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Policy Issues, II

The President’s job proposals were a savvy mix of ideas, some of which were borrowed from Republicans, to avoid a wholesale dismissal of his initiative. Still, he left the problem of how to finance the ideas to the “super-committee”, which is to say, he passed the buck. Nevertheless, the President will probably get some of his proposals approved, notably the reduction in payroll taxes for employees and employers, which should provide some near-term impetus for growth. The Fed is likely to approve an “operation twist” initiative that may reduce lower interest rates slightly. But any near-term focus ought to remain on Europe and its efforts to avoid a Greek default and to shore up its banks and sovereign borrowers.
The European credit crisis remains outside our policy control, although it has the greatest potential to disrupt our markets and domestic growth. European policymakers have been slow to address the market’s concerns, which have remained a depressant on markets everywhere. But this very market turmoil is slowly forcing them to work towards real solutions.
The market volatility will not stop until it becomes clear that sovereign debt losses are manageable and won’t have debilitating effects on bank capital. Markets expect Greece to restructure its debt. So, it is necessary to prove to investors that even a sizable loss on Greek debt will not impair European banks. IMF head Legarde understands this and has been pushing publicly for a capital injection into the banks. A report in Der Spiegel this weekend suggests that the German government is moving in this direction and this might occur with allowing Greece to default. Just as the credit crisis in the U.S. in 2008 was not resolved until TARP injected capital into our banks and the Fed announced programs to stand behind money funds and other key institutions, the Europeans must come to this obvious and necessary conclusion. A default would force them there quickly, but it would be far better and less painful if European policy were proactive.
Domestically, I would prefer that the Fed stop paying interest on excess reserves rather than implement an Operation Twist. Banks are being paid 25 basis points on excess reserves, which is more than investors earn on a Treasury 2-year note. If they were paid zero, banks might be more aggressive on lending. But I’d support implementing both initiatives now. Similarly, I’d like to see much of the President’s proposals approved. Policy should be focused on what can be done to provide greater impetus for growth.