Let's stimulate private risk taking (updated)

Alberto Alesina and Luigi Zingales have a piece in the Wall Street Journal on Let's Stimulate Private Risk Taking: Tax cuts are the way to nudge capital toward productive uses. With regard to the current crisis in the US they write:

But 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.

They then ask the question: So how do we stimulate the economy without increasing the already large current-account deficit? Their answer:

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.

More savings need to be invested, and firms need an incentive to invest in order to help aggregate demand in the short term and promote long-term growth. The best way to do this is to make all capital expenditures and research and development investments done in 2009 fully tax deductible in the current fiscal year.

A large temporary tax incentive may be just enough to jolt investors from their current paralysis to take action. Such a switch will also be fueled by the temporary capital-gains tax cut mentioned above, which will motivate people to move their savings from money-market funds to stocks, increasing valuations, investments and confidence.

Arnold Kling makes the point that eliminating the capital gains taxes for investments made in 2009 would cause much more trading than actual new investment. Allowing firms in 2009 to expense investment rather than have to use depreciation may not help much if companies continue to lose money. In such a case the value of tax deductions is not going to matter.

Update: See here for Donald J. Boudreaux's response to part of the Alesina and Zingales piece.