11/28/2008 05:12 am ET | Updated May 25, 2011

The Urgent Case for a Big Stimulus

Making banks solvent was never going to be all that was necessary to make the American economy whole again. The inexorable recessionary process is now well on its way. We will learn more about how far and fast we are sinking in the next couple of weeks, as the data become more clear. But reports of serious lay-offs are widening. Few are borrowing, or can borrow. There is little spending power out there. Except for the late 1990s, Americans simply did not make enough to get by without borrowing. In the 2000s, wages for typical Americans did not go up at all, nor did family income. Now they will go down. Where will the spending power come from? Living on a credit binge is over.

Perhaps the Paulson plan will work and banks may have adequate capital. But they won't lend it. This is by now an ancient paradox, one forgotten time and again. Businesses won't borrow in times of recession unless they see signs that sales are coming back. Of greatest irony, even Milton Friedman did not believe solving the banking crisis in the early 1930s was enough. Friedman's position is widely misunderstood. Supposedly knowledgeable Harvard historians don't seem to know this. Maybe even some liberal economists don't, either. Friedman argued that the Federal Reserve had to step on the gas. Stopping a run on banks was not enough.

To repeat, making banks whole is at best half the solution. The nation needs spending power. But monetary policy a la Friedman won't be nearly sufficient, either. I don't mean pumping up the money supply. That was discredited some time ago. The Fed doesn't control it as closely as popular myth suggests, and its relationship with growth is highly variable.

Rather, we've escaped recession after recession in recent decades by partly reducing interest rates. Now, however, interest rates are very low. There's not much left in the monetary tank. Moreover, as Nobelist Lawrence Klein has argued repeatedly, stimulus works best when both guns are firing--monetary and fiscal stimulus. The latter means growing budget deficits.

Given the breadth and depth of the problems, we need a lot of federal spending. Sound like John Maynard Keynes? You bet. The collapse in stocks and housing will have an enormous depressing "wealth" effect on consumption and investment. A shock to demand would require a spending increase of two percent of GDP, anyway.

So let's say $300 to $600 billion is what we need pumped into the economy -- and fairly soon. The good news is that money can be directed towards the public investment in such dire need of advancing: infrastructure, alternative energy development, pre-K education, broadband capacity. Much of this will create domestic jobs. The unemployment insurance system also badly needs updating and broadening. States and local government are shutting down services and need money badly.

The bad news is that the anti-government attitudes are still with us, even if Obama wins. The fear of big deficits will restrain liberal economists for recommending what is necessary. The nation is still locked into the ideology of the past and the sense that American cannot afford to do what it must.

The opposite is true. If we don't stimulate the economy, tax revenues will fall far faster and deficits rise, anyway. But they won't be the deficits of constructive investment. They will be the deficits caused by unnecessarily lost income and wealth. It's a difficult but necessary choice. Will the new president make it?