...this particular recession is unique not in its dimensions, but in its sources. First, it is the result of a financial crisis that severely affected stock-market valuations. The bad equilibrium did not originate in the labor market, but in the credit market, where investors are reluctant to lend to risky firms. This reluctance is making it difficult for these firms to refinance their debt, forcing them to default on their credit, further validating investors' fear. Thus, the problem is how to increase investors' willingness to take risk. It's unclear how the proposed stimulus package would help inspire investors to do so.

The second reason this recession is unusual is that it was caused in large part by a significant current-account imbalance due to the low savings rate of Americans (families and government). Even assuming that more public spending would increase private consumption -- a big if -- such a measure would cause even more imbalance.

So how do we stimulate the economy without increasing the already large current-account deficit? It's not easy, but here is an idea: Create the incentive for people to take more risk and move their savings from government bonds to risky assets. There is no better way to encourage this than a temporary elimination of the capital-gains tax for all the investments begun during 2009 and held for at least two years.

If we fear this is not enough, we can temporarily increase the size of the capital loss that is deductible against ordinary income. This will reduce the downside of new investments and increase the upside.

With all due respect to Messrs. Alesina and Zingales, who have much better credentials (and are probably much smarter) than I, temporary tax cuts have temporary effects. As such, temporarily removing capital gains taxes will likely encourage risk-taking in the short run, but at the expense of risk-taking in future periods. To use an analogy I've used before, it's the same concept as auto companies "borrowing" the sale of cars from future quarters via zero percent financing, employee pricing, etc. "Get our investments in now at the cheaper rate, even though we'll have less capital available to invest in the future.", would be the thinking. A similar impact would likely occur if President Obama decided today to raise the capital gains tax at some future date. We would see an influx of capital flows into risky assets today at the expense of later flows. Net-net, you haven't "created" anything, you've just made it more volatile.

What we need is a stable risk-taking environment so that investors can evaluate the merits of taking risk and determine what the payoffs are in the short-term and the long-term. I am certain that candidate Obama's rhetoric on capital gains (as well as corporate tax rates, depreciation allowances, etc.) and his team's comments in the days up to his inauguration are playing some role in what investors view as an appropriate risk-return tradeoff. Obama could encourage risk-taking by simply explaining what he wants to do.

The Dems keep on partying every day for the next 4 years. Let them spend $1M per day. I’ll gladly pay taxes for their $365M per year on parties so long as they pass no legislation, leave security to the current professionals and let the market fix itself. They could even spend $2M per day. That only adds up to $3B.

They may just go for it.

Update [1/21/2009]... A little less rallying, please! Reader RW Cooknotes,

I am tracking the Obama moments as they pertain to the SP 500 (by way of Vanguards Index 500 fund). The day of Obama’s acceptance speech for the nomination was the last day VFINX was over $120 after treading water for several months. Now it’s at $74.17. The day after the election VFINX was off $4.83 or 5.2%. Inauguration day VFINX was off $4.13, or 5.27%. Just as Kerry’s poll numbers went down every time he made a public appearance during his presidential campaign, Obama costs us 5% each time he does something!

“In the days ahead I will propose removing the roadblocks that have slowed our economy and reduced productivity. Steps will be taken aimed at restoring the balance between the various levels of government. Progress may be slow, measured in inches and feet, not miles, but we will progress. It is time to reawaken this industrial giant, to get government back within its means, and to lighten our punitive tax burden. And these will be our first priorities, and on these principles there will be no compromise.”

-- Ronald Reagan, January 20, 1981 Inaugural Address”

“At this particular moment, only government can provide the short-term boost necessary to lift us from a recession this deep and severe.””

--Barack Obama, January 8, 2009 Address at George Mason University

I speak for administrative efficiency, for lightened tax burdens, for sound commercial practices, for adequate credit facilities, for sympathetic concern for all agricultural problems, for the omission of unnecessary interference of Government with business, for an end to Government's experiment in business, and for more efficient business in Government administration.

Occasionally I delve into the other blogs and topics you reference. So I checked out Mr. Delong's blog and although he is probably smarter than me I think I can find a few flaws in his argument. For instance when talking about how government spending stimulates and how Eugene Fama is wrong about all this he states:

Suppose that it is Friday, January 2, 2009, and all of a sudden the federal government borrows some money--reducing savings--and buys some extra stuff. Savings is still equal to investment on January 2: savings went down because the government ran a bigger deficit but investment also went down because firms sold extra and so their inventories dropped.

What happens on Monday, January 5? Over the weekend the firms mark the value of the goods in their remaining inventory up: inventories are now scarce. They revisit their production plans. Sunday night they call some extra workers and tell them to show up on Monday--that they are expanding production because they are now short of inventories. So when Monday rolls around more people are at work. Thus incomes are higher on Monday than they were on Friday.

If only companies marked up unwanted inventory then we would all be rich and prosperous! I think what he fails to realize (or ignore) is the gain he is referencing is an imbalance in the normal supply/demand relationship. What has happened is that the government has shifted private spending from something valued higher to something valued lower. This must be the case because if the new spending were valued higher in the first place the "unwanted" inventory would not have accumulated in the first place. It would have been bought.