While everybody is clamouring for another interest rate cut one guy keeps his eye on the ball..

Lawrence Summers uually speaks his mind. He ran into trouble doing so when he said something which according to some he shouldn’t have as head of Harvard University (he argued that the low number of women in science was perhaps not totally the result of discrimination). But he is a brilliant economist, few doubt that. And he’s also right about what to do next.

Although an interest rate cut would be of considerable value, but that value would largely be symbolic. It’s what Japan did in the 1990s, but it didn’t help a great deal. No matter how cheap money is, you can’t force banks to lend it out.

Two other options are open, although one is already frantically used by the Fed (and other central banks, like the European Central Bank, the ECB). They, but especially the Fed, are pumping great amounts of liquidity in the markets.

This is like printing money, and that is what finally got Japan out of it’s slump when they embarked on these kind of policies after struggling with asset (and real) deflation for over a decade.

The other method is still open, another fiscal stimulus. In theory, this works better than rate cuts. But it depends a great deal how it is executed, and there is where things get messy, because that depends on politics and especially in election times, other forces than economic rationality play a dominant role, unfortunately.

For most effect, fiscal stimuli has to end up there where the chance of actually being spend is the largest. It’s no good to give people large tax breaks who will just hoard it. This means it’s best to:

1. Give tax breaks to the poor. The richer you are, the more likely it is you will just hoard much, or even most of it
2. A good cause can be made for helping people who have severe problems with mortgages, as this can prevent foreclosures and stop at least some of the rot in the housing market
3. Another good candidate are the states, many of them are bound by very stringent fiscal rules, which forces them to cut money for things like education (with dire long-term consequences) and add to the downward spending spiral, rather than trying to revive it.

Summers: New Stimulus, Tax Cuts Now
Tuesday, October 7, 2008 9:36 AM

• Former Treasury Secretary Lawrence Summers says a fiscal stimulus program must be added to the $700 billion financial bailout to prevent the economy from sinking into a deep morass.
• “In the current circumstances, the case for fiscal stimulus — policy actions that increase short-term deficits — is stronger than at any time in my professional lifetime,” Summers, now a Harvard professor, writes in the Financial Times.
• “Unemployment is almost certain to increase — probably to the highest levels observed in a generation.” Job losses hit a 5½-year high last month, when the unemployment rate totaled 6.1 percent.
• Monetary policy can’t bring the economy back by itself, partly because interest rates already are low, with the federal funds rate at 2 percent, Summers says. So the Federal Reserve doesn’t have much room to ease further.
• In addition, the economy is in too much trouble for monetary policy to work alone, he maintains.
• “Experience around the world with economic downturns caused by financial distress suggests that while they are of uncertain depth, they are almost always of long duration.”
• So, government spending and tax cuts are necessary to put people back to work and buoy the economy, Summers argues.
• Certainly, the government shouldn’t forget about the budget deficit, he writes. “Nothing in the short-run case for fiscal stimulus vitiates the argument that action is necessary to ensure the U.S. is financially viable in the long run. We still must address entitlements and fiscal sustainability.”
• Summers isn’t the only one concerned about unemployment. Wachovia’s senior economist Mark Vitner says the jobless rate will surge to 8 percent before the economy rebounds.