Archive for January 8th, 2009

Obama’s Trillion Dollar Gamble

For the last few weeks I’ve been mulling Obama’s stimulus plan.   I believe pumping a trillion dollar stimulus into the economy is a mistake, though there is a chance it could work.   Our new President is going to start his administration with a trillion dollar gamble.   Whether he wins or loses will mean a lot for the future of the country.   Here are the arguments, and why I ultimately come down skeptical.

PRO:  When an economy is in recession the danger is that the slow down will spiral in on itself and last longer than necessary.  As people lose jobs, they buy less, meaning more people lose jobs, also buying less…a spiral with no natural mechanism for turning things around.   The way out is to pump money into the economy to get more people spending money, thereby creating a reverse spiral — more people spending means more demand, which means more jobs in order to meet that demand.   Theoretically, once the economy is growing again the money borrowed to “prime the economic pump” can be paid back, as we move from a recessionary to a growth cycle.

Moreover, there is a real need for government help to states, especially on health care costs and other state expenses that are squeezing budgets from Maine to California.   There is in part a moral obligation to do this, as states have been handed so many unfunded mandates that they have been put in a position where they simply can’t handle all they need to take care of.

In this view a stimulus package that helps individuals, states, and businesses will give the economy a jolt that will kick us back into growth mode and ultimately move out of the recession.  2008-09 may feel like 1980-82, but remember that 1984 was “morning in America.”  Recessions end, this is the way to do it.   The problem with that perspective is that while it sounds good in the abstract, it doesn’t address the real problems in the economy.  Taking the real condition of the economy into account, it becomes obvious that the stimulus choice has severe dangers.

CON:  The real problem with the United States economy is a serious imbalance between production and consumption.  The US has lived beyond its means for nearly three decades, borrowing money to the tune of an $11 trillion government debt, high private debt, and an on going and severe current accounts deficit.  The current accounts deficit is (was?) only sustainable because of the US role in the world as a superpower.  Countries like China assumed the US economy too big to fail, and saw that money spent on American bonds, investments and currency reserves translated into the ability of the US to buy more Chinese goods (before China, Japan engaged in a similar practice).   A major stimulus package may get the economy going again, but it may also make things worse by increasing the imbalance by expanding debt and consumption without doing anything to really increase production.

If that happens, after a short burst of economic activity thanks the stimulus, the economy would move to a stagflationary mode.   If the stimulus increases consumption rather than production we’ll spend the money and emerge with the exact same problem, only this time with even more debt.  The result would be that inflation would start rising even as the economy slows after the stimulus money has been spent.    Since the inflation will not be caused by an overheated economy, but by a drop in the value of the US currency, it will actually increase the depth of the recession by causing interest rates to rise, and perhaps spurring a flight away from US capital and currency reserves.

How can Obama avoid that worst case scenario, which would have a devastating affect on the US economy and our way of life?  The answer is to use the stimulus to address the core problem: the imbalance between consumption and production.   Usually one would see that as automatic — if people consume more, more must be produced.  But due to globalization, the increase in production could come from China, while the increase in consumption could happen here.    If that happens (or in general if the stimulus spurs an increase in consumption of foreign goods — any growth in the current account deficit), it would be the equivalent of getting a new credit card in order to pay off the old one.  For awhile the problem seems to go away, but when you get to the point you can’t make payment on the new card either you’re in a deeper mess than before.

So Obama has few options.  If he does nothing, the recession runs its course, we suffer a deep and painful period of higher unemployment and ultimately inflation as the world loses faith in the US economy.    In other words, stagflation probably cannot be avoided.  However, at some point the inflation will make American goods cheaper than foreign goods (both at home and abroad) and the economy would start to recover.   Optimally this would lead to a sustainable balance between production and consumption, with lower debt levels.

For Obama, that’s unacceptable.  It would be government standing by and letting the country lose prosperity and suffer a crisis without doing much to intervene.

The question then is whether the market alone is best to do this — the do nothing approach — and Obama’s desire to intervene is inherently misguided (free marketers would say so), or if an intervention/stimulus can be crafted that can push us towards a less painful rebalancing.   I am not a hard core free marketeer.  I believe that markets have inherent flaws and must be regulated, and that in normal times — especially if debt is low and the current account in balance — the proper response to a recession is a stimulus.

However, the economy has been so mismanaged over the past quarter century, creating illusions of wealth that were really speculative bubbles, that these imbalances were allowed to fester.   I don’t believe they can be relieved without a real, and deep recession that leaves us in balance, but less prosperous.  The reason we will be less prosperous is because we’ve been living beyond our means; we have to move from a gluttony financed by debt and trade deficits to a balanced lifestyle.

But Obama’s gamble could pay off.  If the stimulus is focused on spurring production and if all economic tools available are used to prevent a rise in the trade deficit (current accounts deficit), then maybe a spurt in domestic production can make the rebalancing quicker and less traumatic.    Obama’s Presidency may depend on whether or not this gamble pays off.