Robert J. Samuelson: The Next Economic Bubble?

Robert J. Samuelson in Washington Post:

When Nouriel Roubini talks, the world listens. Roubini is, of course, the once-obscure New York University economist whose dire warnings about a financial crisis proved depressingly prophetic. Last week, Roubini was shouting. Writing in the Financial Times, he warned that the Federal Reserve and other government central banks are fueling a massive new asset bubble that -- while not in imminent danger of bursting -- will someday do so with calamitous consequences.

Here is Roubini's argument: The Fed is holding short-term interest rates near zero. Investors and speculators borrow dollars cheaply and use them to buy various assets -- stocks, bonds, gold, oil, minerals, foreign currencies. Prices rise. Huge profits can be made.

But this can't last, Roubini warns. The Fed will eventually raise interest rates. Or outside events (a confrontation with Iran, fear of a double-dip recession) will change market psychology. Then investors will rush to lock in profits, and the sell-off will trigger a crash. Stock, bond and commodity prices will plunge. Losses will mount, confidence will fall and the real economy will suffer.

The Fed and other policymakers seem unaware of the monster bubble they are creating, writes Roubini. The longer they remain blind, the harder the markets will fall. Haven't we seen this movie before? Well, maybe.

Like home values a few years ago, asset prices have risen spectacularly. Since its March 9 low, the Standard & Poor's 500-stock index has gained more than 50 percent. An index of stocks for 22 emerging-market countries (including Brazil, China and India) has doubled from its recent low. Oil, now around $80 a barrel, has increased 150 percent from its recent low of $31. Gold is near an all-time high, around $1,090 an ounce. Meanwhile, the dollar has dropped against many currencies. Half of Roubini's story resonates.

But the other half is less convincing: that prices, driven by cheap loans, have reached speculative levels. Remember that the economy seemed in a free-fall early this year. Terrified consumers and cautious companies hoarded cash, cut spending and dumped stocks. Since then, the mood and economic indicators have improved. Higher stock and commodity prices have mostly recovered the big losses of those panicky months. Today's prices are usually below previous peaks. Oil's peak was nearly $150 a barrel.

Similarly, the S&P 500, now around 1065, is a third lower than its peak on Oct. 9, 2007 (1565.15), and roughly where it was on Election Day 2008 (1005.75). By historical price-to-earnings ratios -- the ratio of stock prices to per-share profits -- these levels can be justified, if the economic recovery continues. With massive layoffs, business costs have been cut sharply. The hope is that when consumers and companies start spending, the added sales will drop quickly to the bottom line [profits], says S&P's Howard Silverblatt.

Nor is it clear that cheap dollar loans are promoting speculation. In the United States and Europe, banks are reducing lending, says economist Hung Tran of the Institute of International Finance, a research organization of financial institutions. You see hedge funds taking on less leverage [borrowed money] than in 2007. What actually happened, he says, is that as investors became less fearful, they moved funds from cash into other markets, pushing up prices. He cites outflows this year from money market mutual funds exceeding $300 billion.

Indeed, that's what the Fed wants, argues economist Drew Matus of Bank of America. Low interest rates on money market funds and checking accounts are trying to force you to do something with the money -- either spend it or invest it. Depression prevention means supporting consumption and asset markets.

So, Roubini's new bubble remains unproved. But this doesn't invalidate his warning. We've learned that there's a thin line between promoting economic expansion and fostering bubbles. With hindsight, lax Fed policies contributed to both the tech bubble of the late 1990s and the recent housing bubble, though how much is debated.

The most worrying signs of speculative excesses, says Tran, involve some Asian and Latin American developing countries. They've received sizable capital inflows (money from abroad). These have boosted local stock markets and reflect disaffection with the dollar. Their central banks -- imitating the Fed -- have also kept local interest rates low, fueling rapid credit growth. Some of their stock markets have exceeded previous highs. These countries face a dilemma. Raising rates may attract more hot foreign capital; keeping them low may encourage speculative borrowing in local currency.

But the dilemma arises from the Fed's low interest rates and the weak dollar. The conclusion: how deftly the Fed navigates from its present policy matters for the world as well as the United States. If it's too fast, it may kill the economic recovery; if it's too slow, it may spawn bubbles -- and kill the recovery.


(Zoon Politikon)

Deflation, Inflation, or Both?

Deflation, inflation, and at their crossroad stagflation, which takes the bad from both and throws the good away. Very simplistic, deflation is driven by surplus of products and means cheap prices and loss of jobs, while inflation is driven by demand of products and means rising wages and rising prices; stagflation comes when loss of jobs persists and prices start to increase.

Robert J. Samuelson in Newsweek:

To make sense of today's most perplexing economic debate–whether we're flirting with inflation or—deflation—it's worth recalling what happened after World War II. Under intense political pressure, President Truman lifted wage-price controls. All heck broke loose. Suppressed during the war, wages and prices exploded. Autoworkers, steelworkers and others went on strike for higher pay. In 1946 and 1947, consumer prices rose 8.5 percent and 14.4 percent, respectively.

What's instructive is that prices then stabilized. There was no wage-price spiral as occurred in the 1960s and 1970s. True, a mild recession in late 1948 and 1949 helped temper price increases. But inflation subsided mainly because people didn't expect it to continue. They'd lived through the Depression, when prices declined. Except for wars, American prices were usually fairly stable.

The lesson for today: psychology matters. What economists call expectations shape how workers, managers and investors behave. If they fear inflation, they act in ways that bring it about. The converse is also true, as the late 1940s show. The lesson provides context for today's debate. Are the Federal Reserve's easy-money policies laying the groundwork for higher inflation? Or will these policies prevent deflation– a broad decline of prices–that would deepen the economic slump?

These questions arise from the Fed's strenuous efforts to support the economy. It has cut the overnight Fed funds rate almost to zero. It has made loans when private lenders wouldn't–in the commercial paper market, for instance. To lower long-term interest rates, it's pledged to buy $1.25 trillion of mortgage securities backed by - Fannie Mae and Freddie Mac and $300 billion of long-term Treasury bonds. These meas-ures are without modern precedent.

Precisely, say the inflation worriers. Once the economy recovers, the easy money and credit will spawn inflation. Cheap loans will bid up prices; wages may follow. Low interest rates will encourage spending and deter saving. The Fed will be under pressure from Congress, the administration and business to prevent interest rates from increasing, warns economist Allan Meltzer of Carnegie Mellon University. With huge budget deficits, the White House and Congress will want to keep borrowing costs down. Inflation psychology will take hold.

Nonsense, say deflation worriers. Inflation results mainly from too much demand chasing too little supply. Today, too much supply chases too little demand. High unemployment and slack business capacity (idle factories, vacant office suites, closed mines) impede wage and price increases. If the Fed doesn't maintain cheap credit, shrinking demand might cause prices and wages to spiral down. Deflation, not inflation, is the clear and present danger, retorts Princeton economist and New York Times columnist Paul Krugman.

It seems impossible for both arguments to be correct, but they may be. As Krugman notes, inflationary pressures are almost nonexistent. In the past year, the consumer price index has been roughly stable. In May, the unemployment rate rose to 9.4 percent. A survey by Challenger, Gray & Christmas found that 52 percent of firms had frozen or cut salaries. GM's bankruptcy is but one indicator of excess industrial capacity. The surplus is worldwide, finds a study by economists Joseph Lupton and David Hensley of JPMorgan. Inflationary expectations are low.

All this gives the Fed maneuvering room. Expectations matter; inflation won't burst forth instantly. Even Meltzer doesn't see an immediate surge. When will it come? Surely not right away, he writes.

Still, his warning remains relevant. The Fed has often overdone expansionary policies and fostered inflationary expectations. In the 1960s and 1970s, that occurred through excess demand and a classic wage-price spiral. The danger now might emerge through exchange rates and commodity prices. Inflation fears could raise prices of commodities (oil, metals) and depress the dollar. Imports would become costlier, allowing domestic producers to raise prices. Once inflationary practices take hold, high inflation and unemployment can coexist: dreaded stagflation. In 1977, both inflation and unemployment were about 7 percent.

There's evidence (better housing and auto sales, stronger growth in emerging markets) that the danger of a deflationary economic free fall is ebbing. Someday, the Fed will have to raise interest rates. Fed chairman Ben Bernanke has pledged to preempt high inflation. Will the Fed get the timing right and resist political pressures? Will his pledges reassure markets?

One reason they might not is that Bernanke's term as chairman expires in January. Any replacement named by President Obama would be seen, fairly or not, as more beholden to the administration. The president should eliminate that perception by reappointing Bernanke. That would not settle today's deflation-inflation debate, but it would remove a needless uncertainty.

(Zoon Politikon)

Robert J. Samuelson: Our Depression Obsession

Is it as bad as in 1929? Another question should come first: is it a crisis of the same kind? Robert J. Samuelson in today's W. Post:

The Great Depression of the 1930s was the most momentous economic event of the 20th century. It was a proximate cause of World War II, having fed the Nazis' rise in Germany. It inspired a new American welfare system as a response to mass misery. Everywhere, it discredited unsupervised capitalism. Given today's economic crisis, our renewed fascination with the Depression is natural. But we ought not stretch the parallels too far.

The Depression was exceptional in its economic ferocity. As Liaquat Ahamed writes in his book Lords of Finance: During a three-year period, real GDP [gross domestic product] in the major economies fell by over 25 percent, a quarter of the adult male population was thrown out of work. . . . The economic turmoil created hardships in every corner of the globe, from the prairies of Canada to the teeming cities of Asia.

Anyone who wants to know why should read this engrossing book. Ahamed, a professional money manager, attributes the Depression to two central causes: the misguided restoration of the gold standard in the 1920s and the massive inter-governmental debts, including German reparations, resulting from World War I.

His story builds on the scholarship of economists Milton Friedman, Anna Schwartz, Charles Kindleberger, Barry Eichengreen and Peter Temin. But Ahamed excels in evoking the political and personal forces that led to disaster. His title refers to four men deeply implicated in the era's perverse policies: Montagu Norman, governor of the Bank of England; Benjamin Strong, head of the New York Federal Reserve Bank; Émile Moreau, head of the Banque de France; and Hjalmar Schacht, head of Germany's Reichsbank. Their determination to reinstate the gold standard -- seen as necessary for global prosperity -- brought ruin.

Under the gold standard, paper money was backed by gold reserves. If gold flowed into a country (normally from a trade surplus or a foreign loan), its money and credit supply were supposed to expand. If gold flowed out, money and credit were supposed to contract. During World War I, Europe's governments suspended the gold standard. They financed the war with paper money and loans from America. The appeal of restoring the gold standard was that it would instill confidence by making paper money trustworthy.

Unfortunately, the war damaged the system beyond repair. Britain, the key country, was left with only 7.5 percent of the world's gold reserves in 1925. Together, the United States and France held more than half the world's gold. The war had expanded U.S. reserves, and when France returned to gold, it did so with an undervalued exchange rate that boosted exports and gold reserves. Meanwhile, German reparations to Britain and France were massive, while those countries owed huge amounts to the United States. The global financial system was so debt-laden that it cracked at the first pressure, writes Ahamed.

That came after a rise in American interest rates in 1928 forced other countries to follow (no one wanted to lose gold by having investors shift funds elsewhere) and ultimately led to the 1929 stock market crash. As economies weakened, debts went into default. Bank panics ensued. Credit and industrial production declined. Unemployment rose. Weakness fed on weakness.

Sadly, this tragedy has modern parallels. Like the 1930s, a worldwide credit collapse is a danger. Global stock, bond and bank markets are interwoven. Losses in one may prompt pullbacks in others. Money flowing to 28 emerging market" countries in 2009 will drop 80 percent from 2007 levels, projects the Institute of International Finance. Currency misalignments have, as in the 1920s, distorted trade. China's renminbi is clearly undervalued.

Still, striking differences separate now from then. The biggest is that governments -- unencumbered by the gold standard -- have eased credit, propped up financial institutions and increased spending to arrest an economic free fall. The Federal Reserve and the International Monetary Fund have made loans available to emerging-market countries to offset the loss of private credit. Nor is there anything like the international rancor that followed World War I and impeded cooperation: In 1931, the French balked at rescuing Austria's biggest bank (Creditanstalt), whose failure triggered a chain reaction of European panics.

When countries left the gold standard -- the United States effectively did so in 1933 -- their economies began to recover. Some indicators now imply that the present decline is ebbing (glimmers of hope, says President Obama). China shows similar signs of improvement. All this diminishes the dreary comparisons with the Depression. But if these omens prove false, a more somber conclusion could emerge.

The mistakes of the Depression were rooted in prevailing economic orthodoxies, which had been overtaken by new realities. The present policies likewise reflect today's orthodoxies. But what if they, too, turn out to be misguided because the world has moved on in ways that become obvious mostly in retrospect?


(Zoon Politikon)

China's Dollar Deception

We are in a race between economic recovery and economic nationalism and you cannot have both. Robert J. Samuelson in today's W. Post:

At last week's Group of 20 summit, leading nations agreed to roughly $1 trillion of additional lending, mostly through the International Monetary Fund, to help end the worldwide slump. But beneath the veil of consensus, countries are maneuvering to protect their economies and blame someone else for the crisis. Will the world economic order overcome these stresses or give way to a global free-for-all, characterized by rampant protectionism and nationalistic subsidies and preferences?

Emblematic of the tension is a recent proposal by Zhou Xiaochuan, governor of the People's Bank of China (PBOC), to replace the dollar as the world's major international currency. In a paper, Zhou argued that today's crisis reflects the inherent vulnerabilities and systemic risks of the dollar-based global economy. The PBOC is China's Federal Reserve; Zhou is no obscure bureaucrat.

It may surprise Americans that, up to a point, his analysis is correct. The dollarized world economy developed huge instabilities -- vast trade imbalances (American deficits, Asian surpluses) and massive, offsetting international money flows. But Zhou's omissions are equally revealing. To wit: China is heavily implicated in the dollar system's failings. By keeping its currency artificially depressed -- as an aid to exports -- China abetted the imbalances it now criticizes.

The Chinese denounce American profligacy after promoting it and profiting from it. Low prices for imported goods (shoes, computers, TVs) encouraged overconsumption. From 2000 to 2008, the U.S. trade deficit with China ballooned from $84 billion to $266 billion. China's foreign exchange reserves are now an astounding $2 trillion.

It's not just that exchange rates were (and are) misaligned. American economists have argued that a flood tide of Chinese money, earned from those bulging trade surpluses, depressed interest rates on U.S. Treasury securities and sent investors searching for higher yields elsewhere. That expanded the demand for riskier securities, including subprime mortgages, and pumped up the housing bubble. So China's policies contributed to the original financial crisis, though they were not the only cause.

For decades, dollars have lubricated global prosperity. They're used to price major commodities -- oil, wheat, copper -- and to conduct most trade. Countries such as Thailand and South Korea use dollars for more than 80 percent of their exports. The dollar also serves as the major currency for cross-border investments by governments and the private sector. Indeed, governments hold almost two-thirds of their $6.7 trillion in foreign exchange reserves in dollars.

But overreliance on the dollar can also backfire, as it now has. It is not just that countries have suffered declines in exports to a slumping U.S. economy. They've also lost dollar loans needed to finance trade with third countries. When the crisis hit, U.S. banks cut back on dollar credit lines to foreign borrowers, says David Hu of the International Investment Group, an investment fund specializing in trade finance. The extra loans endorsed at last week's summit aim to offset these losses.

Given the dollar's drawbacks, why not switch to something else, as Zhou suggests? The trouble, as even he concedes, is that there's no obvious replacement. The attraction of an international currency depends on its presumed stability, what it will buy and how easy it is to invest. The euro (27 percent of government reserves) and the yen (3 percent) don't yet rival the dollar. As for China, it hasn't made its own currency (the renminbi, or RMB) automatically convertible for Chinese investments.

We're stuck with the dollar standard for a while. To work, it requires that countries with huge trade surpluses reduce the export-led growth that fed the system's instabilities. The Chinese increasingly recognize this. They're very aware of the need to promote consumer spending, says economist Pieter Bottelier of Johns Hopkins University. In November, China announced a 4 trillion RMB ($586 billion) stimulus. In addition, says Bottelier, the government is improving health and pension benefits to dampen households' need for high savings.

But China also has a default position: promoting exports. It has increased export rebates; engaged in currency swaps with trading partners (the latest: $10 billion with Argentina) to stimulate demand for Chinese goods; and stopped the RMB's slow appreciation. China seems comfortable advancing its economy at other countries' expense. Zhou's pronouncement provides a political rationale for predatory behavior: If we're innocent victims of U.S. economic mismanagement, then we're entitled to do whatever is necessary to insulate ourselves from the fallout. Down this path lies growing mistrust.

The larger point is that the world economy is suspended between the lofty rhetoric of last week's summit and the gritty realities of national politics. Protectionism is rising. A World Bank study found that 17 countries in the G-20 have recently adopted discriminatory policies. Though still modest, they open the door for a lot of other opportunistic measures, says Gary Hufbauer of the Peterson Institute. And the deeper the recession, the greater the danger.

(Zoon Politikon)

Can Capitalism Survive?

Robert J. Samuelson in today's W. Post:

Can capitalism survive? No. I do not think it can.
Joseph Schumpeter, 1942

The story of American capitalism is, among other things, a love-hate relationship. We go through cycles of self-congratulation, revulsion and revision. Just when the latest onset of revulsion and revision began is unclear. Was it when Lehman Brothers collapsed? Or when General Motors pleaded for federal subsidies? Or now, when AIG's bonuses stir outrage? No matter. Capitalism is under siege, its future unclear.

Schumpeter, one of the 20th century's eminent economists, believed that capitalism sowed the seeds of its own destruction. Its chief virtue was long-term -- the capacity to increase wealth and living standards. But short-term politics would fixate on its flaws -- instability, unemployment, inequality. Capitalist prosperity also created an oppositional class of "intellectuals" who would nurture popular discontents and disparage values (self-enrichment, risk-taking) necessary for economic success.

Almost everything about Schumpeter's diagnosis rings true, with the glaring exception of his conclusion. American capitalism has flourished despite being subjected to repeated restrictions by disgruntled legislators. Consider the transformation. In 1889, there was no antitrust law (1890), no corporate income tax (1909), no Securities and Exchange Commission (1934) and no Environmental Protection Agency (1970).

We have subordinated unrestrained profit-seeking to other values. We've gradually taken into account the external effects (of business) and brought them under control, says economist Robert Frank of Cornell University. External costs include: worker injuries from industrial accidents; monopoly power; financial manipulation; pollution.

Great reform waves often proceed from scandals and hard times. The first discredits business; the second raises a clamor for action. Parallels with the past are eerie. No one in 1928 thought that the head of the New York Stock Exchange would end up in Sing Sing (prison) in 1938, says historian Richard Tedlow of the Harvard Business School. That was Richard Whitney, convicted of defrauding his clients. Flash forward: Bernie Madoff, once head of Nasdaq and a member of the financial establishment, goes to the slammer, a confessed swindler.

Some guesses about capitalism's evolution seem plausible. The financial industry -- banks, investment banks, hedge funds -- will shrink in significance. Regulation will tighten; required capital will rise. Profitability will fall. (Until recently, finance represented 30 percent or more of corporate profits, up from about 20 percent in the late 1970s.) More of the best and brightest will go elsewhere.

But Schumpeter's question remains. Will capitalism lose its vitality? Successful capitalism presupposes three conditions: first, the legitimacy of the profit motive -- the ability to do well, even fabulously; second, widespread markets that mediate success and failure; and finally, a legal and political system that, aside from establishing property and contractual rights, also creates public acceptance. Note that the last condition modifies the first two, because government can -- through taxes, laws and regulations -- weaken the profit motive and interfere with markets.

The central reason Schumpeter's prophecy remains unfulfilled is that U.S. capitalism -- not just companies, but a broader political process -- is enormously adaptable. It adjusts to evolving public values while maintaining adequate private incentives. Meanwhile, the striving character of American society supports an entrepreneurial culture and work ethic -- capitalism's building blocks. As for new regulations, many don't depress profitability because costs are passed along to consumers in higher prices.

It's also wrong to pit government as always oppressing business. Just the opposite often holds. Government boosts business.

Some New Deal reforms helped by making risk more manageable, says Stanford historian David Kennedy. Deposit insurance ended old-fashioned bank panics. Mortgage guarantees aided a post-World War II housing boom. Homeownership rates skyrocketed from 44 percent in 1940 to 62 percent in 1960. Earlier, the federal government distributed 131 million acres of land grants from 1850 to 1872 to encourage railroads. Land, as well as bank charters and government contracts, often went to the well connected. Cronyism is sometimes capitalism's first cousin.

Still, the present populist backlash may not end well. The parade of big companies to Washington for rescues, as well as the high-profile examples of unvarnished greed, has spawned understandable anger that could veer into destructive retribution. Congressmen love extravagant and televised displays of self-righteous indignation. The AIG hearing last week often seemed a political gang beating.

If companies need to be rescued from the market, why shouldn't Washington permanently run the market? That's a dangerous mindset. It justifies punitive taxes, widespread corporate mandates, selective subsidies and meddling in firms' everyday operations (think the present anti-bonus tax bill). Older and politically powerful companies may benefit at the expense of newer firms. Innovation and investment may be funneled into fashionable but economically dubious projects (think ethanol).

Government inevitably expands in times of economic breakdown. But there is a thin line between saving capitalism from itself and vindicating Schumpeter's long-ago prediction.

(Zoon Politikon)

Robert J. Samuelson about Obama's Stimulus Plan

President Obama addressed yesterday Congress on the status of the US economy. Governor Jindal gave then the GOP replica. The strategy of the Dems is very ambitious, targeting energy, healthcare, education. Here is a critical view, expressed by Robert J. Samuelson in Newsweek:

Judged by his own standards, President Obama's $787 billion economic stimulus program, which he signed into law last week, is deeply disappointing. For weeks, Obama has described the economy in grim terms. This is not your ordinary, run-of-the-mill recession, he said at his Feb. 9 press conference. It's the worst economic crisis since the Great Depression. Given these dire warnings, you'd expect the stimulus package to focus exclusively on reviving the economy. It doesn't, and for that, Obama bears much of the blame.

The case for a huge stimulus, which I support, is that it's insurance against the possibility of a devastating downward economic spiral. Spending and confidence are tumbling worldwide. In the fourth quarter of 2008, the U.S. economy contracted at a nearly 4 percent annual rate. In Japan, the economy fell at a nearly 13 percent rate; in Europe, the rate was about 6 percent. These are gruesome declines. If the economic outlook is as bleak as Obama says (and it may be), there's no reason to dilute the upfront power of the stimulus. But that's what Obama's done.

His political choices compromise the program's economic effectiveness. Let's start with the numbers. The Congressional Budget Office (CBO) estimates that about $200 billion will be spent in 2011 or later—well beyond when it will do the most good. For starters, there's $8 billion for high-speed rail. Everyone is saying this is [for] high-speed rail between Los Angeles and Las Vegas—I don't know, says Ray Scheppach, executive director of the National Governors Association. Whatever project or projects are chosen, the decision process, design and construction will occupy many years. It's not quick stimulus.

Then there's $20.8 billion for improved health-information technology—more electronic records and the like. Probably most people regard this as desirable, but here, too, changes occur slowly. The CBO expects only 3 percent of the money ($595 million) to be spent in fiscal 2009 and 2010. The peak year of projected spending is 2014 at $14.2 billion. Or consider the $5.8 billion in outlays for water-treatment plants. The CBO reckons that only 27 percent will be spent in 2009 and 2010.

Big projects take time. The reason they're included in the stimulus is that Obama and Democratic congressional leaders decided to use the legislation as a way of advancing many political priorities instead of just spurring the economy. At his press conference, Obama argued (inaccurately) that the two goals don't conflict. Consider, he lectured, the retrofitting of federal buildings to make them more energy-efficient. We're creating jobs immediately, he said.

Yes—but not many. The stimulus package includes $5.5 billion for overhauling federal buildings. The CBO estimates that only 23 percent of that would be spent in 2009 and 2010.

What's worse, the economic impact of the stimulus is already much less than advertised. The final package includes an obscure tax provision: a "patch" for the alternative minimum tax (AMT). This protects many middle-class Americans against higher taxes and, on paper, adds almost $85 billion of stimulus in 2009 and 2010. One problem: It's not stimulus, as Len Burman of the nonpartisan Tax Policy Center says. [Congress was] going to do it anyway. They do it every year. Strip out the AMT, and the stimulus package drops to about $700 billion, with almost 30 percent spent after 2010, by the CBO's analysis.

The central purpose of the stimulus is to prevent, or minimize, declines in one part of the economy from dragging other sectors down. We want to stop a chain reaction. The next big vulnerable sector seems to be state and local governments. Weakening tax payments create massive budget shortfalls. From now until the end of fiscal 2011, these may total $350 billion, says the Center on Budget and Policy Priorities (CBPP), a liberal research and advocacy group. Other estimates are somewhat lower, but it's clear that states—required to balance their budgets—face huge pressures to cut spending and jobs or raise taxes. All would worsen the recession and, presumably, deepen pessimism.

Yet, the stimulus package offers only modest relief. Using funds from the stimulus, states might offset 40 percent of their looming deficits, says Nicholas Johnson of the CBPP. The effect on localities would probably be less. Congress might have done more by providing large, temporary block grants to states and localities and letting them decide how to spend the money. Instead, the stimulus doles out most of the money through specific programs. There's $90 billion more for Medicaid, $12 billion for special education, $2.8 billion for various policing programs. Even $54 billion of block grants to states impose restrictions on how funds can be spent. More power is being centralized in Washington.

No one knows the economic effects of all this; estimates vary. But Obama's political strategy stunts the impact from what it might have been. Postponed spending weakens the economic benefit. By using the stimulus for unrelated political and policy goals, Obama mandates delays. Obama brags that there are no earmarks in the package. This is technically true if an earmark is considered a project specifically designated for a politician's home district. But hundreds of billions are earmarked for identifiable constituencies. There's another downside: temporary spending increases for specific programs, as opposed to block grants, will be harder to undo, worsening the long-term budget outlook.

Politics cannot be removed from the political process. But here, politics ran roughshod over pragmatic economic policy. The stimulus program was highly partisan from the start. The feeble efforts to win Republican support resulted in changes (including the AMT provision) that actually weakened the package. Obama is gambling that his flawed stimulus will work well enough, or seem to work well enough, that he'll receive credit for restarting the economy—and not engineering a colossal waste.

(Zoon Politikon)

Zakaria and Samuelson about the crisis

Fareed Zakaria and Robert J. Samuelson, among others, express their opinion about the crisis in the most recent issue of Newsweek.

For Fareed Zakaria the most critical aspect is the banking crisis. Says he, we haven't turned the corner on the banking crisis, we can't even see the corner... the American public believes that we have already spent far too much money on bailing out the banks; but the economic fact is that we have not spent enough; without several hundreds of billions of dollars, these organizations will remain zombies and the economy will remain paralyzed.

For Robert J. Samuelson, the most critical aspect is that the crisis is global. He sees three interwoven dimensions: the spending crisis, the lending crisis and the trade crisis. While the first two dimensions could be tackled in principle at national level (by stimulus and rescue politics), the third aspect needs concertation at global level. Says he, as Americans save more of their incomes, Asians should save less, and spend more, to generate growth as opposed to exports. And he concludes, this sort of transformation requires basic political changes in Asia to complement changes in U.S. policies; whether China and other Asian societies can make those changes is unclear; the implications are sobering. The success of Obama's policies lies, to a considerable extent, outside Obama's hands.

Here are the two articles:

1. Fareed Zakaria: There's More To Fear Than Fear


Franklin Delano Roosevelt's first inaugural address is now known for only one sentence: The only thing we have to fear is fear itself. But the audience at the time paid little attention to that line and the newspapers buried it in their reports the next day. As Jonathan Alter recounts in his book The Defining Moment, the words that got the greatest applause were something more specific. I shall ask Congress for the one remaining instrument to meet the crisis, FDR said, broad Executive power to wage war against the emergency, as great as the power that would be given to me if we were in fact invaded by a foreign foe. The next day's headline in The New York Herald Tribune was FOR DICTATORSHIP IF NECESSARY.

We are not in 1933, and no one would advocate or encourage any such power grab today. But President Barack Obama will have to quickly start planning for a set of more extraordinary measures to pull the United States out of its current, unsustainable economic condition. The president has understandably focused his first few days on important campaign promises—ending torture, closing Guantánamo—but he will now have to tackle the biggest challenge facing the country.

The American economy is entering its sharpest economic contraction since 1974—a recession that is likely to be the longest since the Second World War. But that's not the worst of it. The American financial system is effectively broken. Major banks are moving toward insolvency, and credit activity remains extremely weak. As long as the financial sector remains moribund, American consumers and companies—who collectively make up 80 percent of GDP—will not have access to credit, and economic activity cannot really resume on any significant scale. We have not turned the corner. In fact, we can't even see the corner right now. In Washington and in the media, we have all stopped thinking about the rescue of the financial system—that was last year's story—and moved on to the automobile bailout and now the fiscal stimulus. Debates have begun as to whether programs represent pork or investment, whether tax cuts should be preferred to government spending. But despite the injection of hundreds of billions of dollars, and the promise of many billions more, banks are still not lending. Without a functioning financial system, even a massive stimulus will not restore the economy to a normal growth trajectory. Japan tried to jump-start its economy with the world's largest fiscal stimulus in the 1990s. It did nothing for long-term growth in that country.

What about the actions taken so far? The $700 billion TARP, the various federal guarantees, the Federal Reserve's extraordinary actions? The outgoing administration has plausibly claimed that these have worked—in the sense that the financial system has not imploded. Paul Krugman, no fan of the Bush administration's approach to the crisis, acknowledges, without the bank bailout, the whole system would have collapsed. But the bailout has not solved the problem; banks are still buried under mountains of bad assets. And while the Bush administration has made mistakes—most of them clearer in hindsight—the Obama economic team knows that there is no simple answer to this extraordinarily complex situation. Britain, which was widely lauded for its first set of bank bailouts, appears to have stumbled in a second set of policies last week. This might be the time to recall screenwriter William Goldman's cardinal rule about Hollywood: Nobody knows anything.

And yet the government has to do something. President Obama faces a terrible dilemma. He needs to act quickly and on a massive scale. Part of what has unnerved markets has been the incremental nature of the government's response. Will it bail out this bank or that one? On what terms? A broad systemic approach commits the government to one course—one solution—and does not allow for experimentation. It is also enormously expensive. And yet without large-scale action, the financial system will keep bleeding. The politics of this are even worse. The American public believes that we have already spent far too much money on bailing out the banks. But the economic fact is that we have not spent enough. Without several hundreds of billions of dollars, these organizations will remain zombies and the economy will remain paralyzed.

Speed is also crucial. In U.S. policy-making circles in the 1990s it was customary to deride the Japanese government for its weak response to the bursting of Japan's real-estate and stock-market bubble—which led to more than a decade of economic stagnation. In fact the Japanese took drastic action: they injected capital into their banks, lowered interest rates and undertook a massive fiscal stimulus. But they waited for a couple of years before confronting their problems and that made the measures far less effective. The Federal Reserve has learned its lesson and has moved much faster than did the Bank of Japan. But will the American political system move any faster than the Japanese political system?

There remains a spirited debate over what should be done now. But at its heart everyone seems to agree with former Treasury secretary Hank Paulson's original diagnosis—the problem is that banks have huge amounts of bad assets (related to mortgages) on their books. These assets are toxic because they infect the rest of the banks' balances, making it difficult for them to operate. These assets must be disclosed, written down and quarantined for the financial system to start functioning again.

Some now argue for a national aggregator bank that would buy up all the toxic assets, still others for a set of government guarantees and insurance, others still for outright nationalization of the worst-off institutions. Paulson's January rescue of Citicorp seemed to use TARP money in an effective way, getting a large bang for the buck. Each policy has its merits and drawbacks, and I am not expert enough to judge which is the right approach. But it does appear crucial that the government's response be systemic. Ideologies need to be suspended in this period of crisis—we don't hear much about moral hazard anymore. We might temporarily limit practices that are causing a downward spiral—such as marking assets to market, the practice of forcing banks to keep lowering the price of securities (even those that they do not intend to sell), which then forces them to raise more capital. Overall, the government must send markets a clear signal: it is futile to bet against us; we have unlimited tools at our disposal and will use them; and in the end we will win.

Tackling the banks will not be the end of these problems. As President Obama has often pointed out, until the housing market stabilizes, the crisis will continue. Housing is what underpins many of these toxic assets. If prices continue to fall, the assets will only become more toxic. A veteran investment banker, Thomas Patrick, has circulated an innovative proposal that would have Fannie Mae and Freddie Mac close out the securitizations and then refinance all the underlying mortgages, thus dispensing with the toxic paper and stabilizing the mortgages in one swoop. No matter what course is taken, the United States will run trillion-dollar deficits for years, the Federal Reserve will accumulate trillions on its balance sheet, and the American financial and mortgage system will have been semi-nationalized, whatever the euphemisms used to disguise that fact.

This current crisis has resulted in a deep erosion of American power that we have not fully understood. Even in the depths of the Iraq War, when much of the globe was enraged by George W. Bush's unilateralism, people everywhere believed that the United States had the world's most advanced economy and that its capital markets in particular were the most sophisticated and developed. American officials, businessmen and economists lectured far and wide on the need to copy the American system. That system is now seen across the world as a sham, a casino game in which highly paid participants mismanaged risk and highly respected regulators cheered them on. I have traveled to Europe, Asia and the Middle East in the past three months and am writing this from Canada. The attitudes of officials and businessmen range from shock to rage at what they see in the United States.

When he began his run for the White House, Barack Obama thought he could restore American power and leadership by righting our foreign policy, winding down the Iraq War, closing Guantánamo, ending torture. These are all important policies, and I am glad that he is pursuing them. But right now, the most important way for him to restore America's credibility and influence in the world is to rescue the American model.

Obama's rhetoric suggests that he understands this issue. But does Congress? Can the American political system rise to the challenge? The United States will have to enact extraordinary measures, many of them unpopular, run up huge deficits, then just as quickly start to unwind these guarantees and commitments, get onto a path of strict fiscal prudence, reform entitlements and bring our financial house in order. If we don't, the world will talk not of American power but weakness. America will be a model, all right, but of pride and its fall.



2. Robert J. Samuelson: It's Really a Global Crisis

We should all want President Obama to succeed in reviving the economy, but that shouldn't obscure the long odds he faces. We need to recognize that we're not grappling with a single economic crisis. We face three separate crises, which are interwoven but which are also distinct and different. The solution to any one of them won't automatically resuscitate the larger economy if the others remain untreated and unchanged.

Here are the three.

FIRST: the collapse of consumer spending. American consumers represent 70 percent of the economy. Traumatized by plunging home values and stock prices—which have shaved at least $7 trillion from personal wealth—they've curbed spending and increased saving. That's led directly to layoffs and higher unemployment. In December, auto and light-truck sales were down 36 percent from a year earlier.

SECOND: the financial crisis. Lending has atrophied, depriving the economy of the credit to finance new factories, homes and costly consumer purchases (cars, appliances). The deepest cuts involve securitization—the sale of bonds. Investors have gone on strike. In 2008, the issuance of investment-grade corporate bonds dropped 35 percent, reports Thomson Financial. Bonds backing credit-card loans fell 41 percent, and those backing car loans, 51 percent.

THIRD: the trade crisis. There's a mismatch between national spending and saving patterns. High-saving Asian countries relied on export-led growth that, in turn, required American consumers to spend ever-larger shares of their income. Huge trade imbalances resulted: U.S. deficits, Asian surpluses. But as Americans shift from spending to saving, this pattern is no longer sustainable. Asia is tumbling into recession. China may grow 6 percent or less in 2009, half its 2007 rate.

Overcoming any of these crises alone would be daunting. Together, they're the economic equivalent of a combined triathlon and Tour de France.

Consider consumer spending. The proposed remedy is the economic stimulus plan. On paper, this seems sensible. If government doesn't offset declines in consumer spending, housing and business investment, might not the economy spiral downward for several years? Last week, House committees considered an $825 billion package, split between $550 billion in additional spending and $275 billion in tax cuts.

The trouble is that, in practice, the program could disappoint. Parts of the House package look like a giant political slush fund, with money sprinkled to dozens of programs. There's $50 million for the National Endowment for the Arts, $200 million for the Teacher Incentive Fund and $15.6 billion for increased Pell Grants to college students. Some of these proposals, whatever their other merits, won't produce many new jobs.

Another problem: construction spending—for schools, clinics, roads—may start so slowly that there's little immediate boost for the $14 trillion economy. The Congressional Budget Office examined $356 billion in spending proposals and concluded that only 7 percent would be spent in 2009 and 31 percent in 2010.

But suppose the stimulus is a smashing success. It cushions the recession. Unemployment (now 7.2 percent) stops rising at, say, 8 percent instead of 10 percent. Still, a temporary stimulus can't fuel a permanent recovery. That requires, among other things, a strong financial system to supply the credit needs of an expanding economy. How we get that isn't clear.

The pillars of a successful financial system have crumbled: the ability to assess risk, adequate capital to absorb losses and trust among the players—banks, investors, traders. A common denominator in these ills has been the consistent underestimation of losses. Economists at Goldman Sachs now believe that worldwide losses on mortgages, bonds and consumer and business loans total $2.1 trillion, with $962 billion belonging to U.S. banks. In March, the Goldman estimate was about half that. Economist Nouriel Roubini's estimate of losses is higher than Goldman's.

All the new credit programs—the Treasury's Troubled Asset Relief Program and various Federal Reserve lending facilities—aim at counteracting these problems by providing government money and government guarantees. Probably Obama will expand these efforts, despite some obvious problems: if government oversight becomes too intrusive or punitive, it might deter much-needed infusions of private capital into banks. Again, let's assume Obama's policies surmount the obstacles. Credit flows and confidence rises.

Even then, we have no assurance of a vigorous recovery, because—at bottom—the economic crisis is global in scope. The old trading patterns simply won't work anymore. If China and other Asian nations try to export their way out of trouble, they're likely to be disappointed. Any import surge into the United States would weaken an incipient American recovery and possibly trigger a protectionist reaction. Down that path lies tit-for-tat economic nationalism that might harm everyone. Growing trade and investment barriers would shrink markets.

Indeed, if the rest of the world doesn't buy more from America, any U.S. recovery may be feeble. What's needed are policies that correct the underlying imbalances in spending and saving. As Americans save more of their incomes, Asians should save less and spend more, so that they rely more on satisfying their own wants to generate jobs and economic growth as opposed to exports. The great trade discrepancies would shrink. Americans would export more, import less; Asians would do the opposite.

But this sort of transformation requires basic political changes in Asia to complement changes in U.S. policies. Whether China and other Asian societies can make those changes is unclear. The implications are sobering. The success of Obama's policies lies, to a considerable extent, outside Obama's hands.


(Zoon Politikon)