President-Elect Obama: How You Can Fix the Economy

In my previous article I highlighted the general economic problems President-elect Obama faces. In short order these are the housing crisis, the financial crisis, the trade deficit, a recession, and a fiscal situation in ruins. This article will outline some of the possible policies -- as well as the pitfalls of the policy proscriptions. Simply put, his upcoming task is daunting.

Housing

Housing's basic problem is simple. Supply is at sky-high levels while demand is at low levels. As a result, prices are dropping as evidenced by the drop in the Case Shiller home price index. This has led to one third of recent homes sales leading to a loss for the seller (For a more complete explanation, see this story from my blog). The question becomes what can be done to deal with this situation?

The answer is there is little the government can do directly. Remember the central issue is massive oversupply of housing. Unless the government wants to actually start buying properties outright or demolishing houses through its eminent domain powers to lower supply there isn't much to be done directly.

However, there is an important indirect policy the government can undertake -- making it far easier to rework mortgages that are underwater (where the mortgage is worth more than the home price). I would suggest three different policy ideas. First, create some kind of tax incentive beyond the policies in the current tax code to encourage private compliance with these goals. For example -- a tax credit or some kind of bonus deduction would help to ease the losses faced by the financial sector when the financial institution directly owns the mortgage. Second, allow bankruptcy judges to rewrite mortgages. We're going to see a big increase in bankruptcy over the next year or so. Housing costs will play a fairly large part in that. Allowing judges the discretion to rework mortgage payments would ease some of the pain.

Finally, something has to be done to allow a rewriting of mortgages that have been securitized. Here's the basic problem. Before securitization the lender actually held the loan. For example, when the borrower went to the bank to get a 30 year loan the bank would own the loan for 30 years. This would make reworking the loan that much easier. Now the problem is much more complicated because the original lender no longer owns the loan. Instead, the lender sold the loan to an investment bank who packages the loan as part of a mortgage backed bond which in turn is sold to large institutional investors. Some type of mechanism needs to be created to help with this situation (if it's possible).

The General Economic Slump

When the recession started is debatable. I have argued it started in the 1Q of 2008. I have seen others argue it started in the 4Q of 2007. Regardless of when it started there can be little doubt we are currently in a recession. That means overall growth is declining. Starting in the 4Q of 2007, the growth rate from the previous quarter was -.2%, .9%, 2.8% and -.3%. The 2.8% growth rate in the second quarter of 2008 was a statistical aberration. Real growth without the import price "inflator" was a decline of 1.3%.

So, the economy is clearly contracting now. This implies government stimulus would help to alleviate the slowdown. Former Labor Secretary Robert Reich explained the situation thusly:

Introductory economic courses explain that aggregate demand is made up of four things, expressed as C+I+G+exports. C is consumers. Consumers are cutting back on everything other than necessities. Because their spending accounts for 70 percent of the nation's economic activity and is the flywheel for the rest of the economy, the precipitous drop in consumer spending is causing the rest of the economy to shut down.

I is investment. Absent consumer spending, businesses are not going to invest.

Exports won't help much because the rest of the world is sliding into deep recession, too. (And as foreigners -- as well as Americans -- put their savings in dollars for safe keeping, the value of the dollar will likely continue to rise relative to other currencies. That, in turn, makes everything we might sell to the rest of the world more expensive.)

That leaves G, which, of course, is government. Government is the spender of last resort. Government spending lifted America out of the Great Depression. It may be the only instrument we have for lifting America out of the Mini Depression. Even Fed Chair Ben Bernanke is now calling for a sizable government stimulus. He knows that monetary policy won't work if there's inadequate demand.

Anyone who is familiar with the way the BEA reports GDP growth will be familiar with the above mentioned format.

So, we have the government spending to help minimize the effect of the slowdown. The question now becomes how much. Paul Krugman offered this analysis:

Right now, we're at 6.5% unemployment and a 3% output gap - but those numbers are heading higher fast. Goldman predicts 8.5% unemployment, meaning a 7% output gap. That sounds reasonable to me.

So we need a fiscal stimulus big enough to close a 7% output gap. Remember, if the stimulus is too big, it does much less harm than if it's too small. What's the multiplier? Better, we hope, than on the early-2008 package. But you'd be hard pressed to argue for an overall multiplier as high as 2.

When I put all this together, I conclude that the stimulus package should be at least 4% of GDP, or $600 billion.

Here's where the plan runs into a big problem. Bush is leaving Obama a fiscal disaster. Total US debt has increased from $5.8 trillion in 2001 to $10.6 trillion today. From a debt to GDP ratio the increase has been from roughly 57% to roughly 72%. These increases indicate that no one in Washington has been able to make any tough choices for the last 8 years. As a result the federal finances are now in terrible shape.

The central problem is interest rates on the debt. The price of a bond and the bond's interest rate are inversely related: as prices drop the interest rate on the bond increases. The Treasury is already issuing tons of debt to pay for the financial bail-out. As a result traders are expecting prices to decline and interest rates on government debt to increase:

"The No. 1 reason is supply,'' said Jason Brady, a survey participant and managing director at Santa Fe, New Mexico-based Thornburg Investment Management, which oversees $4 billion in fixed income assets. "You have Fed and Treasury actions which are supporting credit markets and causing a huge amount of issuance.''

The U.S. is boosting debt sales to fund such programs as the Treasury's $700 billion bank bailout and the Federal Reserve's purchases of commercial paper to thaw credit markets. Federal Reserve Chairman Ben S. Bernanke has made unprecedented use of the central bank's powers as lender of last resort, unlike his predecessor, Alan Greenspan, who relied on interest- rate cuts to stabilize turbulent markets. President-elect Barack Obama called on Congress Nov. 7 to pass economic-stimulus legislation.

Quarterly Borrowing

Last week the Treasury Department estimated that it will need to borrow $550 billion this quarter, more than triple an earlier forecast. New York-based Goldman Sachs Group Inc. said Oct. 29 the government's requirement this fiscal year that started Oct. 1 will almost double to $2 trillion.
The federal budget deficit may climb 58 percent to $687.5 billion for fiscal 2009 as U.S. debt swells and the slowing economy crimps tax receipts, according to a survey by the Securities Industry and
Financial Markets Association of its members released Oct. 31.

Expectations that yields on 10-year U.S. notes will rise increased to 54.08 in November after reaching a seven-month low of 48.91 in October, according to the Bloomberg survey. The measure is a diffusion index, meaning a reading above 50 indicates that participants expect bonds to weaken and yields to go up.

These are hardly alarming interest rates. 5.40% of interest on a 10-year debt is still very reasonable. However, it's important to remember that issuing all of this debt will have consequences. Some of which would be extremely unpleasant:

"The U.S. might really have to look at a default on the bankruptcy reorganization of the present financial system" and the bankruptcy of the government is not out of the realm of possibility, Hennecke said.

"In the United States there is already a funding crisis, and they will have to sell a lot more bonds next year to fund the bailout packages that have already been signed off," Hennecke told CNBC.

So, to help solve some of the basic problems of the economy the US will have to increase spending in a big way. For someone like myself who has been continually harping on the debt this is an extremely difficult policy call. I don't like deficit spending in any way at any time. It is an extremely dangerous precedent to set. However, there are times when it is required. And now is such a time. Simply put, without the cushion provided by a massive injection of government spending we are in serious trouble -- as in a contraction the likes of which we haven't seen since the early 1980s and probably before.

However, in doing so we are walking on extremely slippery policy ground. We have not come close to balancing the budget in over 8 years. As a result the debt/GDP has continually increased. Now -- at a time when it would be great to spend without having to worry about things like a dollar collapse, a loss of our AAA rating or a spike in interest rates -- such an action will in fact increase the possibility of that happening. Simply put there are no good choices right now. Do nothing and risk an extremely painful recession. Do something and place the soundness of the US government's finance sin jeopardy. It's not a pretty set of choices.

Comments

[DocW1673]

One thing that has to be done is we need to return usery laws to the law books.These laws were intended to prevent organized crime groups from collecting on loan sharking. Today these laws are off the books in most places where republicans have been in control,on the theory that businessman were not making enough to loan money.I believe 18% was the rule, now Capital one, Citibank, and others routinely get away with charging 24.9%.

[William1950]

any bail out should go directly to consumers.. taxpayers, substantial payments to compensate for having idiots running our economy and country... greedy bastards all.
The IRS should be abolished and a ten percent flat tax on all income above twenty five thousand, no exemptions or deductions. No loopholes. No estate tax, no death tax... a flat tax on income..

[iLogos]

So what you want is a greater gap between the rich and poor, with less upward mobility, less money for the government to be able to use in times of crisis and generally a rise in the inequality of education and lifestyle resulting in a major rise in crime.

Interesting.

[Perryof1963]

William1950... Sounds logical to me, however,... we would need to pay at least 35% for the rest of our generation's lifetime to even put a drop in the Federal Deficet! 10% of 0 ain't gonna do a thing but drive us further in debt!

[SoD1]

Nice economical expeditionary, conclusions and suggestions, Mr. “Bonddad”. Paul Krugman is a smart cookie but I would say right now, he is slightly over-rated, due to “high expectations” and since he can only see things in a 'mathematical' way..
Just that most of those suggestions and what is been done now alone or combined, would still be very insufficient.
Facts are if we look at the international dimension of this crisis -since the U.S. exported major part of her debt into other Nations – if we factor into it that the Bush Administration is with high possibility hiding the authentic number of U.S. debt and that U.S.'s “ "not too little government involvement is the problem, it is too much government involvement in the market," has made itself to be well-known as the Absurd um it is. What alone means there are very few ways left, most would be very costly and still increases the suffering of the Populace exponential, and over the time still bankrupt the entire System (Consumerism “generates” 'strong' Economy!) .
The way to go here can only be a well-orchestrated (Regulated) “Mix Market” Strategy.
Good Luck in “figuring” it all out, hmm U.S.?!
Best Regards!
SoD1

[paixa3]

Bonddad, I am a fan of yours. HOWEVER, a few points in this blog that I disagree with. Here are my ideas for a few economic 'starters':

Cut the defense budget 25%, but NOT for the troops.
Make ALL subprime mortgages 15 or 20 year fixed terms, 2% above prime BY LAW. There will still be fallout, but those are the fallouts for mortgages that should have NEVER been. Eliminate the fees BY LAW.
Implement a massive "CCC" programme to rebuild the infrastructure.
Eliminate ALL oil breaks for special consideration and taxes that congress have given them. Turn them over to alternative energies.
Take the bailout money back and NEVER bailout anyone again.

Cheers.

[DocW1673]

paixa3, I agree with most of your post, I do not believe we need to fund defense research at this time, and would someone please explain to me why we should be rebuilding,Iraq,Afghanistan,or most importantly Georgia( the country not hte state). I especially agree with the CCC comment.

[democracyman]

There is ONLY ONE WAY to FIX the ECONOMY and that is to FIX the GOVERNMENT. We need to INCORPORATE the UNITED STATES GOVERNMENT. Why is it a NOT FOR PROFIT SOCIALIST STATE? Why isn't the greatest capitalist state run by a CORPORATION, instead of a SOCIALIST NON-PROFIT as the Soviet Union was?

The real solution is INCORPORATION so that we can achieve several things at once.

1. We can start to HOLD our CEO's ACCOUNTABLE to higher standards of generally accepted accounting principles.

2. We an issue STOCK in AMERICA to all her citizens. This would make us all RICH by the time we RETIRE, have health problems and need to be RICH.

3. It would allow anyone on the planet to BUY STOCK IN AMERICA, thus pushing up the value of our shares.

4. We could ALL VOTE OUR SHARES, creating the world's first REAL DEMOCRACY.

I call this America 2.0, Inc. - Let's all TAKE STOCK IN AMERICA. Why only the FAT CATS on WALL STREET? www.america2inc.com GET ON BOARD now.

[iLogos]

So what you are advocating is Social Democracy... what happens when the first IPO happens and then the next day we have a few hundred thousand citizens born? Do they get new stock issued to them? Doesn't that devalue our own stock? Do we have a finite amount that we issue? What happens when we have citizens with no shares? What happens when a foreign nation buys up a majority of our shares?

It is interesting in theory, but unworkable in reality, similar to free market capitalism and communism.

[Pdubya]

lets say we spend more money on infrastructure and stimulation...say $750 Billion (seems to be a popular number). The only way for it to work is to cut spending by a Trillion somewhere else, apply said portion to the deficit. Resulting production/export/savings to be applied to deficit. But, if the Fed is continued to be allowed to print or borrow, there really is no way out.

[mioffe]

"Housing's basic problem is simple. Supply is at sky-high levels while demand is at low levels."
That is true not only for housing but also for cars industries and many others companies in USA and the world. All Government involvement to give money to save Companies which produce product with low demand are counterproductive. Give money to save our car industries for example and their CEO will spend them on the same cars, which have low demand. It circle of stupidity will bring more harm than good things. Only new directions, new products can bring Companies new possibilities.
Trying to help almost deadly sick industries is waste of money and time.
It is difficult to swallow, but reality asking us to stop dead end directions.

[DuganS1]

Demand is only low for vehicles because of the loss of consumer confidence due to the financial crisis and the constant talk of depression by the media. Once confidence returns, sales will go up substantially. For housing, too many sellers won't sell at a loss and too many buyers don't think prices are at a bottom yet. Once buyers and sellers come together, sales will go up substantially.

[William1950]

people don't want to buy cars now because of fuel prices and the prospect of alternative fuels on the forseeable horizon... yeah, I know gas prices are down now... and they should remain so... however my point remains... we need alternative choices and we all know it. the electric car is coming.

[ReasonIsMyReligion]

We must distinguish between a well-regulated market in which the players are free... and a lawless market in which the players are regulated, or worse, in which the strongest players effectively set the rules.

[oldfart1]

Well, his figure of $600 billion at least matches Paul Krugman's.

Two things are certain

(1) it will take years to sort all this Bush mess out, and

(2) The Bush -McCain philosophy ("greed is good") got us into this mess, and if McCain had won (as he would have done had the crunch come two months later), we would only sink deeper and deeper, just as we did with Hoover.

[Lionsden]

The president has no Constitutional power to "fix" the economy. If the federal government is to fix anything about the economy, it is done through congress.

The Founding Fathers took nearly all power over the private economy from the president accept to vote or veto congressional bills. He does have to general power to see all laws are executed.

To defend the Constitution from the attacks by the anti-federalists, Federalist 69 point blank says that the president will not have the powers King George III (or monarchs) had over economies.

It is is grave error to look to a president to resolve these matters. His powers lie elsewhere and it is wrong for the people to look to him for relief.

[paixa3]

What is the congressional approval rating these days, around 2%?

[AllSeeingEyeball]

Finally, someone that understands the limited role of the Presidency in or Constitutuional Republic. The problem is Congress got us into this mess. In fact, their regulation triggered the Fannie Mae and Freddie Mac collapse. In case you forgot, Henry Paulson came from Goldman Sachs to Treasury. Paulson did such a fine job there that he breezed into the Secretary of the Treasury position. Before you all go ape on that "fool" Bush, understand that these people control everything. Witness the new Chief of Staff for Obama, Rahm Emanuel.
Wikipedia bio: Emanuel was named to the Board of Directors for the Federal Home Loan Mortgage Corporation ("Freddie Mac") by then President Bill Clinton in 2000. His position paid him $31,060 in 2000 and $231,655 in 2001. During the time Emanuel spent on the board, Freddie Mac was plagued with scandals involving campaign contributions and accounting irregularities. The Office of Federal Housing Enterprise Oversight (OFHEO) later accused the board of having "failed in its duty to follow up on matters brought to its attention." Emanuel resigned from the board in 2001 when he ran for congress.
These people have all their bases (and political parties) covered. Good post.

[brodon]

Wait a minute. . . . you guys actually thought Obama had a PLAN??

The only plan PE Obama had was to end the war, bring the troops home and that's where the money was going to come from. . . . . remember???

[SoD1]

WELL, WELL apparently Conservatives never bothered to fully read Obama's Program.
That would be one part; ending a senseless and most wasteful Wars that can not be won whatsoever in that manner for what reasons "Brodon"? Alone because the U.S. is not fighting a "Nation" but a group of People, also named "Insurgency".
I am sure that even you could agree that the Millions of Dollars daily blown into the Air- with a number of human lives - can be better spent domestically, hmm?
Unless, YOU want to pay for the Bushim crisis out of your very own pocket alone. What we all surely would be very grateful for, if that was your "plan" hmm my conservative 'friend'?!

Regards!
SoD1

[yodaveg]

I will gladly pay
some distant tuesday for a
hamburger today

[daddysboy]

I think the combination of the title of this piece and the bleak picture it evokes with little actual solutions comes across more as a taunt to Obama than anything else. Maybe I missed the subtleties in the math, but I didn't see any solutions, just fuzziness. Also, the basic model you used to describe the economy is faulty considering it gives equal weight to domestic consumption as if this is a reliable source of stability. American consumption should always be the icing on the cake, not the filler. This is the dead-end road that the folks moving the money to the top have put Americans on because it is a huge distraction from the fact that our government has moved every productive industry off-shore. America is over-flowing with resources, still has a few of the brightest minds available, has just elected a great leader for the federal government, and the economy hasn't completely collapsed yet. Instead of wallowing in the negatives and thinking old-school, let's figure out how we can move industry back to America and out of Malaysia.

[WritusMaximus]

Obama is on the Paulson Express, heading over the cliff. Someone please wake Obama up before it's too late!

[daddysboy]

Obama is not our president; bush is. Someone please ask our president to wake up before it's too late.

[oldfart1]

The only way to get things moving is for Bush, just for once, to do the right thing, and RESIGN (along with Cheney).

[shakker]

Bu$h the inferior is wide awake and busy rewarding cronies at warp speed. He doesn't care if there is a crash and explosion that destroys more poor people. He has never cared and he never will although he has been programmed to fake empathy when told to do it by the teleprompter.

His escape plan is well thought out and will work fine even if the US is not safe he can go elsewhere or wall himself in a compound. We can never rehabilitate our image of this guy like Nixon was in some peoples' minds.

[WritusMaximus]

"Here's where the plan runs into a big problem. Bush is leaving Obama a fiscal disaster."

Here's another bigger problem: Paulson is running amok, leaving Obama with a bigger disaster.
Paulson is indeed free to do as he wants. He already went through over $200 billion, no strings attached. He and his buddies at the Fed already said they will NOT provide details as to who got what and what if anything of value was put up for collateral. Yup, they are giving the finger to the Congress, Obama, and ultimately the American people. Who woulda thunk that one person, Paulson, could wield absolute power when Congress and Obama had "fixed" the bailout legislation to prevent such power grab from happening??????????

Paulson made fools of the incompetent Congress and the then-Senator, now Prez-elect Obama. Me thinks Paulson is purposefully sabotaging Obama, to insure a repub comeback in 2010 AND 2012.
Strange that the Obama team hasn't reacted to Paulson's attack. Paulson has the power to decide the fate of both Congress and the presidency. Machiavelli would be proud!

[idest]

Huh...and who appointed the scoundrel Paulson again? OH, that's right, the scoundrel in chief, whom you only mention in quotes.

Say NO to Bush apologism.