Obama's stimulus plan - for China
By Hossein Askari and Noureddine Krichene
The United States has gone deeper into recession with the loss of 524,000 jobs
in December, bringing to 2.6 million the total job loss for year, the largest
annual total since World War II, and pushing the unemployment rate to 7.2% of
the labor force.
The Congressional Budget Office is predicting a contraction of US real gross
domestic product by 2.2% in 2009, unemployment to rise to 8.3%, and the US
fiscal deficit, excluding president-elect Barack Obama's stimulus program, to
widen to a record $1.2 trillion, or about 8.3% of GDP.
Obviously, the Troubled Assets Relief Program (TARP) has failed
to deliver what Treasury Secretary Henry Paulson considered to be the best
alternative for American families, forcefully convincing Congress that the
monumental $700 billion plan would pull the economy out of recession. House
speaker Nancy Pelosi's $165 billion stimulus package in 2008, a housing package
of $300 billion, and massive bailouts (of Fannie Mae and Freddie Mac, insurer
AIG, the auto industry and on and on) have failed to deliver the expected quick
turnaround in the US economy.
Massive liquidity injections by the Fed - which pushed its assets to $2.2
trillion, pulled down interest rates to zero-bound and expanded money supply
(M1) by 37% in 2008 - have only turned out to be self-defeating.
There is no explanation for this dismal performance and rising social cost of
unemployment, except Fed chairman Ben Bernanke's aggressive policy, and that of
Alan Greenspan before him, which has caused a collapse of the financial system
and consequently a collapse of the stock market, with the Dow index falling
from 14,164 on October 9, 2007 to 7,552 on November 20, 2008 for a decline of
47%.
Despite early warning signs since the breakout of the financial crisis in
August 2007 in the form of a widespread credit freeze, exploding oil and food
prices, food riots and energy protests, a depreciating dollar, and rising
unemployment in the US, Bernanke has been adamantly determined to unleash an
expansionary monetary policy to fight a recession that he was all along
initiating.
He must believe in demand and credit policies to provide free money to those
who do not earn it to spend and to kick-start aggregate demand. In doing so, he
stalled the economy, triggered economic recession and financial chaos and
inflicted excessive fiscal costs in the form of gigantic bailouts and falling
taxes. US policymakers remain supportive of Bernanke's policy, despite the
chaos it has been causing, seeing in it a magic way out of recession without
any need for painful adjustment.
Policymakers always support unsustainable fiscal and monetary policies until
the cost of these policies become overbearing and outweigh considerably the
cost of adjustment.
Reminiscent of Paulson's approach, Obama has put out an urgent $1 trillion plan
economic recovery aimed at creating 3.5 million new jobs. Like Paulson's TARP,
the plan has as of now little detail and asks for immediate and unconditional
approval by Congress, claiming, as Paulson previously did, that without this
plan the sky would fall and the US economy would stand to loose another 4.5
million jobs.
Obama' message is his desire to put the jobless quickly back to work. The
catchwords are infrastructure and tax rebate. In spite of its laudable
objective, the authors of the vague plan, mostly Harvard economic professors,
have failed to provide a diagnosis of the US economy and the underlying factors
that brought it to this recessionary state. Without this diagnosis, policy
recommendations have no foundation.
They failed to analyze why earlier massive stimulus programs combined with
unorthodox monetary policy and negative real interest rates have not yet
delivered the long-promised turnaround, or what makes their plan different from
others. The most difficult aspect of the plan is the financing of a
record-shattering fiscal deficit exceeding $2.2 trillion in 2009. Have Obama's
big-name experts explored the alternative of reviving the US economy through
curtailing the fiscal deficit instead of exacerbating it?
A much lower deficit could lead to faster economic recovery than monstrous
unsustainable deficits. Without truly understanding John Maynard Keynes, much
of the media and academics have called Obama's plan a triumph of Keynesians
economics.
While a diagnosis and sectoral analysis of the US economy are either scanty or
totally missing in the present rush to action, it behooves us to address some
of the most pressing macroeconomic questions: could the US economy sustain any
further a combination of unseen expansionary monetary and fiscal policies? How
could a projected fiscal deficit, exceeding $2.2 trillion, or 16% of GDP, be
financed? Could the US economy grow out of recession with the federal funds
rate zero-bound? Are demand-led policies still valid for the US economy?
Empirically, no economy has been able to sustain an overburdening fiscal
deficit without ending with unmanageable public debt, a depressed economy and
financial disorder. Economic history is replete with examples of the disastrous
consequences of excessive expansionary fiscal policies, which resulted in high
or hyperinflation, falling real output and rising unemployment.
Because of strongly expansionary demand policies under the George W Bush
administration, US national savings have become very low or even negative. Low
savings invalidate a basic assumption for a Keynesian expansionary fiscal
policy and make the financing of the deficit from real domestic savings
unfeasible. The only sound financing option would be foreign financing, as in
previous fiscal deficits.
On the one hand and under this assumption, the growth of the US fiscal deficit
will have a negligible impact on US real GDP; it will only increase domestic
consumption, and as experience in recent years has shown, it will end up
stimulating through the classical multiplier effect the economies of China,
Japan and commodity-producing countries. In other words, Obama's plan will end
up creating 3.5 million jobs outside the US, and only few jobs domestically.
On the other hand, if foreign financing were discouraged by ridiculously low
interest rates and fears of an expected further depreciation of the US dollar,
the fiscal deficit would have to be financed through monetization. This
scenario would be the most likely and the most detrimental. If it materializes,
it will trigger inflationary dynamics that will be difficult to control, with a
depreciating US dollar and a rapidly falling real economy. In brief,
inflationary financing would be a catastrophic and a costly failure of Obama's
plan. It would propel the economy into a stagflationary mode and push
unemployment to much higher levels than the currently estimated high-end rate
of 10-12%.
There is no doubt that the Obama administration is inheriting possibly the
worst financial mess in US history resulting from the Bush administration's lax
and disorderly financial policies. Populist economics, however, that replicate
these policies for another four years would be very costly for the US economy.
The economy still has great potential for recovery to regain its premier status
in the world. For that, it needs appropriate macroeconomic policies. Obama
should have the courage to clean the prevailing financial mess and stabilize
the US economy so it can return to its growth path. A stabilization program
supported with supply side policies that enhance competitiveness will achieve
the employment creation of 3.5 million new jobs and will ensure that these jobs
are indeed created in the US and not in China or elsewhere.
The most pressing priority of a stabilization program is to rein in monetary
policy, contain the fiscal deficit within a manageable 3% of GDP and
consolidate the banking sector. The freeing of interest rates will enable banks
to quickly resume lending, take price risks and consolidate their incomes and
reserves. Enterprises will be able to borrow and finance the most efficient and
profitable projects that will sustain economic growth. Real savings will
increase and so will real investment; and stock markets will recover.
Maintaining interest rates at zero-bound will force banks to hold largely
government paper and will erode their incomes and profitability. At such
negative real interest rates, banks can never extend long-term loans. Besides
freeing interest rates, money supply growth has to be brought within a
reasonable target of say 5% per year.
The private sector produces food, clothing, appliances, cars and all goods and
services needed for survival and well-being. Expanding the fiscal deficit
beyond a reasonable limit will absorb all available savings and may crowd out
private sector investment, hence forcing a decline in private output and
employment. This point has been rightly made by Hal Varian in an article in the
Wall Street Journal, January 7, 2008, headlined "Boost Private Investment to
Boost the Economy". Spending on infrastructure could be achieved through a
restructuring of spending in favor of capital expenditure without necessarily
increasing overall government expenditure.
Supply side policies are most indicated for sustained economic growth. Tax
credits on new investment would encourage private investment. The US and world
economies continue to suffer food price inflation. There is a pressing need to
expand food production and increase competitiveness and competition in food
processing and marketing industries.
The US has large deficits in energy. Policies for expanding energy supply and
increasing energy efficiency would be favorable to economic growth. The US car
industry suffers from a lack of competitiveness and innovation. Plans to
produce energy-efficient and high-quality vehicles would create and preserve
jobs in the auto industry.
The housing industry has been subject to unusual speculation and interference
with price adjustment. Such interference could only prolong the housing crisis.
The government should refrain from preventing an orderly adjustment of prices
in line with market fundamentals. It could, nonetheless, acquire or construct
low-cost housing for low-income families.
The sharp decline in commodity prices affords the US economy an opportunity to
resume recovery provided stable and sound macroeconomic policies are
immediately implemented. Such policies will restore needed private sector
confidence and revive the growth dynamics of the US economy. Hossein Askari
is professor of international business and international affairs at George
Washington University. Noureddine Krichene is an economist at the
International Monetary Fund and a former advisor, Islamic Development Bank,
Jeddah.
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