Eurozone Watch

Fifth part of our series on the winners and losers of the current crisis

If there was someone profiting from the current economic and financial crisis it must be Barack Obama, the new American president, right? The polls before the elections showed clearly: the economic situation was the most important election issue.

Whereas in January 2008 only 34 percent of respondents said that economic policy was the main challenge for the next president, by summer, as oil prices continued to rise, this percentage increased to 61 percent. When the housing and banking crisis culminated in a near meltdown of the financial markets in September, 75 percent listed the economy as the single most important election topic. The weak economy was a clear advantage for Obama: In general, Americans tend to vote for the candidate of the opposition party in times of economic downturn. And although neither of the candidates was a presiding president or vice-president, there was nonetheless a strong degree of continuity on the Republican side, since the Republican candidate John McCain did not break explicitly with former President Bush’s economic policy. What’s more, economic policy was not perceived as one of McCain’s strengths. In a survey conducted by the Pew Research Center for the People & the Press, 47 percent of the respondents believed Obama to be the better candidate as far as the economy was concerned, compared to only 33 percent who saw that quality in McCain. That the majority of voters thought McCain to be more qualified on foreign policy issues proved little helpful in the end, as only 27 percent of voters considered the war in Iraq a top priority. But Obama did not only profit from McCains believed weakness in economic issues, he was also lucky in another respect: The financial crisis did not turn into a full fledged economic crisis before the fourth quarter of 2008. Had the financial crisis affected the real economy already in early summer with increasing unemployment numbers, soaring insolvencies and the troubles of the automobile industry, Obama would have faced a much tougher race against his Democratic opponent Hillary Clinton in the Primaries. Clinton found strong support among blue collar workers in the old industrial states – states hit particularly hard by the economic downturn today.

A Window of Opportunity

Not only has the economic crisis paved Obama’s way to the White House. Every crisis offers a chance for a new beginning – a chance for change to say it in Obama’s words. History has shown that every major reform effort in the United States was preceded by a crisis. Without the depression of 1907 the Federal Reserve System, the United States’ central bank, would hardly have been created in 1913. The Social Security Act of 1935, which introduced a national unemployment insurance and pensions system, would have been unthinkable without the world economic crisis of the 1930s. The same holds true for many financial market reforms such as the 1933 Glass-Steagall Act that prohibited commercial banks from undertaking investment banking activities such as underwriting the securities of private corporations. Undoubtedly, President Truman would not have had the domestic support for founding the Bretton Woods Institutions and signing the GATT without the Second World War. The same accounts for the Employment Act of 1946 that charged the government with the responsibility of maintaining a high employment level as well as price stability, and created the Council of Economic Advisors.

Obama likewise has the chance to rapidly introduce fundamental reforms. He has given many indications of favoring activist government on questions of social welfare, jobs, income, health care, and energy. Usually, a new administration has only a short window of opportunity to enact reforms since voters hold the President accountable at the next congressional midterm-elections – not even two years after the President’s inauguration. In Obama’s case, however, the honeymoon period is somewhat longer. The Democrats have increased their majority in Congress considerably, and loosing some seats in 2010 is, by all means, not to threaten this. Not only did the transition period from President Bush to Obama go relatively smoothly, Obama has shown also considerable aptness in choosing his economic team. And he has already enacted some of the programs he envisioned, including the economic stimulus package.A much Deeper Crisis than ExpectedBut the crisis turned out much worse than most economist expected. And the way out of the recession is proving much harder than hoped. According to the U.S. Department of Labor, the number of unemployed persons increased by 851,000 to 12.5 million in February, and the unemployment rate rose to 8.1 percent, its highest level in a quarter-century. As troubled banks remain hesitant to lend, even healthy companies are laying off workers. Over the past 12 months, the number of unemployed persons has increased by about 5.0 million, and the unemployment rate has risen by 3.3 percentage points.

According to the National Bureau of Economic Research (NBER), the recession already started in December 2007. But numbers for the fourth quarter 2008 were particularly bleak: Instead of the initial estimate that the economy contracted at an annualized rate of 3.8 percent in the last three month of the year, the Department of Commerce found that the pace of decline was actually 6.2 percent, making it the worst quarter since 1982. The sources of the weakness were a continuing decline in consumer spending – real personal consumption expenditures decreased 4.3 percent in the fourth quarter –, a sharp downturn in exports by 23.6 percent, a larger reduction in business investment and a continuing decline in housing. The Office of Management of Budget expects the U.S. economy to shrink by 1.2 percent in 2009. Federal Reserve chief, Ben Bernanke, said that full recovery from this recession will take more than two or three years.    Although President Obama signed the American Recovery and Reinvestment Act into law on February 17, 2009 – the more than 700 billion dollar stimulus package – the economy could need additional federal measures. According to the New York University economist Nouriel Roubini, one of the few who predicted the economic downturn, the global recession could continue until the end of 2010 as the response by governments to rectify it was “too little, too late”. Roubini argues that the situation could be improved by appropriate policies, including governments taking over insolvent banks, cleaning them up and re-selling them to private investors. Even if one does not share his approach, there is much to do for the new president. While the U.S. still ranks number one in the Global Competitiveness Index of the World Economic Forum, is scores particularly badly when it comes to macroeconomic stability, where it ranks a low 67th overall. The U.S. has built up large macroeconomic imbalances over recent years, with repeated fiscal deficits leading to rising levels of public indebtedness. The report criticizes the country for not preparing financially for its future liabilities, warning that interest payments will increasingly restrict its fiscal policy freedom.

Tough Policy Choices

And this is precisely where the trouble starts: Policies which make much sense in the short-term to jump-start the economy might very well prove problematic in the long-run. And there is little consensus among economists how to solve the entailing conflicting policy goals.
Without doubt, the fiscal stimulus package is needed to stabilize aggregate demand – personal consumption accounts for 70 percent of GDP – and thus stimulate growth. But with it, the federal budget deficit will skyrocket to almost two trillion dollar in 2009. A reduction of the deficit will indeed only be possible once the economy is growing again. Even the Clinton administration did not manage to convert a deficit into a surplus through stringent budgetary discipline alone. The real key to this was eight years of economic growth resulting in higher tax revenues and less social spending. However, it remains to be seen how quickly the U.S. economy will get back on track. Accordingly, the economy is facing an unarguable danger: A crowding-out effect not unlike in the 1980s when the increase in government borrowing to finance its investment lead to increasing interest rates and subsequently to a reduction in private investment.
 Against that backdrop, Obama argued that budget reform was not only an option but an imperative. Obama wants to restrict the practice of pork-barrel spending, in which bills are linked with other spending items, which only benefit the constituents of particular members of Congress, and enforce pay-as-you-go (PAYGO) budgeting rules which require new spending commitments or tax changes to be paid for by cuts to other programs or new revenue. He pledged a “page-by-page, line-by-line” budget review to root out unneeded spending. But as the passage of the stimulus bill showed, reintroducing fiscal discipline in Congress might prove a herkulean task. What’s more, not even Obama’s 2010 budget plan, which clearly reflects his reform agenda (health care reform, a new energy economy), places consolidating the budget high on the agenda. The estimated deficit will again reach 1.2 trillion dollar. Only in the medium-term he wants to reduce the deficit quota to three percent.

The Fed faces a similar dilemma. Mid-December, the Federal Reserve Board lowered the target federal funds rate, the rate at which banks lend to one another, to a range of 0 percent to 0.25 percent in order to stimulate lending. The discount rate, the rate at which the Fed directly lends money, was lowered to 0.5 percent. In addition, the Fed has tried to stabilize the financial markets by expanding its asset-side policies. Through its Term Asset Backed Securities Loan Facility, for example, the Fed pledged to support key credit markets like consumer credits (student loans, credit card loans, small business loans) of up to 200 billion dollars from February 2009. Without question, an expansionary monetary policy is necessary to supply the markets with the much needed liquidity and restore confidence in financial markets and financial institutions. But here again, the government faces conflicting policy aims. Thus, low interest rates do not necessarily prove an incentive to households to increase savings. And while total household debt has begun to shrink as a percentage of income, debt nonetheless stands at 135%, which still is a heavy load. The U.S. economy thus remains vulnerable. Furthermore, the Fed may lay the ground for the next asset price bubble. So far, no consensus has emerged how central banks should handle asset bubbles. According to the European Central Bank (ECB), central banks should “lean against the wind” to fight asset bubbles, “tolerating somewhat lower inflation and growth in exchange for smaller bubbles and less risk of systemic collapse and deflation at a longer time horizon”. But this would mean a much longer and more painful path to recovery – and a difficult path for the Fed as it is, unlike the ECB, not only mandated to secure price stability but also to foster employment. Even if the Fed were to accept its responsibility in pricking bubbles, this is anything but an easy task: First, bubbles are hard to identify, i.e. it is difficult to distinguish them from asset price movements that are in lie with underlying fundamentals. Second, the right moment for pricking a bubble is difficult to choose. A substantial adjustment of the interest rate could very well trigger or exacerbate an economic downturn. And third, the interest rate is a rather blunt instrument, which has an effect on all sectors, not just those affected by asset price inflation.

For History to Tell

Whether or not Obama will enter the history text books as Roosevelt of the 21st century, who led the U.S. out of one of the deepest economic recessions since the Great Depression of the 1930s, or as president, who blew up national debt without setting the economy back on track before being voted out of office after his first term in office, remains to be seen. But one thing is certain: Obama faces many pitfalls on the way to success and many difficult policy choices will have to be made. And he is not the only one who will have to make these choices. Two institutions to watch closely in the upcoming months are Congress and the Fed. Whether Obama will belong to the winners of the economic crisis is therefore anything but certain.

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