A recession looms again if policymakers don't wise up

As I wrote this Thursday afternoon, the Dow Jones industrial average was free falling, heading for a loss of 391 points or 3.5 percent. This followed a loss of almost 300 points the day before, and a drop of nearly 15 percent since stock prices peaked in the spring. In good times such a plunge would be painful. Given the economy's current distress, it is too much to bear.

The stock market plays a central role in both sentiment and the real economy. Higher-income households have much of their net worth tied up in stocks, and big companies use their stock prices to determine whether they should hire and invest. The stock market thus is a real-time report card showing how well we are doing.

We aren't doing so well. Investors have been spooked by the economy's stall. Just a few months ago, businesses were hiring strongly and unemployment was moving lower. It looked as though the economy was set to take off. But then Congress and the Obama administration came to loggerheads over the federal budget in the spring, bringing the government to the brink of a shutdown.

Washington's summer battle over the federal debt ceiling was an over-the-top spectacle. President Obama felt compelled to warn Social Security beneficiaries that they might not receive full payments unless the ceiling were raised. Even military personnel worried they wouldn't be paid in full. Rating agency Standard & Poor's downgraded the nation's debt in response.

European policymakers committed even more egregious errors, most seriously their failure to continue bailing out Greece's floundering government. Greece is likely to eventually default on its mountain of public debt, but this cannot happen now or investors will fear a similar fate for Portugal, Ireland, Spain, and Italy. The turmoil in financial markets will only intensify.

Europe's banking system could also collapse. Its banks are hip-deep in the debt of troubled European nations, and have made loans to businesses, households, and other financial institutions in these nations. Banks simply do not have enough capital to withstand the losses they would suffer on these loans, and even the French and German governments would be hard-pressed to fill in the hole that would open up.

Europe needs to bail out Greece long enough to insulate the rest of the continent from the fallout of a default. Yet it is taking a painfully long time to muster the political will to do this. Damage is spreading to the European economy and financial markets, and given that the United States is economically tethered to Europe, our stock market and economy are being dragged down as well.

The Federal Reserve has aggressively responded to all this. Just a few weeks ago Fed officials said they would not raise interest rates for at least two years, and last week they announced plans to buy more long-term Treasury bonds to lower long-term interest rates, which are already very low, even more. Fixed mortgage rates will soon fall below 4 percent, a record.

Lower interest rates are helpful, but they're not a silver bullet. Indeed, the Fed last week also warned of growing risks to the economic outlook. While that wasn't news, the central bank's dark words crystallized investors' fears, triggering the latest stock market sell-off.

This all threatens to become self-reinforcing and self-fulfilling. The stock market reflects problems here and in Europe, but each 100-point drop in the Dow raises the odds of a new recession, as wealth evaporates and nervous businesses resume cutting payrolls.

Only aggressive action by Congress and the president can short-circuit this negative cycle. There is irony in this statement, because Washington's bad policymaking undermined the recovery earlier. Still, the only way to avoid returning to recession is for policymakers to do the right thing now.

First, they must follow through on the debt-ceiling deal and agree to additional long-term deficit reduction. They've agreed to how much needs to be cut from future budget deficits and made some progress getting there, but they must agree to more before the year is over, and they have to do it in a reasonably graceful way. The inevitable political rhetoric can't be allowed to boil over as it did this past summer. That would be unnerving.

Lawmakers must also scale back some of the tax increases coming our way. With no action, everyone's payroll-tax payments will increase next year. The president has proposed extending the current payroll-tax cut for another year, and even deepening it a bit. This is absolutely vital. Extending the cuts may be costly to the budget, but a new recession will cost taxpayers much more.

I was optimistic about the economy's prospects earlier this year. I was clearly wrong. I didn't count on such large errors in judgment by policymakers. Perhaps I'm still too optimistic, but I'm counting on them to get it together, at least enough to avoid another recession. They had better act soon.