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President-Elect Obama: How You Can Fix the Economy

12/14/2008 05:12 am ET | Updated May 25, 2011

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.

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