable allies.

The modern system of floating exchange rates and unregulated international capital markets is only 30 years old. It may very well now prove unable to support a return to prosperity in the United States. This being so, planning for a transition toward a more stable system should begin soon; we may need to fix parities with the euro, yen, and sterling before long. And comprehensive debt relief for cooperating countries--Pakistan, to begin with--is needed now, as a down payment on a system of stable development finance after this conflict.

Finally, there is compelling reason to examine the structural sources of the U.S. trade position. Oil is a major factor; cars are a larger factor still. Reconstruction of our transportation networks and housing patterns so that they rely far less heavily on oil and on automobiles (and on airlines) may be the necessary domestic adjunct of real security abroad. A major national initiative in transportation and urban housing, planned now and launched soon, would also help absorb resources presently being released into unemployment by the private sector.

These are the first steps. If widespread unemployment or inflation cannot be avoided by preemptive means, then the entire experience of the New Deal and the war economy will seem pertinent once again.