President-Elect Barack Obama will face a daunting set of challenges when he takes office in January—similar, in many ways, to the systemic problems that confronted Franklin D. Roosevelt when he assumed the presidency in 1932 during The Great Depression. Will President Obama put forth a vision, and possess the leadership and legislative moxie, to pursue an aggressive economic stimulus package to stanch the crises in the banking and financial-services industry, energy dependence and global warming, mortgage foreclosures, job losses, health care, and the auto industry? How should he do it? And what should be his priorities? What would be the practical ramifications of a stimulus package, short- and long-term?
The systemic problems that confront President Obama are indeed similar to those that confronted FDR in 1932. Asset prices were run-up in the Roaring Twenties, fueled by greed, easy credit and lax regulation, much as they were in the current sub-prime crisis.
The ensuing Crash of 1929 deteriorated into the Great Depression primarily due to four humongous macro-policy mistakes:
(1) A misguided wage floor that exacerbated unemployment,
(2) Drastic tax increases that demolished business and consumer confidence,
(3) The Smoot-Hawley tariffs that precipitated a global trade war, and
(4) The inactivity of the Fed that led to a shocking liquidity crisis
It appears likely that President Obama may indeed be listening to reason and history, and backing away from switching to the higher pre-Bush taxes on incomes and capital gains, etc. Tax increases deal confidence a crippling blow that might take generations to recover, as evidenced in Japan over the last ten years. Memories of the tax increases of 1932 loom large today as we face similar asset-price collapses—in 1932 the highest tax bracket jumped from 25% to 63%, and corporate taxes went from 12% to 13.75%. By not raising taxes, Mr. Obama will have scored a just-in-time victory in the battle to rebuild consumer confidence (already at its lowest ever reading in November 2008) as well as business confidence.
Mr. Obama cannot afford a trade war. The Smoot-Hawley tariffs of 1930 slapped a tax of 45% on US imports in 1930, and were increased to 60% by 1933. These taxes precipitated countervailing tariffs on our exports, and the ensuing trade war basically shut down global trade.
Data Source: http://www2.census.gov/prod2/statcomp/documents/CT1970p2-08.pdf
While many economists attribute the global depression to our Smoot-Hawley tariffs, this time around, unbelievably, the stakes are even higher! Since the 1980s, the US has been running large trade (current account) deficits, with foreign economies accumulating the equivalent US dollars. These dollar deposits have been promptly invested back in the US in the form of foreign purchases of US government debt (Treasury bonds), businesses, real estate, and more recently, and much to their chagrin, foreigners have bought vast amounts of mortgage-backed securities issued by Fannie Mae and Freddie Mac. The point is that without this massive capital inflow--the “flip side” of the US trade deficit--Uncle Sam goes broke. Before the financial meltdown in September 2008, we needed about $2.4 billion in capital inflow every work day to stay afloat. These inflows—mainly from China, Japan, followed by Brazil and OPEC, funded most of our government spending and served to keep interest rates low.
Data source: www.treas.gov/tic/s1_99996.txt
At the present time, with bailouts galore (currently up to $7.76 Trillion, according to Bloomberg!), and more infrastructure spending planned, it is imperative that there be no disruption in these inflows. A trade war would demolish capital inflows, which in turn would render us insolvent.
The Obama stimulus plan is as yet not fully articulated, but is likely to be on the order of some $500 billion or more over two years. The responsible way to fund government spending is by borrowing from domestic and foreign investors (issuing Treasury bills and bonds). How long can this go on? Is there an upper limit to the borrowing? Past research has indicated that when the Federal budget deficit/GDP ratio exceeds 5%, bond-financed deficits become non-sustainable—domestic and foreign investors stop lending to Uncle Sam. At this point, the Fed has to resort to a mind-numbing monetization to “finance” the deficit, and this is, of course, the road to hyperinflation. The US ratio of fiscal deficit -to- GDP is projected to exceed 5% next year, but there is hope. This time around, given the global contagion, with virtually all major economies in recession, there is no other "safe haven" competing for global capital, and this may allow the US to be able to borrow more than conventionally thought possible. Technically, this may lead to a sustainable maximum deficit/GDP ratio of perhaps, 8-9%, and may place some timely fiscal ammunition within Mr. Obama’s reach.
Finally, Mr. Obama has to resist the urge to roll back the Reagan deregulation. In the wake of the financial malfeasance of the last few years, and the Enron debacle, the country is in a regulating mood. And, smarter and in some cases more strict regulation of previously un- and under-regulated financial instruments and practices may be warranted. But Mr. Obama should not throw out the baby with the bath-water. Innovation, R&D, venture capital inflows, and explosions in productivity all spring from a free-flowing creative environment, uncluttered by invasive government regulation. Our greatest strength lies in our ability to bounce back as a country, time and again, from seemingly hopeless situations. This applies to innovation and business too. Just when we “lost” automobiles to the Japanese, we invented minivans and SUVs. Just when we lost computers to foreign competition, we invented the internet and the browsers. And when the Japanese and Koreans made semiconductor chips better and cheaper, we invented microprocessors. Once again, the US needs to bring the world the “next big thing”, funded by the venture capital—by the global “smart money” and not by US taxpayers. While Government stimulus-investment is a helpful prescription at the present time, Government spending is a blunt instrument, unsuitable for allocating resources to emerging technologies. By retaining the incentives and friendly environment for private innovation, private capital will naturally flow to those areas of the US economy (biotech, nanotech, and whatever else comes next) which offer the highest potential.
With low regulation, low taxes, gifted leadership, American creativity, and the undeniable “Obama dividend” we can make it happen. The world is waiting.
-Farrokh Langdana, Ph.D.
Rutgers University Business School
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