The Wall Street Journal-20080214-The Investment Slowdown

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The Investment Slowdown

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Yesterday, President Bush signed into law a $170 billion bipartisan "stimulus" package of tax rebate checks and housing subsidies to try to steer the economy clear of recession. The ink is hardly dry yet and Democrats are now agitating for a second "stimulus," in the form of infrastructure spending and welfare payments such as food stamps and longer unemployment benefits. All of this government check-writing is on top of the $3 trillion the federal government is already scheduled to spend this year.

Unfortunately, neither of these "free money" stimulus plans are likely to solve the nation's economic woes -- just as a similar economic rescue package of tax rebates and spending programs failed in 2001, the last time the economy slid into recession.

The current mortgage meltdown closely resembles what happened after the technology industry bubble burst at the end of the Clinton years. What Congress failed to understand, now as then, is that America is suffering from an investment slump driven by falling asset values, not a Keynesian consumption drought.

Much as we have seen with housing in recent years, in the late 1990s there was an irrational euphoria pushing tech stocks ever higher. The Nasdaq topped out on March 10, 2000 at more than 5000, up from 1400 just a few years earlier. Over the year and a half that followed, the Nasdaq lost two-thirds of its value and, across the economy as a whole, some $6 trillion in wealth was wiped out. For those heavily invested in tech stocks, it felt like a financial meltdown.

In response to the bursting of the tech bubble, Washington served up a Keynesian brew of demand-side stimulus. The Fed cut interest rates 11 times, hoping to pump liquidity into the market, and President Bush signed into law a tax rebate of up to $600 per household. (Sound familiar?)

There's a spirited argument about whether those rebate checks helped pull the economy out of recession. The evidence is mixed. The statistics tell us that the economy did pull out of the recession in late 2001. Instead of sprinting forward to make up for lost ground, however, as often happens at the start of a recovery, the economy and job market grew at a snail's pace. The stock market also remained bearish. Former Federal Reserve Board Member Wayne Angell noted at the time that "the economy will not fully recover until the stock market does."

Only after President Bush's 2003 investment tax cuts -- the second attempt Congress and the administration made at stimulating the economy -- did the economy start to gain speed. The key was to cut capital gains and dividend tax rates to 15%, from 35%, and to offer new tax write-offs for businesses investing in new plants and equipment.

Most Keynesians dismissed these tax cuts, saying they would not keep the economy from slipping back into recession because they wouldn't put a floor underneath consumer spending. But Americans' love affair with spending wasn't the problem. Between 2001 and 2005 consumer spending mostly stayed above 2% and in some years was well above 6%.

The investment tax cuts had two positive effects on the economy. First, almost from the day the tax cuts were enacted the stock market capitalized the value of the lower taxes on corporate profits and capital gains. Within months, the Dow Jones Industrial Average rose nearly 10%. And, we now know, the investment slump was converted into an investment boom. Business capital spending, down 4.8% in 2001 and 6.1% in 2002, surged in 2004 by 7.4% and in 2005 by 9.5%. It was this investment spurt that financed job and GDP growth in recent years. In short, what we experienced was a classic supply-side recovery.

The most recent GDP numbers for the fourth quarter of 2007 confirm that we're experiencing a replay of the investment slump of 2001-02. Consumer spending is slowing down, but it is still within its normal growth range (it grew 2% last quarter) and the numbers out yesterday were better than expected. Consumers are more cautious in their spending mostly because of the negative wealth effect of declining home values.

And, like earlier in the decade, the real economic drag today is from a slowdown in investment. Gross private investment topped $1.9 trillion in 2006. Last year it fell by $88.3 billion (with more than half of that drop coming in the fourth quarter alone). Most of that decline came in residential housing, but other areas, such as business spending is slowing too.

Why is investment declining? One explanation is that firms and investors know that there is a tax hike on the way when the Bush tax cuts expire in 2010. "The two big negatives for investment loom on the horizon," says economist Michael Darda, "higher tax rates and higher inflation due to easy money." Mutual fund data from the fourth quarter of 2007 confirm that a weak dollar and the risk of higher taxes are pushing capital overseas.

Republicans blundered by not insisting that extending the Bush investment tax cuts be part of any package. The GOP should also be pushing a permanent supply-side tax cut that would include expensing for business purchases, inflation-indexing for capital gains, and a corporate tax cut to bring capital back home.

Congress, the administration and the Fed are about to do very little for the economy. Sending tax rebates and cutting interest rates with the hope of sparking consumer spending -- without a corresponding increase in output -- will likely give us higher prices and little else. Before being sworn into office, politicians should be forced to learn Say's Law of economics, which tells us that no one can consume until someone produces. Our leaders in Washington need to look to the supply side if they want to avert a recession.

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Mr. Moore is senior economics writer for the Wall Street Journal editorial board.