Obama's $800bn stimulus may not be enough

 

The Obama plan is one of damage limitation, not of triggering the next boom, writes Proinsias O’Mahony

WITH THE inauguration of president-elect Barack Obama just days away, attention is increasingly focusing on the incoming administration’s financial stimulus package.

How does it differ from previous efforts to deal with the financial crisis? What is the thinking behind the plan? What are its prospects of success?

Obama’s $800 billion stimulus is designed to supplement rather than replace existing policies.

The Troubled Assets Relief Programme (Tarp), the $700 billion bailout plan passed into law at the height of the Lehman-induced financial panic last October, was initially designed to buy up the toxic assets clogging up bank balance sheets before being recast as a recapitalisation effort, with billions being injected into America’s biggest financials.

Monies have since found their way to a host of troubled firms outside the banking sphere.

Despite being attacked for its ever-changing nature – US strategist Ed Yardeni dismissed it as “a dumb plan as originally conceived that morphed into a really stupid one” – Tarp is set to be overhauled rather than jettisoned, with increased transparency and greater efforts to address the issue of mortgage foreclosures being promised.

Obama this week asked President George Bush to request from Congress the remaining $350 billion in Tarp funds. Federal Reserve chairman Ben Bernanke suggested that Tarp may yet be used to buy bank toxic waste, adding that stimulus alone would not solve America’s economic ills.

The Obama stimulus, while not a cure-all, might provide a “significant boost” to the economy, Bernanke added.

While Tarp was designed to resuscitate a financial system that had suffered cardiac arrest, the stimulus aims to energise a host of different industries and ultimately lift America out of recession.

Approximately $500 billion in extra spending over a two-year period has been earmarked with up to $300 billion in tax breaks for workers and businesses also being promised.

The goals have grown more ambitious as the recession deepens. One million jobs were promised during the election campaign. By November, that figure had multiplied to 2.5 million. Four weeks ago, a three million target was set and, last weekend, a new report estimated that 3.675 million jobs would be created.

Ninety per cent of jobs would be in the private sector, Obama said, with the green energy and construction sectors seeing significant growth.

“Without such a stimulus, the economy appears headed toward the worst downturn since the Great Depression,” said Mark Zandi, chief economist at Moody’s Economy.com and an adviser to senator John McCain during the presidential campaign.

Nobel Prize-winning economist Paul Krugman’s comment that there are no libertarians in financial crises seems borne out by the widespread acceptance of Zandi’s thesis, even among conservative economists.

Slashing rates hasn’t revived the economy so a major stimulus is essential, according to Harvard professor Martin Feldstein, a former adviser to Ronald Reagan.

“It pains me to say that,” he says, “because I am a fiscal conservative who dislikes budget deficits and increases in government spending.”

If anything, Obama is being criticised for being too cautious.

Both Krugman and fellow Nobel economist Joseph Stiglitz have said that the stimulus is not ambitious enough, with Krugman accusing the incoming administration of “low-balling its plans in an attempt to get bipartisan consensus”.

He is particularly critical of the tax breaks, saying that the money would be better spent on poverty relief. Evidence suggests that the last three tax rebates have not had the desired effect, with research showing that people spent between one-third and a half of the money within nine months.

Benefits to America is $14 trillion economy would clearly be modest were that scenario to be replicated in 2009.

The latest Obama economic report accepts that tax cuts are “likely to create fewer jobs” but nevertheless insists that they are “crucial” in that they can be “implemented quickly”.

Sceptics caution, however, that Americans are likely to be even more cautious with their money in the future.

Merrill Lynch chief economist David Rosenberg estimates that collapsing asset prices has resulted in household wealth destruction of over $13 trillion, or a decline of more than 20 per cent from the 2007 peak.

That is more than twice the 9.6 per cent decline seen after the bursting of the dotcom bubble, more than five times the decline seen in mid-1970s and more than half of the household wealth destruction seen in the Great Depression.

For decades, the American personal savings rate was in the region of 10 per cent or more. That changed in the mid-1980s and famously fell to a negative rate in 2006. With Americans having suffered two equity bear markets and a housing crash in the last decade, Rosenberg predicts that they will turn into savers once more – just when their economy needs them to spend. Policy measures, no matter how aggressive, are “no match” for this inevitability.

Even without accepting the Rosenberg thesis, there is little conclusive evidence that fiscal stimulus packages achieve their countercyclical aims.

A recent IMF study that looked at various stimulus packages delivered during economic downturns found that effects are “positive, albeit modest”. The best packages, it found, were “timely, temporary, and targeted”. In the US, it said, fiscal interventions tended to be timely but rarely satisfied the other criteria.

The IMF study also raised “concerns about debt sustainability”, an issue with which the president-elect is already grappling.

“Potentially, we’ve got trillion-dollar deficits for years to come, even with the economic recovery that we are working on at this point,” he said recently.

The Congressional Budget Office last week estimated that the US budget deficit would touch $1.2 trillion this year even without the stimulus and would “shatter the previous post-second World War record” relative to the size of the economy.

The stimulus is likely to push the deficit to 10 per cent of GDP.

Against such a background, it is clear that the stimulus – or indeed, any one measure – cannot be a simple panacea for US woes.

Aspiring to create at least three million jobs is a “very concrete way of saying we want to ease as much of the pain as we can”, according to Christina Romer, an economist on the Obama team.

The word “ease” conveys that the plan is one of damage limitation rather than one that will trigger the next boom. Even with the plan, Ms Romer is reported to have estimated an average unemployment rate of 7.3 per cent over the next three years.

“That is a scary number,” said Krugman, “big enough to pose a real risk that the US economy will get stuck in a Japan-type deflationary trap.”

US economy: a protracted crisis?

THE OBAMA plan estimates that unemployment will peak at 9 per cent without a stimulus package. With its proposals, it sees unemployment dropping to 7 per cent by the end of 2010.

However, a new academic paper co-authored by Harvard economics professor Kenneth Rogoff suggests that may be optimistic.

A former chief economist with the IMF, Rogoff hit the headlines when he predicted in advance of the Lehman collapse that a “whopper” of a bank was about to “go under”. A year ago, he presented historical analysis showing that the US was on the verge of a “severe” financial crisis.

A similar comparative historical analysis of the aftermath of financial crises suggests that the current crisis is likely to be protracted.

On average, real average house price declines of more than 35 per cent are seen, typically stretching out over six years.

Equity collapses average 55 per cent and tend to last approximately 3½ years. Unemployment soars, rising by 7 per cent over the down phase of the cycle, which lasts an average of over four years. Government debt explodes, rising by 86 per cent.

Interestingly, the “inevitable collapse in tax revenues” as the economy contracts, coupled with “ambitious countercyclical fiscal policies”, are the main drivers of this debt rather than the “widely cited” cost of bank bailouts.

If history repeats itself, US unemployment would ultimately hit 11 per cent and equity and housing markets would not see any upturn until 2011 and 2012, respectively.

Of course, no two crises are ever the same.

The authors also note that central banks have already shown an “aggressiveness” to act, having learnt from the mistakes of their predecessors in the 1930s or from Japan in the 1990s.

Still, “one would be wise not to push too far the conceit that we are smarter than our predecessors”, the professors said.

“A few years back, many people would have said that improvements in financial engineering had done much to tame the business cycle and limit the risk of financial contagion.”

PROINSIAS O’MAHONY