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September 18, 2001, 8:00 a.m. Fiscal Footing America needs some powerful Fed solutions.

s our nation begins to cope with the aftermath of last Tuesday’s horrendous events, there should be no doubt that fiscal policy must play a key role in an American recovery. Monday morning, Alan Greenspan cut the fed funds rate 50 basis points to 3.0%. Well done Mr. Greenspan. Now loosen us up a little more.

This would be unacceptable. Intermediate and long term, the strength of the economy should be of paramount concern. Indeed, a strong economy will be an absolute requirement as the nation shifts to wartime footing.

Right away, we should seek to understand why the economy, which had been growing at more than 4%, started to slow. As we discussed in our August 23 column, the most pronounced symptom of the slowdown has been a dramatic decline in purchases of equipment, particularly high-technology. The investment slump that began during the latter half of 2000 and continues today resulted from a combination of overly-tight monetary and fiscal policy.

The underlying cause of monetary tightness traces back to the second half of 1999. To head off liquidity problems in anticipation of Y2K hoarding, the Federal Reserve pumped in money at double-digit rates. As this chart shows, the growth in the money base, measured as a six-month moving average, peaked at 22.6% in December. That was 3 times (15 percentage points) faster than its average growth rate of 7.8% during the 1990s. However, once it became clear that financial systems world-wide reached the year 2000 without incident, the Fed began taking money out of the system with a vengeance. By June 2000, money base was growing at a negative 6%, 14 percentage points below its average. Money growth only climbed back up to its average last month.

Roller-coaster monetary policy undoubtedly contributed to the investment slowdown. The excessive pumping in and then draining of reserves helped inflate then burst the technology bubble. And the continuation of tight money up through today has certainly discouraged some investment activity. But we believe that fiscal policy has played the bigger role in causing the slump — and can have a bigger influence on turning the economy around.

Tight fiscal policy stems primarily from the tax increases enacted during the early 1990s. In an effort to reduce federal deficits, tax bills passed in 1990 and 1993 raised income taxes by, among other things, adding rates of 31%, 36%, and 39.6%. As recovery from the last recession gradually picked up steam and real growth pushed people into higher brackets, those tax increases really began to bite.

Thanks to gains from the bull market and the wealth created from the technology boom of the 1990s, income from capital has been especially hard hit the last three years. As this chart shows, for the economy as a whole, investors and entrepreneurs, on average, now send $0.625 out of every dollar earned on added investment to federal, state, and local governments. That is 15% higher than the marginal rate in 1995 (54.1%) and 20% above the 1989 rate (51.9%). These ever-rising tax rates both raise the cost of capital and reduce returns to savers and investors, thereby limiting expansion of U.S. capital. Less capital, in turn, reduces labor productivity and economic growth overall.

Just as fiscal policy has helped create the problem, fiscal policy can provide powerful solutions. Picking the most effective ones should be a focus of the policy debate this fall.

STAY TUNED: In their next column, Aldona and Gary Robbins look at some specific fiscal policy proposals.

— Aldona and Gary Robbins operate Fiscal Associates, an economic consulting firm in Arlington, Va. Both are Senior Research Fellows with the Institute for Policy Innovation in Lewisville, Tex.